Step One: Risky Assets, Riskless Assets Distilled to its essence, there are only two kinds of financial assets: those with high returns and high risks, and those with low returns and low risks. The behavior of your portfolio is determined mainly by your mix of the two. As we learned in Chapter 1, all stocks are risky assets, as are long-term bonds. The only truly riskless assets are short-term, high-quality debt instruments: Treasury bills and notes, high-grade short-term corporate bonds, certificates of deposit (CDs), and short- term municipal paper. To be considered riskless, their maturity should be less than five years, so that their value is not unduly affected by inflation and interest rates. Some have recently argued that Treasury Inflation Protected Securities (TIPS) should also be considered riskless, in spite of their long maturities, because they are not negatively affect- ed by inflation. What we’ll be doing for the rest of this chapter is setting up a “lab- oratory” in which we create portfolios composed of various kinds of assets in order to see what happens to them as the market fluctuates. How we compute the behavior of these portfolios is beyond the scope of this book; for those few of you who are interested, I suggest that you read the first five chapters of my earlier book, The Intelligent Asset Allocator. Suffice it to say that it is possible to simulate with great accu- racy the historical behavior of portfolios consisting of many assets. Keep in mind that this is not the same as predicting the future behav- ior of any asset mix. As we discussed in the first chapter, historical returns are a good predictor of future risk, but not necessarily of future return. Let’s start with the simplest portfolios: mixtures of stocks and T-bills. I’ve plotted the returns of Treasury bills, U.S. stocks, as well as 25/75, 50/50, and 75/25 mixes of the two, in Figures 4-1 through 4-5. In order to give an accurate idea of the risks of each portfolio, I’ve shown them on the same scale. As you can see, when we increase the ratio of stocks, the amount lost in the worst years increases. This is the face of risk. In Table 4-1, I’ve tabulated the return, as well as the damage, in the 1973–74 bear markets for a wide range of bill/stock combinations. Finally, in Figure 4-6, I’ve plotted the long-term returns of each of these portfolios ver- sus their performance in 1973–1974. Figure 4-6 provides the conceptual heart of this chapter, and it’s worth dwelling on for a few minutes. What you are looking at is a map of portfolio return versus risk. The numbers along the left-hand edge of the vertical axis represent the annualized portfolio returns. The higher up on the page a portfolio lies, the higher its return. The num- 110 The Four Pillars of Investing The Perfect Portfolio 111 Figure 4-1. All Treasury bill annual return, 1901–2000. (Source: Jeremy Siegel.) Figure 4-2. Mix of 25% stock/75% Treasury bill annual returns, 1901–2000. (Source: Jeremy Siegel.) 112 The Four Pillars of Investing Figure 4-3. Mix of 50% stock/50% Treasury bill annual returns, 1901–2000. (Source: Jeremy Siegel.) Figure 4-4. Mix of 75% Stock/25% Treasury bill annual returns, 1901–2000. (Source: Jeremy Siegel.) bers on the horizontal axis, at the bottom of the graph, represent risk. The further off to the left a portfolio lies, the more money it lost in 1973–74, and the riskier it is likely to be in the future. It’s important to clear up a bit of confusing terminology first. Until this point in the book, we’ve used two designations for fixed-income securities: bonds and bills, referring to long- and short-duration obli- gations, respectively. Bonds and bills are also different in one other respect: bonds most often yield regular interest, whereas bills do not— they are simply bought at a discount and redeemed at face value. The most common kinds of bills in everyday use are Treasury bills and commercial paper, the latter issued by corporations. Long-duration bonds are generally a sucker’s bet—they are quite volatile, extremely vulnerable to the ravages of inflation, and have low long-term returns. For this reason, they tend to be bad actors in a port- folio. Most experts recommend keeping your bond maturities short— certainly less than ten years, and preferably less than five. From now on, when we talk about “stocks and bonds,” what we mean by the lat- ter is any debt security with a maturity of less than five to ten years— T-bills and notes, money market funds, CDs, and short-term corporate, government agency, and municipal bonds. For the purposes of this book, when we use the term “bonds” we are intentionally excluding The Perfect Portfolio 113 Figure 4-5. All-stock annual returns, 1901–2000. (Source: Jeremy Siegel.) long-term treasuries and corporate bonds, as these do not have an acceptable return/risk profile. I’ll admit that this is a bit confusing. A more accurate designation would be “stocks and relatively short-term fixed-income instruments,” but this wording is unwieldy. The data in Table 4-1 and the plot in Figure 4-6 vividly portray the tradeoff between risk and return. The key point is this: the choice between stocks and bonds is not an either/or problem. Instead, the vital first step in portfolio strategy is to assess your risk tolerance. This will, in turn, determine your overall balance between risky and risk- less assets—that is, between stocks and short-term bonds and bills. Many investors startatthe opposite end of theproblem—by deciding upon theamountofreturn they requiret omeet their retirement, educa- tional, life style, orhousing goals. This isamistake. If your portfolio risk exceeds your tolerance forloss, there isahigh likelihood that you will abandon your planwhen the going gets rough.That is not to say that yourreturn requirements are immaterial. For example, if you havesaved a largeamount forretirementand do not plan to leavealarge estate for 114 The Four Pillars of Investing Table 4-1. 1901–2000, 100-Year Annualized Return versus 1973–1974 Bear Market Return Annualized Return Total Return Stock/Bill Composition1901–2000 1973–1974 100%/0% 9.89% Ϫ41.38% 95%/5% 9.68% Ϫ38.98% 90%/10% 9.46% Ϫ36.52% 85%/15% 9.23% Ϫ34.03% 80%/20% 8.99% Ϫ31.48% 75%/25% 8.74% Ϫ28.89% 70%/30% 8.48% Ϫ26.25% 65%/35% 8.21% Ϫ23.57% 60%/40% 7.93% Ϫ20.84% 55%/45% 7.64% Ϫ18.07% 50%/50% 7.35% Ϫ15.25% 45%/55% 7.04% Ϫ12.38% 40%/60% 6.72% Ϫ9.47% 35%/65% 6.40% Ϫ6.51% 30%/70% 6.06% Ϫ3.51% 25%/75% 5.72% Ϫ0.46% 20%/80% 5.36% 2.64% 15%/85% 5.00% 5.78% 10%/90% 4.63% 8.97% 5%/95% 4.25% 12.21% 0%/100% 3.86% 15.49% yourheirsor to charity, you may requireavery lowreturn to meet your ongoing financialneeds. In that case, there would be littlesense in choosing a high risk/return mix, no matterhowgreat yourrisk tolerance. There’s another factor to consider here as well, and that’s the prob- ability that stock returns may be lower in the future than they have been in the past. The slope of the portfolio curve in Figure 4-6 is steep—in other words, in the twentieth century, there was a generous reward for bearing additional portfolio risk. It is possible, for example, that the future risk/reward plot may look something like Figure 4-7, with a much lower difference in returns between risky and risk-free investments. In this illustration, I’ve assumed a 7% return for stocks and a 5.5% return for bonds. In such a world, it makes little sense to take the high risk of an all-stock portfolio. Finally, it cannot be stressed enough that between planning and execution lies a yawning chasm. It is one thing to coolly design a port- folio strategy on a sheet of paper or computer monitor, and quite another to actually deploy it. Thinking about the possibility of losing 30% of your capital is like training for an aircraft crash-landing in a simulator; the real thing is a good deal more unpleasant. If you are just starting out on your investment journey, err on the side of conser- vatism. It is much better to underestimate your risk tolerance at an The Perfect Portfolio 115 Figure 4-6. Portfolio risk versus return of bill/stock mixes, 1901–2000. early age and adjust your risk exposure upwards later than to bite off more than you can chew up front. Millions of investors in the 1920s and 1960s thought that they could tolerate a high exposure to stocks. In both cases, the crashes that fol- lowed drove most of them from the equity markets for almost a gen- eration. Since the risk of your portfolio is directly related to the per- centage of stocks held, it is better that you begin your investment career with a relatively small percentage of stocks. This flies directly in the face of one of the prime tenets of financial planning conventional wisdom: that young investors should invest aggressively, since they have decades to make up their losses. The problem with an early aggressive strategy is that you cannot make up your losses if you per- manently flee the stock market because of them. This all adds up to one of the central points of asset allocation: Unless you are absolutely certain of your risk tolerance, you should probably err on the low side in your exposure to stocks. Step Two: Defining the Global Stock Mix Why diversify abroad? Because foreign stocks often zig when domes- tic markets zag, or at least may not zig as much. Let’s look at the most recent data. 116 The Four Pillars of Investing Figure 4-7. Likely future portfolio risks/returns. In the early part of this century, the international capital markets were a good deal more integrated than they are now. It was com- monplace for an Englishman to buy American bonds or French stocks, and there were few barriers to cross-border capital flow. The two World Wars changed that; the international flow of capital recovered only slowly afterwards. The modern history of international diversifi- cation properly begins in 1969, with the inception of Morgan Stanley’s EAFE (Europe, Australasia, and Far East) Index. As of year-end 2000, there is a 32-year track record of accurate foreign returns. For the peri- od, this index shows an 11.89% annualized return for foreign invest- ing, versus 12.17% for the S&P 500. Why invest in foreign stocks if their returns are the same, or perhaps even less than U.S. stocks? There are two reasons: risk and return. In Figure 4-8, I’ve plotted the annual returns of the two indexes. Note how there can be a considerable difference in return between the two in any given year. Particularly note that during 1973 and 1974, the EAFE lost less than the S&P: a total 33.16% loss for the EAFE versus a The Perfect Portfolio 117 Figure 4-8. Returns for S&P 500 and foreign stocks, 1962–2000. 37.24% loss for the S&P 500. What this means is that foreign investing provided a bit of cushion to the global investor. An even more vivid case for diversifying into foreign stocks is made by looking at returns decade by decade, as shown in Figure 4-9. Notice how during the 1970s, the return of the S&P 500 was less than infla- tion—that is, it had a negative real return—whereas the EAFE beat inflation handily. You’ll also see that the EAFE beat the S&P 500 by a similar margin in the 1980s. Thus, for a full two decades you would have been very happy with global diversification. This would have been particularly true if these two decades had been your retirement years, since a U.S only portfo- lio would have very likely run out of money due to its relatively low returns. In the 1990s, the law of averages finally caught up with for- eign stocks, souring many on global diversification. Despite the slightly lower rewards of foreign stocks, the most pow- erful argument, paradoxically enough, can actually be made on the basis of return. Most investors do not simply select an initial allocation and let it run for decades without adjustment. Because of the varying returns of different assets over the years, portfolios must be “rebal- 118 The Four Pillars of Investing Figure 4-9. S&P 500, EAFE, and inflation, by decade. (Source: Morningstar Inc.) anced.” To see what rebalancing means, let’s look at the two-year peri- od from 1985 to 1986. The overall return of the S&P 500 for those years was quite high— 57%—but the return of the EAFE was off the charts—166%! Had you started with a 50/50 portfolio at the beginning of the period, at the end, it would have been 63% foreign and 37% domestic. Rebalancing the portfolio means selling enough of the better performing asset (in this case, the EAFE) and with the proceeds buying the worse per- forming asset (the S&P 500) to bring the allocation back to the 50/50 policy. Had you rebalanced a 50/50 S&P 500/EAFE portfolio every two years between 1969 and 2000, it would have returned 12.62%. This was almost one-half percent better than the best-performing asset, the S&P 500. Why? Because when you rebalance back to your policy allo- cation (your original 50/50 plan), you are generally selling high (the best performer) and buying low (the worst performer). So, over the long haul, international diversification not only reduces risk, but it may also increase return. But be warned: as the past decade has clearly taught us, foreign diversification is not a free lunch, especially if your time horizon is less than 15 or 20 years. Until recently, the average U.S. investor did not have to worry about diversifying abroad—it simply wasn’t an option. Although domestic investors have been able to purchase foreign stocks for more than a century, in practice this was expensive, cumbersome, and awkward; it could only be done one stock at a time. Although the first U.S based international fund opened its doors almost five decades ago, it wasn’t until the early 1980s that these vehicles became widely available. In 1990, the Vanguard Group made available the first easily accessible, low-cost indexed foreign funds. What is the proper allocation to foreign stocks? Here we run into an enormous problem—one that makes even the most devout believer in efficient markets a bit queasy. The rub is that the total market cap of non-U.S. stocks is about $20 trillion versus only $13 trillion for the U.S. market. If you believe that the global market is efficient, then you should own every stock in the world in cap-weighted fashion, mean- ing that foreign companies would comprise 60% of your stock expo- sure. This is more than even the most enthusiastic proponents of inter- national diversification can swallow. So what’s a reasonable foreign allocation? Certainly less than 50% of your stock pool. For starters, foreign stocks are more volatile, in gen- eral, than domestic stocks on a year-by-year basis. Second, they are more expensive to own and trade. For example, the Vanguard Group’s foreign index funds, on average, incur about 0.20% more in annual The Perfect Portfolio 119 [...]... sums can be lost On the other hand, we usually don’t have to worry about a bubble in bank, auto, or steel stocks There can be no question that small stocks are riskier than large stocks Small companies tend to be insubstantial and fragile More importantly, they are thinly traded—relatively few shares change hands during an average day, and in a general downturn, a few motivated sellers can dramatically... has no pretension of being a documentary work But of the four key areas of investment knowledge—theory, history, psychology, and investment industry practices the lack of historical knowledge is the one that causes the most damage Consider, for example, the principals of Long Term Capital Management, whose ignorance of the vagaries of financial history almost single-handedly brought the Western financial... generation, the markets go barking mad When this happens, most investors sustain serious damage, many are totally ruined Unless you have been living at the bottom of a well these past several years, you are keenly aware that we are in the midst of such a period Markets can crash, but it is less well known that markets can also become depressed for decades at a time The following two chapters will deal... improve on the market return by using sectors is by picking the areas with the future highest returns And, as we’ve already seen in the preceding chapter, lots of luck There’s another reason why it’s generally a bad idea to focus on sectors: they can virtually disappear For example, at the turn of the last century, railroad companies constituted most of the U.S market’s total value But by 1950, they had been... (real estate investment trusts) and precious metals stocks Of the two, a much stronger case can be made for REITs Their historical returns, as well as their expected future returns, are probably comparable to the market’s And, as we saw a few pages ago, they can do quite well when everything else has gone down the tubes Unfortunately, the same table showed that the opposite is also true: they can do... the large-cap arena, you should have 122 The Four Pillars of Investing Figure 4-10 S&P 500, small, large value, and small value, by decade (Source: Dimensional Fund Advisors, Morningstar Inc.) a reasonable balance of value and growth stocks Small-growth stocks have relatively low returns and high risks, so your allocation to small value should be much larger than to small growth But realize that the. .. had been devastated by the automobile and the The Perfect Portfolio 123 aircraft In 1980, the market was dominated by oil stocks, but within a decade, they had shrunk to one-quarter of their former share of market capitalization The real risk in the sector game is that you may wind up owning the next generation’s buggy whip and leather industries But with some trepidation, I think that there are two sectors... Tops: A History of Manias 131 imagined today Within a brief period, the speed of transportation increased tenfold, and communications became almost instantaneous For example, as late as the early 1800s, it took Jefferson ten days to travel from Monticello to Philadelphia, with considerable attendant expense, physical pain, and peril By 1850, the steam engine made the same journey possible in one day, and... faster, and, as far as Jefferson’s contemporaries were able to tell, nothing ever would The revolution in communication was even more dramatic For most of recorded history, information traveled as slowly as physical goods With the invention of the telegraph by Cooke and Wheatstone in 1837, instantaneous telegraphy abruptly changed the face of economic, military, and political affairs in ways that can scarcely... with the periods of euphoria and depression that occur on a fairly regular basis The average investor lives through at least a few markets of both types Even with an appreciation of their behavior, dealing with both buoyant and morose markets is difficult Sometimes even the best-prepared can fail But if you are unprepared, you are sure to fail This page intentionally left blank 5 Tops: A History of Manias . requirements are immaterial. For example, if you havesaved a largeamount forretirementand do not plan to leavealarge estate for 114 The Four Pillars of Investing Table 4-1. 1901–2000, 100-Year Annualized. practices the lack of historical knowledge is the one that causes the most damage. Consider, for example, the principals of Long Term Capital Management, whose ignorance of the vagaries of financial. during the 1970s, the return of the S&P 500 was less than infla- tion—that is, it had a negative real return—whereas the EAFE beat inflation handily. You’ll also see that the EAFE beat the S&P