The quest for maximum returns with limited risk is an eternal one. However, chasing big returns ignores the fact that the average investor actually loses money, when you consider the ravages of fees, taxes and inflation.
How could this be?
Most investors use brokers or advisors who place them in actively managed portfolios and mutual funds in an effort to "beat the markets." These investors typically underperform the markets due primarily to the high cost of active management.
You can easily capture market returns. I set forth a simple portfolio that would permit you to do so in a previous blog: It's So Easy Your Broker Could Do It! .
Now for the frosting on the cake. The availability of a wide array of ETFs gives you the possibility of adding to market returns, without stock picking, market timing or manager picking.
I deal with this subject in this week's column.
Thanks for your questions. Please keep them coming.
Question: You have convinced me to avoid active management. But how do I put together a portfolio with the best asset allocation?
Answer: For most investors, the Vanguard Total Stock Market Index Fund (VTSMX) and the Vanguard Total International Stock Index Fund (VGTSX) provide adequate diversification for both the domestic and international stock markets. These two mutual funds, plus an index fund that benchmarks the Lehman Bros. Aggregate Bond Index (like the Vanguard Total Bond Index Fund [VBMFX]), would result in a vast improvement in the returns of the average investor, based on historical data.
There is considerable academic data that tilting your stock asset allocation to capture the excess returns historically found with small and value stocks will produce higher returns with less volatility. Much of this research is based on the ground breaking studies published by Eugene Fama and Kenneth French.
For example, over a period of 74 years, the small cap value index had a total return 12 times the S&P 500.
So, why not invest all of your money in small and value stocks?
Because this portfolio would be too volatile for almost any investor.
The funds managed by Dimensional Fund Advisors permit investment advisors to utilize its wide assortment of global large and small value stocks. The typical DFA portfolio consists of approximately 15 mutual funds and includes a globally diversified mix of value and small stock funds, as well as domestic and foreign stock funds, all passively managed. (Full disclosure: I own DFA funds and recommend them to my individual and institutional clients).
Sophisticated investors who feel comfortable replicating the small and value tilt in their portfolios on their own now have the means to do so. Consider the following ETFs:
- iShares MSCI Emerging Markets Index Fund (EEM);
- iShares MSCI EAFE Small Cap Index Fund (SCZ);
- iShares Russell 2000 Index (IWM).
You would need to be sure the balance of your portfolio included the other sectors in the domestic and foreign stock markets as well as exposure to domestic and foreign bonds.
Finally, since all of your returns depend upon the right asset allocation, you should take an asset allocation questionnaire to determine your capacity for risk. There is a free, interactive one on my website.
The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.