Archives for December 2013

Due to a lack of tax-deferred space, my current tax bracket, and the current interest rate spread over US Treasury bonds, I started investing part of my portfolio in Vanguard’s tax-exempt municipal bond funds. As a result, I try to read every single muni bond article that Vanguard puts out. In this month’s blog post Municipal debt, Detroit, and diversification, one of the topics covered was the importance of minimizing fund fees.

Research shows that lower-cost mutual funds have tended to perform better than higher-cost funds over time. So instead of worrying about things we can’t control (e.g., how a judge in a municipal bankruptcy is going to decide a case), we should focus on controlling the one variable that we can, which is cost.

The article included the chart below, which plots the net fund expense ratios of municipal bond funds against their 5-year annualized returns.

Source: Vanguard Blog, Morningstar

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More charts! The Atlantic has a big collection of 41 economic charts for 2013. Some are neat, some I don’t understand, and some I don’t think anyone really understands. 😉 Here are two investing-related graphs that caught my eye. The first one shows that correlations between multiple asset classes have dropped significantly recently. Submitted by Joe Weisenthal of Business Insider, who states that “one of the characteristics of a crisis is extreme correlation between multiple asset classes: everything trades up or down together.”

The second one shows the cumulative investment inflows into stock and bonds funds over the last year. Submitted by Joshua Brown of The Reformed Broker, who suggests that this shows “America is regaining confidence in the institution of investing again”.

When I see low correlations, it feels like a good time to rebalance your asset allocation. At the same time, it certainly looks like stocks have some momentum right now. Perhaps it’s best just to take a long nap until 2014.

In the post Foreign Stocks For The Long Run, author Rick Ferri recently revisited the topic of how much international stock exposure you should add to your portfolio’s asset allocation. I also have an older post about this – Choosing An Asset Allocation: Deciding On The Domestic/International Ratio – as part of my Rough Guide to Investing series.

One of the reasons to invest in international stocks is for the diversification benefit. While both have historical average returns of 8-10% annually before inflation, they don’t always move in sync (not perfectly correlated). As a result, Markowitz showed us you can attain a higher risk-adjusted return by holding some of both as opposed to just one or the other. So how much of each should you hold?

In my 2007 post, I posted this chart taken from the then-current edition of the bestseller A Random Walk Down Wall Street by Burton Malkiel. It maps the risk/return for portfolios that range from 100% US stocks to 100% EAFA (Non-US Developed countries) for the period January 1970 to June 2006:

From 1970-2006, foreign stocks outperformed US stocks, while the point of optimal risk-adjusted returns was a split of 76% US and 24% Foreign (70% is a typo).

However, the updated data collected by Ferri shows a different yet similar story (see chart below). From 1970-2013, we see that now US stocks outperformed foreign stocks instead, with the point of optimal risk-adjusted returns at 70% US and 30% Foreign.

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Howard Marks is famous among many investors for his Client Memos as the chairman and cofounder of Oaktree Capital Management. He even weaved many of the older ones into a book, which I read and reviewed. I now try to read every one that comes out. Here’s the most recent client memo dated November 26th, 2013 [pdf]. Below are a few selected excerpts. First, a quick lesson on risk aversion:

Risk aversion is the essential element in sane markets. People are supposed to prefer safety over uncertainty, all other things being equal. When investors are sufficiently risk averse, they’ll (a) approach risky investments with caution and skepticism, (b) perform thorough due diligence, incorporating conservative assumptions, and (c) demand healthy incremental return as compensation for accepting incremental risk. This sort of behavior makes the market a relatively safe place.

In short, it’s my belief that when investors take on added risks – whether because of increased optimism or because they’re coerced to do so (as now) – they often forget to apply the caution they should. That’s bad for them. But if we’re not cognizant of the implications, it can also be bad for the rest of us.

What about now? Marks does see an increase in risk tolerance recently. But how bad is it?

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