"The Investor's Manifesto:" Chapter 3


We continue our chapter-by-chapter notes on the "Investor's Manifesto" by Bernstein with Chapter 3, about the different assets you'll keep in your portfolio, and how you'll balance them.

And here, it's appropriate to review our goals in investing. We are not striving to rich quickly. If that's your goal, you're on the wrong website. Our goal is to build up enough financial reserves so that we can retire (at the age of our choosing) and live secure, fulfilling lives thereafter, without running out of money before we die. Optionally, we can also intend to leave an inheritance to children or a bequest to charity. All of this is about getting rich slowly, not quickly. (The best way to make a small fortune quickly is to start with a large fortune.)

Investing in assets with some risk gets you better returns than investing in assets with little or no risk. Why not just invest everything in safe assets? Currently, safe assets have returns of close to zero, and inflation has historically averaged 3%. "Retirees who spend 5 percent of their portfolios each year and lose 3 percent more to inflation will see the real value of their savings deplete at roughly 8 percent per year, and they will run out of money in about 12.5 years." Not a rosy picture unless you like the taste of dog food.

Now, on to the notes from Chapter 3.

The Four Steps To A Secure Retirement

Next Bernstein hits on the four main steps to building a secure financial future:

First, save. If you can not save, investing will not help you. "Save as much as you can, and do not stop saving until you die."

Second, put away enough savings to sustain you for at least six months in the event of job loss or serious illness.

Third, diversify as widely as you can.

Fourth, diversify using index funds.

Portfolio Allocation -- Stocks vs Bonds

There are really only two decisions an investor will make in building their portfolio: First, the allocation between stocks and bonds, and second, the allocation of the stock portion between various classes of stocks.

Younger investors should own a higher percentage of stocks because they will continue earning for many years in the future, giving them many opportunities to buy stocks at low prices if the stock market goes down. For young investors, their future earnings dwarf their savings and investments, and they can afford to take more risks for greater future reward.

Older investors have much lower future earnings, and may need to withdraw money from their investments to fund living expenses at a time when the market is low. This is obviously exactly the wrong time to sell investments, but everyone needs to eat. Older investors should have a higher percentage of their investments in bonds.

The most common rule of thumb for allocating between stocks and bonds is to allocate your age to bonds. Thus, at age 30, 30% of your portfolio should be in bonds an 70% in stocks. At age 50, they would be equally divided, and at age 65, 65% of your portfolio would be in bonds and 35% in stocks.

In addition, you could modify your bonds/stocks split by your risk tolerance. If you were extremely risk tolerant you could move an additional 20% over to the stocks side, and if you were extremely risk-averse, you could move 20% over to bonds. Be careful in judging your risk tolerance, because if you think it's higher than it actually is, you'll end up panicking when your portfolio declines, and selling your stocks at the bottom of the market, when you should be buying.

It is one thing for investors to look at a spreadsheet when they are 25 and decide that they can tolerate an 80/20 portfolio that might, under extraordinary circumstances, lose 40 percent of its value. It is something else entirely to live through such misfortune with equanimity.

Another rule of thumb would be to increase the portion of your portfolio allocated to bonds until you sleep soundly at night.

Portfolio Allocation -- Classes of Stocks

A belief in the Efficient Market Hypothesis gives you a simple strategy here -- buy and hold an index fund that contains the entire basket of the world's stocks. One way to do this is via the FTSE World Index.[1. You can purchase this index in the US via the Vanguard Total World Stock Index Fund. Bernstein does not advise this because he believes the management fees are too high (although they appear to be lower than when he wrote the book) and because he believes the fund is weighted too heavily towards foreign stocks for US investors. ]

A Digression Into Market Cap Weighting

Market capitalization is the total value of all the outstanding shares in a company. If a company had 1,000 shares, and the current market price of those shares was \\(2, the market cap of that company would be \\)2,000. The average US corporation has a market cap of about a billion dollars.

In a market cap-weighted index fund, the fund owns stocks in a company in proportion to that companies share of the total stock market capitalization. For instance, per Bernstein, at the end of 2008, ExxonMobil accounted for 1.9% of the value of all the stocks in the entire world. Accordingly ExxonMobile stocks accounted for 1.9% of the FTSE World Index.

The beauty of cap-weighting is that it is 'fire and forget'; no matter what the stock price does, the fund manager does not have to buy or sell. If the company’s stock quadruples relative to the rest of the index, so does its share of the index and of any index fund that mimics it. The same happens if its stock price falls—so will its market cap fall, and so will its representation in the index. Remember, buying and selling costs money, and the less of it you do, the better. For a mutual fund, because of the high transactional costs of trading large share volumes, this goes double.

Portfolio Rebalancing

So how does this work? Let's say our stock investments are divided equally between a total US stock market index fund and an international index fund.[2. This is just for purposes of exposition. Don't do it in real life.]

At the end of a year, US stocks have gone down, and your international index fund has done very well, so instead of 50-50, your portfolio is now allocated 60% to foreign stocks and 40% to US stocks. You will sell a portion of your international index fund and use the proceeds to buy more shares in your US index fund, until you are allocated 50-50 again.

The wonderful thing about this is that, in addition to reducing your risk, you have increased your return. By selling the foreign stocks, you're selling high, and by buying the US stocks, you're buying low. Doing the right thing is built into the system!

The Right Mix

So the stock portion of your portfolio should be divided somewhere between 80/20 and 60/40 domestic/foreign. You might do 70% Total US Stock Market and 30% Total Foreign Market.

If you had a 60/40 stock/bond split, your overall portfolio would look like this:

This simple, amateurish portfolio will beat the overwhelming majority of all professional investors over the next few decades. It can be improved upon, but not without additional effort and some risk of making things worse.

What will we change? First, add in some more asset classes, like REITs. Second, separate foreign stocks into those of developed nations and emerging-market nations. Third, add some risk premiums by increasing exposure to value stocks and to small stocks. Here's what that looks like:

Now we're starting to get some management issues -- the effort we referred to above. For example, the minimum investment for the Vanguard REIT fund is \\(3,000, implying a total portfolio size of more than \\)100,000. If your portfolio is smaller than that, just use the three-part portfolio we listed first. Also, the total US market fund already includes some REITs, so your actual REIT allocation will be about 3.8%.

If you have a large portfolio, in excess of \\(250-\\)500k, and you can handle the complexity, you way want to split your domestic and foreign developed market allocation:

  • 10% US Large Market
  • 9% US Small Market
  • 10% US Large Value
  • 10% US Small Value
  • 3% REITs
  • 3% Foreign Developed Large Market
  • 3% Foreign Developed Small Market
  • 3% Foreign Developed Large Value
  • 3% Foreign Developed Small Value
  • 3% Emerging Markets Large Market
  • 3% Emerging Markets Large Value
  • 40% Total Bond Market

Asset Classes to Avoid

We'll cover this further in chapter 5 apparently, but Bernstein doesn't trust any of the companies selling commodities funds. In addition, he's not enthusiastic about gold, silver, and platinum mining companies, and has very limited enthusiasm for international REITs.

The stocks of gold, silver, and platinum mining companies provide much of the same diversification benefits as commodities futures. I am less enthusiastic about them now than I was a few years ago for two reasons. First, my old favorite in this area, the Vanguard Precious Metals and Mining Fund, has broadened its charter to invest in companies that mine base metals (mainly aluminum, copper, and lead) and other natural resources, and this significantly decreases its diversification value. Second, gold and gold stocks have also become an asset class du jour, with high recent returns and a good deal of publicity. Unless you are going on the lam, buying gold bullion itself, gold coins, or an ETF that invests in them, is rarely a good idea. The long-term, real return of the yellow metal itself is zero—an ounce of it bought a fine men’s suit in Shakespeare’s time, and still does today. In addition, gold yields no dividend and incurs storage costs.

Another asset class worthy of consideration is international REITs—property companies in Europe, Asia, and Australia. Like U.S. REITs, they have suffered recent massive price falls, and consequently yield dividends in excess of 8 percent. They may also offer even more diversification than their domestic cousins. Their only drawback is that they are only available in passive funds to independent small investors in ETF form, and thus incur commissions and spreads. Since this asset class should not constitute more than a few percent of anyone’s assets, I do not recommend including it in a portfolio unless its size is at least several hundred thousand dollars, and you can tolerate a highly complex mix of assets.