Archives for November 2007

So far we’ve looked into the stock/bond ratio and the domestic/international ratio. Instead of taking these total stock markets as whole, you can further subdivide them into “styles” or additional asset classes. Although these vary in specific definition, in the general layout is shown by the Morningstar style box shown to the top right.

Value vs. Growth Stocks
Value stocks are those that tend to trade at a lower price relative to objective measures like dividend yield, earnings, sales, or book value. For example, you could screen by low P/E ratio. To generalize, value stocks tend to have low growth prospects or are in unglamorous industries. On the other side are growth stocks, which have high relative valuations. Again to generalize, these companies tend to have big growth expectations like Google or Apple.

If you look across long periods of history, it actually turns out that value stocks outperform growth stocks as a whole. People use different ways to explain this phenomenon. One camp says that value stocks are riskier because they are more likely to fail due to poor prospects, so obviously they should have higher return. Others use a behavioral view, saying that since they are “boring” or “ugly” stocks then they tend to be undervalued by investors in general.

Either way, including value stocks as part of a portfolio has also historically provided a diversification benefit, as can be shown by this graph from the excellent book All About Asset Allocation:
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I don’t know if this is the proper next step, but after deciding on a stock/bond ratio for myself, I want to think about the specific breakdown of stocks (equity). As mentioned when talking about investing in total markets, you could simply “own the world” using just two funds or ETFs and weighting them according to market capitalization – using one Total US fund and one All-World Except-US fund:

If you use the ETFs, the total weighted expense ratio would be a mere 0.17% annually!

Concerns About Investing Abroad
However, according to various surveys the average US investor has much less than 55% of their equity portfolio in international stocks. Here are a few reasons that have been cited:

• Country/political risk – This includes the possibility that the economy of certain countries could collapse due to war or other internal strife. Also many governments have less oversight and transparency than the US and other developed countries.
• Currency risk – These days it seems like people want to hedge against a falling dollar, but only recently people were worried about a strengthening dollar affecting international investments. Either way, it does add an element of risk.
• Added cost – Investing in international mutual funds usually cost more in management fees.
• Existing exposure – Some statistics show that a very large chunk of revenue from US-based companies now come from outside our borders, so even without adding international companies we are already being exposed to many of the same effects. This also explains the recently increasing correlation between domestic and international stocks.
• Performance-chasing – Recently international funds have been on a very good run. Some believe this is the main factor in increasing foreign exposures, as opposed to fundamental factors.

Historical Risk/Reward Relationship – Benefits of Diversification
On a very general level, the reason to invest in international stocks as it pertains to Modern Portfolio Theory is that you get a diversification benefit. Historically, international stocks in general have had higher average returns, but also higher risk (volatility). But due to low-ish correlation, mixing domestic and international stocks has resulted in less risk and greater return.
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Last time I did a really simplified overview of Modern Portfolio Theory. Much of the credit for this is due to a fellow name Harry Markowitz, who figured out that if you combine two assets with the same return that aren’t perfectly correlated, this diversification can result in reduced risk without reducing return. Even if you don’t combine two assets with the same return, combining two assets that have low correlations (don’t move together) will get you a better reward/risk ratio. Markowitz later won a Nobel Prize for his work in this area.

Stocks vs. Bonds
Studies have shown that somewhere between 77% and 94% of the variability in portfolio returns are determined by asset allocation. So our goal is to use asset classes with low correlation to get the best reward/risk ratio. One of the most popular examples of assets that have low correlation is stocks and bonds. Accordingly, adjusting your ratio between stocks and bonds is one of the most basic ways to adjust the amount of risk you wish to take in a portfolio.

The chart below shows the risk/return trade-off between bonds and stocks for 1980-2004. The stock portfolio is represented by the S&P 500 index, while the bond portfolio contains 60% five-year Treasury notes and 40% long-term Treasury bonds. The portfolios range from 100% bonds, to 95% bonds/5% stocks, 90% bonds/10% stocks, all the way to 100% stocks. (via this AAII article)

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