Mark Cuban recently had a post on his blog called Wall Street’s new lie to Main Street – Asset Allocation. In it, he quotes a recent newspaper article that presents this model asset allocation:
15% in an S&P 500 index fund
5% in a small-capitalization value fund
20% in a diversified international stock fund
5% in an emerging markets international fund
5% in Real Estate Investment Trusts
10% in stocks with a history of paying competitive and increasing dividends
10% in a diversified portfolio of convertible securities
5% in a U.S. Treasury inflation-indexed bonds and notes
15% in an international bond fund with traditional fixed coupon bonds
5% in an international bond fund for inflation-indexed bonds
5% in cash equivalents.
To which he translates as:
I want you to invest 5pct in cash and the rest in 10 different funds about which you know absolutely nothing. I want you to make this investment knowing that even if there were 128 hours in a day and you had a year long vacation, you could not possibly begin to understand all of these products. In fact, I don’t understand them either, but because I know it sounds good and everyone is making the same kind of recommendations, we all can pretend we are smart and going to make a lot of money. Until we don’t
Now, I don’t rely on Cuban for investing advice, but I do think he has a point. Over the past couple of years, I have to come value simplicity and also belief in investing. Now, I think asset allocation is important. To me, asset allocation is owning different assets that (1) all have good prospects for long-term returns above inflation, and (2) don’t necessarily move in the same direction. This allows you to reduce volatility when one things zigs while the other zags.
However, this also means you have to own said assets both when they are up and down. If the only reason you own something is because it’s in some financial newspaper article, then you’ll just sell it when the same newspaper starts touting the next new thing. This will likely lead to worse returns than just holding cash. You should only invest in asset classes that you understand and have strong reasons to hold in both good times and bad.
Here are the asset classes that I have strong beliefs in. This is of course my own personal opinion, but I’ll try to share my reasoning as well.
I believe in US stocks as a way to own domestic companies that are creating value and making money. I like to own a “total market” fund that owns essentially every stock in proportion to their value. I own big companies to small companies. If a certain small company turns into a big company, I’ll own it. Instead of searching for a needle in a haystack, I just buy the haystack. More in-depth explanation here. Stocks should expected to give you a bumpy ride. But I believe that in the long-term, they will provide a decent return.
I try not to split this class up too much into value or growth, or micro-cap/small-cap/mid-cap/large-cap. It just gets confusing to me. I do have a small addition of a small-cap value index fund, because these companies are such a small part of the “total market” that I figure a little extra can’t hurt.
I also believe in international stocks. Other developed countries also have smart people making innovative products. Many US companies make a lot of their money internationally, and many international companies make a lot of money from US consumers. International stock funds are usually in their own currency, which provides some currency hedging when the dollar is weaker. Again, I like to own a low-cost, passive fund that owns the entire market in proportion to their values.
I believe in holding domestic and foreign stocks nearly in proportion to their world market cap. Currently that is about 45% US and 55% foreign. I think it’s fine to add a slight bias to domestic stocks so that you are less affected by currency swings – this is assuming you are still spending US dollars.
High Quality Bonds
I was swayed by the arguments of David Swensen in his book Unconventional Success, which argued that alignment of interests is important. With stocks, they want to make profits, and you want them to make profits. In contrast, the job of bond issuers is to look as creditworthy as possible, even if they are not. This keeps the interest rates they pay lower. The safety ratings of bonds usually only get worse – usually quickly and unexpectedly as we saw with subprime mortgages. Ratings agencies are not very good at their jobs, mostly in a reactionary role, and are paid by the same people they rate.
Therefore, I only hold bonds with the highest safety ratings. This means primarily US Treasury bonds, inflation-linked TIPS, and FDIC-insured cash equivalents. In limited cases, I might break this rule slightly with high quality, short-term municipal bonds and insured stable value funds. I don’t invest in corporate bonds, high-yield bonds, mortgage bonds, or bonds in emerging markets.
Real Estate Investment Trusts
I believe that real estate is a different type of investment with unique characteristics, and Real Estate Investment Trusts (REITs) are an easy and relatively direct way of owning real estate. REITs own and operate income-producing real estate such as apartments, shopping centers, office buildings, hotels and warehouses. They are required to distribute at least 90% of their taxable income to shareholders. More on REITs here. I don’t have to collect rent, screen tenants, or fix anything. Over the long-term, the returns should outpace inflation.
For all of these asset classes, I can see past a long period of low returns, because I feel confident in their structure and reasons for long-term solid returns. Who knows, I may be wrong, but I’m willing to bet my hard-earned money on them. Next up, I’ll talk about asset classes that I may like at times, but am either not educated enough about or just not convinced by their proponents.