Defining Your Mix The time has come to build your portfolio. Similar to the construction of a house, we will proceed methodically, examining each brick, timber, and s.h.i.+ngle in turn, before a.s.sembling them into a whole.

The individual construction materials will be the investment vehicles we have discussed in previous chapters-for the most part, open-end mutual funds or exchange-traded funds, with the odd single Treasury security thrown in. The three main materials-the bricks, timbers, and s.h.i.+ngles, if you will-are the three main kinds of investments-U.S. stocks, foreign stocks, and short-term bonds.

After we've examined these basic materials in some detail, we'll discuss which are most appropriate for the house you are building. Just as you would favor steel beams and concrete over wood for the construction of a large apartment house, so too are certain a.s.set cla.s.ses and mutual funds more appropriate for certain kinds of portfolios.

To complete the a.n.a.logy, the ultimate purpose of your portfolio, just like your house, is to protect you from the unpredictability of the elements. When you build a house, it is often hard to predict exactly which force of nature will most threaten it. If you knew in advance whether flood, fire, or hurricane would strike, then you could design it more precisely. But often you cannot accurately forecast the precise nature of the risks it will face. So you compromise and design it so that it might withstand all three tolerably well within your construction budget.

In the same way, you will not know exactly what kinds of economic, political, or even military, adversity will befall your portfolio. If, for example, you knew for sure that inflation would be the scourge of the economy for the next generation, then you would emphasize gold, natural resources, real estate, and cash, as well as a fair amount of stocks. If you knew that we were to suffer a deflationary depression, similar to what occurred in the 1930s, you would hold only long-maturity government bonds. And if you knew that the world would suffer a loss of confidence in U.S. industrial leaders.h.i.+p, you would want a portfolio heavy in foreign stocks and bonds.

In short, during the next 20 or 30 years, there will be a single, best allocation that in retrospect we will have wished we had owned. The only problem is that we haven't a clue what that portfolio will be. So, the safest course is to own as many a.s.set cla.s.ses as you can; that way you can be sure of avoiding the catastrophe of holding a portfolio concentrated in the worst ones.

Famed money manager and writer Charles Ellis, in a 1975 article in Financial a.n.a.lysts Journal, Financial a.n.a.lysts Journal, observed that investing was like amateur tennis. The most common way of losing a match at this level is to make too many "unforced errors." That is, missing easy shots by trying to hit the ball too hard or nailing the corner. The best way to win a game with your friends is to simply make sure you safely return the ball each time. In other words, in amateur tennis, you don't win so much as you avoid losing-hence the t.i.tle of Ellis's article, "Winning the Loser's Game." observed that investing was like amateur tennis. The most common way of losing a match at this level is to make too many "unforced errors." That is, missing easy shots by trying to hit the ball too hard or nailing the corner. The best way to win a game with your friends is to simply make sure you safely return the ball each time. In other words, in amateur tennis, you don't win so much as you avoid losing-hence the t.i.tle of Ellis's article, "Winning the Loser's Game."

Portfolio strategy is exactly the same as the Ellis version of tennis-the name of the game is not not losing. losing. In this chapter, what we'll strive to do is design portfolios that have the best likelihood of In this chapter, what we'll strive to do is design portfolios that have the best likelihood of not not losing. losing.

Bricks What do we mean when we say, "the U.S. market?" Most a.n.a.lysts start with the S&P 500. Contrary to popular perception, these are not the 500 biggest companies in the nation, but instead are 500 firms chosen by Standard & Poor's as representative representative of the makeup of the U.S. industry. It is a "capitalization-weighted" index. We've already come across this term, but it's worth reviewing again. of the makeup of the U.S. industry. It is a "capitalization-weighted" index. We've already come across this term, but it's worth reviewing again.

As this is being written, the total value of all outstanding U.S. stock-about 7,000 companies in all-is $13 trillion. This is also referred to as its "market capitalization," or "market cap" for short. Of this, the S&P 500 accounts for $10 trillion, or about three-quarters, of the market cap. The biggest company in the S&P 500 is General Electric (GE), with a market cap of about $400 billion, or 4% of the index. The smallest, American Greetings, has a market cap of $700 million, or 0.007% of the index-six hundred times smaller than GE. So an index fund which tracks the S&P 500 would have to own 600 times as much GE as American Greetings.

What happens if GE plunges in value and American Greetings zooms? Nothing. Since an index fund simply holds each company in proportion to its market cap, the amount of each owned by an S&P 500 index fund adjusts automatically with its market cap. In other words, an index fund does not have to buy or sell stock with changes in value (unlike Wells Fargo's ill-fated first index fund, which had to hold equal-dollar amounts of all 1,500 stocks on the New York Stock Exchange).

This raises some important semantic points. When most investors say the words "index fund," they are almost always referring to an S&P 500 fund. But the U.S. market consists of more than 7,000 publicly traded companies. So the S&P 500 is not a true "market index," since it only holds about 7% of the total number of companies in the market. However, these 7% of companies, because they are very large, make up 75% of the total U.S. market cap.

There are actually three true "market indexes." The most widely used is the Wils.h.i.+re 5000, which, in spite of its name, consists of 7,000 publicly traded stocks. The second is the Russell 3000, which owns the 3,000 biggest companies. Even though it excludes the smallest 4,000 U.S. companies in the Wils.h.i.+re 5000, these very small stocks amount to only 1% of the U.S. market capitalization. Finally, the Center for Research in Security Prices' (CRSP) "universe" index is of historical value only, as its returns can be followed back to 1926, when it held just 433 firms in cap-weighted fas.h.i.+on. It now holds thousands and behaves very similarly to the Wils.h.i.+re 5000.

Here is where things start to get interesting. There are funds that track the Wils.h.i.+re 5000 and Russell 3000, but they are not truly "index funds," because it would be too c.u.mbersome to own all 7,000 or 3,000 stocks in the index. Instead, these funds own a representative sampling of the market. Thus, they do not track the indexes precisely. The exact term for such a fund is "pa.s.sively managed"-that is, it owns some, but not all, of the stocks in an index, or those meeting certain criteria.

On the other hand, an S&P 500 fund is almost always a true "index fund," because it owns all 500 stocks in the index. But it is not not pa.s.sively managed. In fact, it is quite actively managed-by the Standard & Poor's selection committee-whose members determine the index's makeup! In practice, though, there is little real difference between "pa.s.sively managed" and "index" mutual funds, and in common usage both terms are employed interchangeably. pa.s.sively managed. In fact, it is quite actively managed-by the Standard & Poor's selection committee-whose members determine the index's makeup! In practice, though, there is little real difference between "pa.s.sively managed" and "index" mutual funds, and in common usage both terms are employed interchangeably.

As discussed in a previous chapter, we most certainly want to index, since doing so incurs minimal expenses, thereby beating the overwhelming majority of active-fund managers. So, we are faced with two basic choices-the S&P 500, which includes only the biggest companies, or the more broadly based Wils.h.i.+re 5000 and Russell 3000 total-market indexes, which include smaller stocks.

Owning the U.S. "market" means the whole shooting match-the Wils.h.i.+re 5000. The granddaddy of all "total-market" funds is the Vanguard Total Stock Market Index Fund. With rock-bottom expenses of 0.20%, it is a superb choice. Since its inception in 1992, it has done an excellent job of tracking the Wils.h.i.+re 5000, Wils.h.i.+re actually besting it by a few basis points before expenses. (A basis point is one one-hundredth of 1%. For example, when Alan Greenspan cuts interest rates by 0.5%, he has cut the rate by 50 basis points.) Even more amazingly, over the past five years, it has managed to beat the index by four basis points even after expenses. even after expenses.

This gets to an important issue, so-called "transactional skill." It is often said that a monkey could run an index fund. Nothing could be further from the truth. Precisely tracking an index requires a very high degree of market savvy, discipline, and nerve. The head of Vanguard's indexing shop, George U. ("Gus") Sauter, is the universally recognized master of the craft and is usually able to squeeze out a "positive tracking error"-that is, actually beat the index by a slight amount, particularly with smaller, less-liquid stocks.

Transactional skill is one of investment's many ironies. Recall that in Chapter 3 Chapter 3 we showed that investment managers demonstrated no evidence of we showed that investment managers demonstrated no evidence of selection selection skill-that is, they could not successfully pick stocks. But quite clearly, as Mr. Sauter and a few other pract.i.tioners have demonstrated year after year, there is skill-transactional skill-in the actual skill-that is, they could not successfully pick stocks. But quite clearly, as Mr. Sauter and a few other pract.i.tioners have demonstrated year after year, there is skill-transactional skill-in the actual execution execution of stock purchases and sales. of stock purchases and sales.

There are multiple vehicles that enable you to buy the entire U.S. market in one fund. I've listed all of the players in the "total-market" playground in Table 13-1 Table 13-1.

When and where do you own a total-market index fund? In two situations. First, a total-market index fund is an ideal "core" equity holding in a taxable account, because of its "tax efficiency." The Russell 3000 and the Wils.h.i.+re 5000 have essentially no turnover. Stocks may leave the index via mergers and acquisitions, but these are often not taxable events. The only way a stock truly leaves these portfolios is feet first, by going bankrupt, in which case you don't have to worry about capital gains. Would you want to hold a total-market fund in a retirement account? Only, in my opinion, if you want to keep things extremely simple and not have to own more than a few funds. Otherwise, in a retirement account, you'll want to break the U.S. market into separate parts.

Table 13-1. U.S. Total Market Funds [image]

Lumpers and Splitters It's now time to tackle an extremely difficult issue-one that is so th.o.r.n.y that even experts occasionally disagree strongly about it. Namely, is it worthwhile to further break down the U.S. stock market into subcla.s.ses, such as small and large, or value and growth?

The naysayers (lumpers) have a very simple and powerful argument: because the market is ruthlessly efficient, there are no segments of the market that offer superior long-term expected returns. Breaking the market into subcla.s.ses is at best expensive and distracting and, at worst, will expose you to unnecessary risk.

The splitters say, "Look at the historical data. Value stocks have higher returns than growth stocks, and small stocks have higher returns than large stocks. It is logical to overweight value and small size." The reason why small stocks have higher returns is obvious-they are more risky. But the reason for the higher returns of value stocks is a bit of a mystery. Interestingly, the two possible reasons for this are mutually exclusive. The first is the behavioral reason we discussed in Chapter 7 Chapter 7-investors overestimate the earnings growth of glamour stocks. The second possible reason is that value stocks are, in fact, riskier than growth stocks and therefore should have higher returns. My sympathies lie with the behavioral camp, but this controversy is far from settled.

We need to get a bit of nomenclature out of the way here. In Figure 13-1 Figure 13-1, I've diagrammed the relations.h.i.+p between the market and its segments. The most commonly accepted way of splitting the market is into four corners-large growth, large value, small growth, and small value. Large growth and large value together form the "large market," which is generally defined as the S&P 500. Small value and small growth together make up the "small market," defined by most as the Russell 2000 or the S&P 600. Since growth stocks have market caps that are much larger than value stocks, they overwhelm them in most indexes, so large growth and large market behave nearly identically. The same goes for small-cap stocks; the small-growth and small-market subsegments behave in nearly the same way.

As you have probably guessed by now, my sympathies lie with the splitters. Once you decide to split, you are faced with just how to do so. Where, for example, do you draw the line between a large company and a small company? The most commonly used U.S. small company index is the Russell 2000, which has a median market cap of about $1 billion. On the other hand, in academia the most commonly used small-stock index is the CRSP 9-10 Decile index; it has a median market cap of just $152 million. ("9-10 Decile" refers to the fact that these stocks are in the ninth and tenth deciles-that is, the bottom fifth-of market cap size. Many refer to these very small companies-in the $50300 million market-cap range-as "microcap" stocks.) And, yes, there's a fund tracking this microcap index, although it isn't available to the general public.

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Figure 13-1. The four corners of the market. The four corners of the market.

How do you draw the line between a value company and a growth company? The most common approach splits the market by the ratio of price-to-book values by thirds, into value (bottom third) and growth (top third), with the middle third being called "blend."

Here things start to get a little confusing. The Barra/Vanguard method splits value and growth into halves according to market cap-the most expensive half of the market cap is designated as "growth," the other half as "value." Since growth stocks have higher market caps than value stocks, halving the S&P 500 by this method produces many more names on the value list (usually around 350) than on the growth list (usually around 150).

The point of all this is that whereas the Vanguard Growth Fund contains only growth stocks, the Vanguard Value Fund contains both value and blend. On the other hand, value index funds from some other companies contain only value stocks. (Vanguard/Barra similarly splits the S&P 600 Small-Cap Index into a small-growth index with about 200 stocks and a small-value index with about 400. This method suffers from the same problem of "blend contamination" of the large-value index.) You can see that slicing the market into the four corners of the U.S. market-large value, large growth, small value, and small growth-can be very complicated, since we have to decide twice where to make the cuts. There's another factor to consider here as well. In Chapter 1 Chapter 1, we discussed the fact that the stocks of small companies had higher returns than the stocks of large companies. In actual practice, you have to be exceptionally cautious about attempting to implement small-stock strategies, because these companies are very expensive to trade. Most actively managed mutual funds and small investors do not pay much attention to the costs of trading small stocks and wind up wiping out any possible small-stock advantage in this manner. Thus, for your small-stock exposure, it's critical to employ an index fund manager experienced in the techniques of small-stock trading, such as the Vanguard or DFA groups. John Montgomery of the Bridgeway Group is quite adept at this as well.

In Table 13-2 Table 13-2, I've listed the major U.S. market-sector index funds available to the investor. Pay careful attention to the last column, which indicates whether or not each fund is appropriate for taxable accounts, sheltered accounts, or both. Note that three of the four "corner a.s.sets" (large value, small value, small growth) are not suitable not suitable for taxable accounts because of the high turnover necessary to maintain their characteristics. For example, a small-value fund may toss out a stock because it has become too large, turned into a growth stock, or both, triggering a large amount of capital gains. Even the Vanguard Value Index Fund, which invests only in large-cap stocks, distributes about 5% of its portfolio each year as capital gains, reducing your after-tax return accordingly. The REIT sector is also inappropriate for taxable accounts because most of its return comes from dividends, which are taxed as ordinary income. for taxable accounts because of the high turnover necessary to maintain their characteristics. For example, a small-value fund may toss out a stock because it has become too large, turned into a growth stock, or both, triggering a large amount of capital gains. Even the Vanguard Value Index Fund, which invests only in large-cap stocks, distributes about 5% of its portfolio each year as capital gains, reducing your after-tax return accordingly. The REIT sector is also inappropriate for taxable accounts because most of its return comes from dividends, which are taxed as ordinary income.

Also note that several of the funds levy a "contingent redemption fee," again, payable to the existing shareholders, for shares held less than one to five years, to discourage trading. There's one other wrinkle at Vanguard that small investors should be aware of, and that's the $10 service fee on index fund accounts of less than $10,000. At $1,000 of a.s.sets, this amounts to 1% per year, and at just below $10,000 a.s.sets, 0.10% per year. Fortunately, most investors grow out of this problem, but it is an unpleasant annoyance.

It's worth discussing the difference between Mr. Montgomery's offering in Table 13-2 Table 13-2-the Bridgeway Ultra-Small-Company Tax-Advantaged Fund-and the other small-company funds. The Bridgeway fund, which is aimed at taxable accounts, invests in much smaller companies than the other small company funds-typically in the $50-$100 million "microcap" range, versus about $1 billion for the others. It is thus riskier than the other small-company funds in Table 13-2 Table 13-2, and, as a consequence, has a higher expected return. It should also be a better "diversifier" than the other funds, since smaller stocks tend to be less correlated with the rest of the market than larger ones. On the other hand, its expenses are higher, and it is also subject to greater "inst.i.tutional risk"-the possibility that Bridgeway, or at least its investment culture, may not survive long-term.

Table 13-2. U.S. Stock Index Funds U.S. Stock Index Funds [image]

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Some of you will notice that the Nasdaq 100 Cubes fund is not listed. Yes, this is an efficient, inexpensive (0.18% annual fee) index exchange-traded fund, which we discussed in Chapter 10 Chapter 10. But it is essentially a concentrated large-growth fund. Its average holding sells at more than 50 times earnings, and it is fearfully vulnerable to market declines, having lost more than 60% of its value during the recent downturn. In fact, I recommend completely avoiding the large-growth and small-growth categories.

As we've already seen in Chapter 1 Chapter 1, small growth is a very bad actor in the long term, with the lowest return of any of the four corner portfolios and very high risk. Because of the way that large growth is defined, the Nasdaq 100 is very similar to the S&P 500, except that because of its much higher valuation, it has a relatively low expected long-term return.

I recommend using a small-market fund in place of a small-growth fund, and a large-market (i.e., S&P 500) fund in place of a large-growth fund. You will get enough exposure to large- and small-growth stocks via the S&P 500, total market, and small cap index funds, since they consist mainly of growth issues.

This is why I believe it is worthwhile to slice and dice the domestic component of our equity portfolios-we can pare down our exposure to overvalued growth stocks, particularly the smaller ones, which historically have had the lowest long-term returns.

There's a fifth domestic a.s.set cla.s.s to consider-real estate investment trusts (REITs), which we discussed in Chapter 2 Chapter 2. Because they often behave very differently from the four corners of the market, most allocation experts consider them a separate a.s.set cla.s.s. Given the relatively high expected returns of REITs, they deserve serious consideration from every investor.

We've only scratched the surface of the many possible ways that the domestic market can be carved up. There are now ETFs and open-end funds that will allow you to invest in midcaps (companies midway in size between large and small caps) of the market, value, and growth variety. It is even possible to buy only value or growth stocks of all sizes in one portfolio (i.e., the Russell 3000 Value and Growth). And, of course, you can buy industry sectors in index form as well. But there comes a time when even the most devoted a.s.set-cla.s.s junkie says, "enough already." It is unlikely that there is any benefit to slicing the domestic equity market thinner than the five a.s.set cla.s.ses we've concentrated on above.

To summarize, the five major domestic a.s.set cla.s.ses you should use are: * Large Market* Small Market* Large Value* Small Value* REITs Timbers The next material you will need to construct your portfolio is foreign equity. This is a much simpler task because you have relatively few choices. About the only indexed products you can buy are the foreign equivalents of "large-market" stocks. There are no indexed international small-market, large-value, or small-value vehicles available to individual investors.

What is available is the choice of region. You can invest in the whole shooting match-all foreign stocks in cap-weighted fas.h.i.+on, or you can divvy things up into the three main regions-Pacific (mainly j.a.pan), Europe, and emerging markets (Mexico, Brazil, Turkey, Indonesia, Korea, Taiwan and the like). With some trepidation, you can invest in foreign value stocks reasonably efficiently using the Vanguard International Value Fund. This is not indexed, but does have low expenses and tracks an index of international value stocks reasonably well. In Table 13-3 Table 13-3, I've listed this fund, plus the foreign index funds I'd recommend.

There are a few wrinkles to consider. Ideally, I would avoid owning the Vanguard Total International Fund in a taxable account, as it is a "fund of funds," consisting of the three regional funds. As such, it is not eligible for the foreign dividend tax exclusion, which allows you to deduct the taxes on dividends from foreign stocks on your U.S. tax return.

Pay attention to the fund size. If the fund is particularly small, say less than $100 million, I'd be wary-it is likely that the fund company may kill it due to lack of interest. The Emerging Markets Stock Index Fund levies 0.5% purchase and sales fees. Do not confuse these with a sales load. These fees are paid to the existing shareholders in order to cover the transactional costs of shares just purchased. In other words, they directly benefit the existing shareholders, not a salesman or the fund company.

Table 13-3. International Funds International Funds [image]

There are two other options to consider when looking at international vehicles. First, iShares does offer indexed ETFs for single nations. I'd recommend against them because of complexity and cost-these funds carry expense ratios of nearly 1%, far higher than those of the open-end funds. Second, there is Dimensional Fund Advisors (DFA). These folks are among the best and brightest in finance, with a strong connection to Eugene Fama and the University of Chicago.

DFA indexes just about any a.s.set cla.s.s you might want, including small, value, and even small value foreign markets. They also have individual funds for small stocks from the U.K., Continental Europe, j.a.pan, Pacific Rim, and emerging markets. Better yet, their index funds for the U.S. market have much more focused exposure to value and small stocks than Vanguard or the other indexers. They even have tax-managed value index funds aimed at both U.S. and foreign value stocks.

But there's a hitch. DFA only sells their funds through approved financial advisors. Is it worthwhile to engage the services of a financial advisor just to gain access to DFA? Probably not. Their tax-managed, foreign-small and foreign-value funds carry expenses which are 0.2% to 0.6% higher than Vanguard's, and by the time you add in the advisor's expense, the advantage of these funds may be lost. But if you have decided that you need the services of a financial advisor, then you should certainly seek one with access to DFA.

s.h.i.+ngles Like the s.h.i.+ngles on a roof that shelter your house from the rain and snow, so do bonds provide comfort and succor (as well as dry powder) during troubled times in the market. Table 13-4 Table 13-4 lists the recommended bond funds. lists the recommended bond funds.

The overriding principle of bond investment is to keep it short. keep it short. As we saw in As we saw in Figure 1-10 Figure 1-10, long-maturity bonds can be quite risky. If you own a bond with a 30-year maturity and interest rates double, then your bond will lose almost half of its value. On the other hand, the excess return earned by extending bond maturities is minimal, as shown by the "yield curve" for the U.S. Treasury market I've plotted in Figure 13-2 Figure 13-2. Notice that you get about 4% of extra return by extending your maturity from 30 days out to 30 years. This is about as "steep" as the yield curve gets. Much of the time, the curve is much less steep-perhaps 1% to 1.5% difference between long and short yields-and there are even times when the yield curve is "inverted," i.e., when long rates are lower than shorter rates.

Table 13-4. Bond and Bond Index Funds Bond and Bond Index Funds [image]

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Figure 13-2. U.S. Treasury yield curve. U.S. Treasury yield curve. (Source (Source: The Wall Street Journal, The Wall Street Journal, 3/14/02.) 3/14/02.) In Figure 13-2 Figure 13-2, note that you get the most "bang for the buck" by about a five-year maturity. This is the steepest part of the yield curve-the part that rewards you the most. Beyond that, the extra return diminishes, with continually increasing risk. The stock portion of your portfolio is the place to take risk, not the bond portion, where the purpose is to shelter you from market downturns and provide ready liquidity. The curve is steepest in the first year or two. For the most part, then, you should keep the maturity of your bond portfolio between one and five years. There are a wide variety of bond funds that will accomplish this.

There are three main categories in the bond arena, and you will likely use all of them: * Government securities. These are mainly Treasury bills (up to a one-year maturity), notes (one to ten years), and bonds (more than ten years). The others in this category are "agencies"-GNMA, FNMA, FHLB, FFCB, etc., which are backed by the U.S. government. Treasuries are subject to federal, but not state tax. Some of the agencies are exempt from state tax; some are not. Unless you are investing a small amount of money in Treasuries, there is no reason to buy a fund for this purpose. Since all Treasuries carry the same credit risk-zero-there is no need to diversify. Treasuries can be bought at auction directly from the government without a fee, allowing you to manufacture your own "Treasury Fund" at no expense. (You can reach Treasury Direct at 1-800-722-2678 and www.publicdebt.treas.gov/sec/sectrdir.htm.) Even if you are purchasing a Treasury at auction through a brokerage firm, the fee is nominal-typically about $25. For a five-year note worth $10,000, this equals an annual expense of 0.05%.* High-quality corporate bonds and commercial paper. Corporates not only carry interest rate risk, but also credit risk. Even the highest-rated companies occasionally default. How often does this happen? Very rarely. According to bond-rating service Moody's, since 1920 the rate of default for the highest-rated AAA bonds was zero, 0.04% per year for AA-rated, 0.09% for A-rated, and 0.25% for BBB-rated. BBB is the lowest of the four "investment-grade" categories.These categories are a tad deceptive, since, for example, it is highly unlikely that an AAA-rated bond would suddenly default-it would likely undergo successive downgradings first. For taking this risk, you have been rewarded historically with about 0.5% of extra return. Currently the "spread" between high-quality corporate bonds and Treasuries is over 1%. What does all this mean for investors? First, you will need wide diversification to invest in corporate bonds. You should only purchase these through a corporate bond mutual fund. You should not buy individual corporate bonds for the same reason you do not buy individual stocks, which is that you are bearing the unnecessary risk that your portfolio could be devastated by a single default-something you would not want to happen in the "riskless" part of your portfolio. The wise investor pays attention to the "spread" between high-grade corporate and Treasury yields that we plotted for junk bonds in Figure 2-6 Figure 2-6. When this gap is small, buy Treasuries. And when the gap is large, favor corporates. Another way of saying this is that when safety is cheap, you buy it (in the form of Treasury securities). At the present time, safety is very very expensive. expensive.* Munic.i.p.al bonds. "Munis" are the debt issues of state and local governments, as well as other qualified quasi-governmental bodies, such as transit, housing, and water authorities. They are exempt from the taxes of the jurisdictions they are issued in. For example, New York City residents pay no federal, state, or city taxes on N.Y.C. munis. Munis issued by, say, Syracuse, are exempt from federal and state but not city tax to the N.Y.C. resident, and an Illinois muni would be exempt only from the federal tax to the N.Y.C. resident. Since they are tax-exempt, their yields tend to be lower than Treasury securities of comparable maturity and much lower than corporates. Like corporates, it is necessary to protect yourself from credit/default risk by buying a fund. Wealthy investors tend to a.s.semble their own muni portfolios because they can buy enough issues to maintain adequate diversification. This is usually unwise because muni bonds are thinly traded and have very high bid/ask spreads-around 3% to 4%. Thus, even if you buy and hold these issues to maturity, you still will be paying a 1.5% to 2% "half-spread" on purchase, which amortizes out to about 0.2% to 0.3% per year, in addition to trading costs and management fees. This is the one field where Vanguard is all alone in the quality of its product-it offers many national and single-state muni funds, all with annual expenses of 0.20% or less. And since almost all are well in excess of $1 billion in size, the bid/ask spreads paid by these funds are estimated by Vanguard to be less than half that quoted above. So unless your name is Warren Buffett or Bill Gates, you're better off buying a Vanguard Fund. (Vanguard has recently brought out "Admiral" cla.s.s shares, with muni bond fees in the 0.12% to 0.15% range. These carry $50,000$250,000 minimums). In Table 13-5 Table 13-5, I've listed Vanguard's national and single-state tax-exempt funds.

Obviously, it makes no sense to purchase munic.i.p.al bonds in a tax-sheltered account. Here, the choice will be between government and corporate issues. In a taxable account, there are multiple possibilities, depending on the level of interest rates and taxes. Let's a.s.sume, for example, that you are subject to the 36% marginal federal rate and live in a state with a 5% marginal rate. In your taxable account, you can purchase the Vanguard Limited-Term Tax-Exempt Fund, which has a yield of 3.15%. Since you will pay state tax on most of this, the yield falls to 3.05% after tax. A Treasury note of the same maturity will yield 4.90%. But after paying federal, but not state, tax, its after-tax yield is only 2.50%. And finally, the Vanguard Short-Term Corporate Fund yields 5.18%, but after paying taxes at both levels, its after-tax yield falls to 3.15%. So, the nod here goes ever-so-slightly to the corporates. But there are times when either the Treasury or the muni fund will have a higher after-tax yield, and many times when it will be too close to call.

If you're confused, join the crowd. The choice of bond vehicles for your taxable accounts is a difficult decision, and the "right" answer may change from week to week. My advice is to split your taxable accounts among all three of the above bond cla.s.ses (munic.i.p.al, Treasury, and corporate), if you have enough a.s.sets to do so. The Treasuries will usually have a lower after-tax yield, but have the advantages of being perfectly safe and liquid, and free from state tax. Quite frankly, the yield differences aren't enough to be continually fretting over.

Table 13-5. Munic.i.p.al Bond Funds Munic.i.p.al Bond Funds [image]

Surprisingly, unless you are investing a small amount (less than $5,000 to $10,000) in bonds, it makes no sense to buy a bond index fund. Why? Because about 50% of a such a fund is invested in Treasuries and other government securities, which you can own separately without paying ongoing fund fees. For that reason, I'd buy whatever Treasuries you want directly. (Remember, there is no need for diversification here.) I'd use the Vanguard Short-Term Corporate Fund (or the GNMA fund, which has a higher yield, but a longer maturity) for the non-Treasury part of your bond allocation-you'll get off cheaper, plus you'll have more control of your portfolio. And again, you'll need to be cognizant of the $10 Vanguard minimum account fee. If your total bond allocation is in the $10,000 to $30,000 range, it just may be advantageous to consolidate all of your bond holdings in one of their bond index funds to avoid the fee for fund accounts of less than $10,000.

What Kind of House Are You Building?

This is a trick question, for the most part. What I'm really asking is, what financial hand have you been dealt? There are the obvious questions of how much you will have and what your needs will be (and even more importantly, the ratio of the former to the latter), but in terms of portfolio design, the key question is, what is the tax structure of your portfolio? For example, many professionals have most of their portfolio a.s.sets in 401(k), IRA, Keogh, and pension accounts. This gives them the freedom to invest in almost any a.s.set cla.s.s they desire without regard to tax consequences. At the other end of the spectrum is the entrepreneur who has sold his business for a lump sum and has no tax-sheltered a.s.sets at all. This investor is severely limited as to the kind of a.s.sets he can own. The reason for this is the "tax efficiency" of the index mutual funds used for exposure to each a.s.set cla.s.s.

Tax-efficiency is an extremely important concept to understand. It is a measure of the percent of a fund's return you receive after the taxes on the distributions are paid. For example, a stock fund with no turnover will produce no capital-gains distributions; you will be taxed only on the relatively small amount of stock dividends the fund pa.s.ses through to you. Such a fund is highly tax-efficient. On the other hand, a stock fund with high turnover will periodically distribute a large amount of capital gains to you, on which taxes must be paid. Such a fund is tax-inefficient. Worst of all are REIT and junk bond funds, which distribute almost all of their return in the form of dividends. Further, these dividends are taxed at the high ordinary income rate. Obviously, then, you will want to hold only tax-efficient funds in your taxable account, reserving the most tax-inefficient ones for your retirement accounts.

The problem, as we've already mentioned, is that certain a.s.set cla.s.ses are inherently tax-inefficient, such as junk bonds and REITs. Value funds are also relatively tax-inefficient, because if a value stock increases enough in price, it may no longer qualify for the value index and must be sold at a substantial capital gain. On the other hand, S&P 500, Wils.h.i.+re 5000, and large-cap foreign index funds tend to be highly tax-efficient and are thus suitable for taxable accounts. Finally, some fund companies, including Vanguard, have brought out a cla.s.s of super tax-efficient "tax-managed" funds for U.S. large and small and foreign large-cap stocks.

The taxable/sheltered question even dictates the overall stock/bond allocation to a certain extent. As we just saw above, after-tax bond yields are nothing to write home about. Since tax-efficient equity funds provide excellent deferral of taxation, the all-taxable investor will want a higher portion of stocks than the all-sheltered investor, all other things being equal.

Finally, there is the all-too-common situation of the investor with only a small amount of sheltered a.s.sets. In this case, he will want to prioritize which tax-inefficient a.s.set cla.s.ses to place in the sheltered portion of his portfolio.

A Duplex, Really Actually, you're not building one house, but two. As we've touched on many times, you are really building two different allocations-one for risky a.s.sets (stocks) and one for riskless a.s.sets (generally, short-maturity bonds). In terms of how you allocate among different stock a.s.set cla.s.ses, it really doesn't matter what your overall stock/bond ratio is. The person who has an aggressive 80% stock/20% bond mix will have exactly the same kind of stock portfolio and bond portfolio as the person who has a conservative 20% stock/80% bond portfolio. What's different is the overall amount of a.s.sets in stocks versus bonds. We're not building houses so much as warehouses warehouses-one each for stocks and bonds. Once we've constructed them, we can then control our port-folio's risk and return by how much of our a.s.sets we load into each.

The most basic principle of portfolio design is that once you think you've designed an allocation for stock a.s.sets that is reasonable and efficient, then you keep that stock allocation across portfolios from the safest (all bond) to the riskiest (all stock). All you have to do to move up or down the risk/return scale is to vary the overall stock/bond ratio.

Recall from Chapter 2 Chapter 2 that it is likely that long-term stock returns will not be much greater than bond returns. In such an environment, we find it hard to recommend an all-stock portfolio; 80% would seem to be a reasonable upper limit at the present time. Even wild-eyed optimists like Jim Gla.s.sman and Kevin Ha.s.sett, authors of that it is likely that long-term stock returns will not be much greater than bond returns. In such an environment, we find it hard to recommend an all-stock portfolio; 80% would seem to be a reasonable upper limit at the present time. Even wild-eyed optimists like Jim Gla.s.sman and Kevin Ha.s.sett, authors of Dow 36,000, Dow 36,000, admit that they could be wrong and recommend holding 20% bonds. admit that they could be wrong and recommend holding 20% bonds.

We'll ill.u.s.trate these principles with four different investors: Taxable Ted, Sheltered Sam, In-Between Ida, and Young Yvonne.

Taxable Ted Ted's life has not been a great deal of fun. Because of his straitened upbringing, he had to work his way through an electrical engineering degree by moonlighting as a bouncer. Then, after graduation, he rapidly grew tired of his first job in aircraft manufacturing and lit out on his own, starting a firm specializing in cellular phone transmission components. His professional life was a punis.h.i.+ng succession of 80-hour weeks punctuated by labor troubles, parts shortages, incessant travel, payroll squeezes, and divorces. After 23 years of this, it did not take a lot of convincing for him to accept a seven-figure buy out offer from a larger compet.i.tor and leave the entrepreneurial life for good. Ted's now sitting on a large wad of cash to tide him over until he decides what to do when he grows up. He's never had the time or money to set up a pension plan or even an IRA. What should he do with it all?

From the point of view of his stock allocation, Ted is seriously constrained. He realizes that there are only three a.s.set cla.s.ses available to him: U.S. total market/large-cap, U.S. small-cap, and foreign large-cap. There is one other option available to him, and that's to open a variable annuity (VA) so that he can invest in REITs. I didn't have many nice things to say about these vehicles a few chapters ago, but here I'd make a rare exception. Vanguard does make available a relatively low-cost VA, and REITs are one of the few areas where this makes sense. This will enable him to hold REITs in his portfolio without being punished by the taxes on their hefty dividend distributions, since they would be sheltered inside the annuity account. Taxes are not paid until he withdraws the funds from the VA much later. The disadvantages are an extra 0.37% in insurance expense and not being able to withdraw funds before age 59 without penalty. (Also, there is a $25 per-year fee for account sizes under $25,000, making investing under $10,000 in their VA uneconomical.) Here's what his stock allocation looks like: * 40% Vanguard Total Stock Market* 20% Vanguard Tax-Managed Small-Cap* 25% Vanguard Tax-Managed International* 15% Vanguard REIT (VA) Ted's from California, so he decides to split his bond portfolio four ways. One quarter goes into a five-year "Treasury ladder." He does this with equal amounts of one-, two-, three-, four-, and five-year Treasuries. As each matures, he rolls it into a new five-year note at auction. (Initially, the two- and five-year notes are bought at auction, the others in the "secondary market.") The other three-quarters of the bond allocation are split among the Vanguard Short-Term Corporate, Limited-Term Tax-Exempt, and California Intermediate-Term Tax-Exempt funds. The California fund appeals to him because of its higher yield and state tax exemption, but he also realizes that quite often, downgrades and defaults can concentrate in one state (as recently happened in California because of the electrical power squeeze), and he wants to keep his risk down. Also, the California fund has a longer average maturity, making it somewhat riskier. Here's what his bond portfolio looks like: * 25% Treasury Ladder* 25% Vanguard Short-Term Corporate Bond* 25% Vanguard Limited-Term Tax-Exempt* 25% Vanguard California Intermediate-Term Tax-Exempt Note that Ted has no need of a separate "emergency fund," since in a pinch he can easily tap his bond money. Once Ted has arrived at efficient stock and bond allocations, they can be mixed to produce portfolios across the full range of risk. This is demonstrated in Table 13-6 Table 13-6; note how all of the portfolios, from 100% stock down to 100% bond, maintain the same 8:4:5:3 ratio of large:small:foreign:REIT.

Now all Ted has to do is to determine his overall stock/bond mix. First he takes a look at Figures 4-1 Figures 4-1 through through 4-5 4-5. Being an a.n.a.lytical type, he comes up with a table that relates his risk tolerance to his overall stock allocation. This is shown in Table 13-7 Table 13-7. Take a good look at it. Realize that this is only a starting point.

Have you ever actually lost 25% of your a.s.sets? It is one thing to think about it, and quite another to actually have it happen to you. (Remember the aircraft-simulator crash versus real-aircraft crash a.n.a.logy mentioned earlier.) The cla.s.sic beginner's mistake is to overestimate his risk tolerance, then decamp forever from stocks when the inevitable loss hurts more than he had ever expected. When in doubt, tone down your portfolio's risks by shaving your exposure to stocks. It is one thing to think about it, and quite another to actually have it happen to you. (Remember the aircraft-simulator crash versus real-aircraft crash a.n.a.logy mentioned earlier.) The cla.s.sic beginner's mistake is to overestimate his risk tolerance, then decamp forever from stocks when the inevitable loss hurts more than he had ever expected. When in doubt, tone down your portfolio's risks by shaving your exposure to stocks.

Finally, given that our estimates for future stock and bond returns are so close, it makes little sense to own more than 80% stocks, no matter how aggressive and risk-tolerant you are.

Sheltered Sam Sam's a respected CPA in a small midwestern city. He lives with his wife of 25 years and their four children. Being a smart and disciplined tax professional, he's deferred as much income into his firm's pension plan as possible. His oldest child is just beginning college, and he intends to retire when the youngest is done. He knows that by the time the last tuition bills are paid, his taxable savings, which he's placed mostly in Treasury notes, will be gone, and he will be left with only his retirement a.s.sets, which he intends to roll into an IRA when he closes up shop.

Table 13-6. "Taxable Ted's" Portfolios "Taxable Ted's" Portfolios [image]

Table 13-7. Allocating Stocks versus Bonds Allocating Stocks versus Bonds [image]

Sam has much more freedom in his choice of a.s.set cla.s.ses than Ted, because he can invest in any a.s.set cla.s.s he desires without tax consequences. In terms of stocks, he can embrace the forbidden fruit that Ted can't touch-value stocks and precious metals stocks. In addition, he can aggressively "rebalance" the foreign and domestic components of his portfolio. This process, which increases portfolio return and reduces portfolio risk, will be discussed in the next chapter. So instead of just owning the foreign market, he can break it down into regions. Finally, he can go flat out for yield in his bond portfolio and not have to worry about taxation until he withdraws his cash. Here's a reasonable stock allocation for Sam: * 20% Vanguard 500 Index* 25% Vanguard Value Index* 5% Vanguard Small Cap Index* 15% Vanguard Small Cap Value Index* 10% Vanguard REIT Index* 3% Vanguard Precious Metals* 5% Vanguard European Stock Index* 5% Vanguard Pacific Stock Index* 5% Vanguard Emerging Stock Markets Index* 7% Vanguard International Value Note that he can hold the REIT fund in his IRA/pension. He does not need to resort to the expense and trouble of a VA, as Ted did.

For the bond portion of his portfolio, Sam can employ whatever kind of debt instrument he desires. He decides to put 60% in the Vangard Short-Term Corporate fund as his primary bond holding, because of its relatively high yield. And because he's a bit afraid of inflation, he will invest the remaining 40% of the bond portion in long-dated TIPS (Treasury Inflation Protected Security)-the[image] bond of 2032. bond of 2032. Table 13-8 Table 13-8 shows what Sam's portfolios, from all-stock to all-bond, look like. shows what Sam's portfolios, from all-stock to all-bond, look like.

Once again, Sam has no need for an emergency fund, since he is over 59 years of age and can tap the bond portion of his retirement accounts without penalty.

In-Between Ida Our most difficult case study is In-Between Ida. Unfortunately, Ida, who is 57 years old, has just lost her husband after a long illness. But her late spouse planned well and left her with $1 million-$900,000 in personal savings and a life insurance policy, and $100,000 from his company pension plan, which she has now rolled over into an IRA.

Ida's situation is unlike Ted's and Sam's. Before we build her "two warehouses," we must first determine her stock/bond mix. The reason for this is that her stock/bond mix determines how much of her stock a.s.sets wind up in the taxable versus sheltered parts of her portfolio. For example, if she invests only 10% of her a.s.sets in stocks, she will have free rein to purchase whatever stock a.s.sets within the sheltered (retirement) part of the portfolio she chooses. On the other hand, if she invests all of the money in stocks, then she will be able to invest only the tax-sheltered 10% of it in the tax-inefficient a.s.set cla.s.ses-value stocks, gold stocks, and REITs.

So before Ida builds her two warehouses, she must first decide on her stock/bond mix. a.s.sume that she picks a 50/50 mix. She will want to use the sheltered 10% of her portfolio to maximum advantage, so she will use it to purchase value stocks, which she would otherwise not be able to own on the taxable side. Since she wants to invest in REITs, she reluctantly agrees to open a VA to do so. Her bond portfolio, being taxable, will look very much like Ted's. For argument's sake, let's say she lives in Cleveland. Here's what she winds up with: * 15% Vanguard Tax-Managed Growth and Income* 5% Vanguard Value Index (IRA)* 7.5% Vanguard Tax-Managed Small-Cap Table 13-8. Sheltered Sam's Stock/Bond Mixes Sheltered Sam's Stock/Bond Mixes [image]

* 5% Vanguard Small-Cap Value Index (IRA)* 12.5% Vanguard Tax-Managed International* 5% Vanguard REIT (VA)* 12.5% Treasury Ladder* 12.5% Vanguard Short-Term Corporate Bond* 12.5% Vanguard Limited-Term Tax-Exempt* 12.5% Vanguard Ohio Long-Term Tax-Exempt Ida will admit that this portfolio is less than ideal. It does not contain as much of a value tilt as she would like, but there simply was not enough room in the sheltered part of her portfolio. And she's not wild about the Ohio muni fund's relatively long duration (6.4 years). Unfortunately, it was the only reasonably priced Ohio fund available.

Both Ida and Ted provide us with examples of the kinds of compromises that investors in the real world make because of their port-folio's tax structure. Ted is unable to own value stocks at all, and neither Ted nor Ida is able to take advantage of the excess return that comes from rebalancing with splitting their foreign stocks into regions.

Obviously, there are many intermediate cases between Ted's and Sam's; Ida's is just one. Take a look at Sam's portfolios in Table 13-8 Table 13-8. At the risk/return level of 100% stocks, fully 60% of his a.s.set cla.s.ses are tax-inefficient (U.S. large and small value, international value, REITs, and precious metals). If an investor has decided on a 50% allocation to stocks, owning all these tax-inefficient a.s.set cla.s.ses mandates that at least 30% of his a.s.sets be tax-sheltered. And even in this case, it would actually be nice to have about 10% more sheltering for cash-in fact 40% of the total-to allow for rebalancing stock purchases in the case of a generalized market fall.

Young Yvonne The highest hurdle of all in the investment game is the one faced by young people. Not only do they find it impossible to contemplate saving for retirement, but they face special problems relating to the small amounts involved. Young Yvonne will ill.u.s.trate these issues.

At the moment, Yvonne doesn't have a penny to her name. Twenty-six years old and in between boyfriends, she's just begun work as an a.s.sistant district attorney. When she was barely into her teens, her father ran off, leaving her mother, twin brother, and her in desperate straits.

Through hard work, scholars.h.i.+p money, and frugality, she persevered and eventually earned her law degree through night school and pa.s.sed the bar exam. And slowly but surely, the sun seems to be peeking through. She's got her own apartment, a health plan with her new job, and, according to her calculations, a bit of disposable income. After she pays for rent, food, gas and insurance on her 1985 Corolla, plus the odd night out with friends, she figures that she's left with about $4,000 per year to invest.

Yvonne has seen tough times. Unlike her friends, she doesn't need to be told that even at her tender age, job one is to save for her retirement and the inevitable rainy day. Sure, she'd like to spend a week in Maui or upgrade from her old junker, but her financial security comes first.

Yvonne's mom works in a bank trust department and has drilled into her that the first dollars set aside should go into retirement and emergency accounts. The one benefit not offered by her employer is a retirement plan, so Yvonne is going to have to set up her own IRA. How does she invest? Since her portfolio will be largely sheltered, she will aspire to one of Sam's allocations from Table 13-8 Table 13-8. She picks the 60/40 version, modifying the bond portion to accommodate a taxable emergency fund: * 12% Vanguard 500 Index* 15% Vanguard Value Index* 3% Vanguard Small-Cap Index* 9% Vanguard Small-Cap Value Index* 6% Vanguard REIT Index* 1.8% Vanguard Precious Metals* 3% Vanguard European Index* 3% Vanguard Pacific Index* 3% Vanguard Emerging Markets Index* 4.2% Vanguard International Value* 40% Cash, Bonds Initially, however, Yvonne cannot own the sophisticated portfolio held by Sam, since all of the stock funds listed have $1,000 minimums for IRA accounts. Further, Vanguard's fee structure for IRAs has to be taken into account. Ten dollars per fund will be charged, but these fees are waived above aggregate a.s.sets of $50,000, or above $5,000 in each individual fund. Researching other fund families, she found that it is possible, in theory, to construct indexed retirement portfolios with Schwab, and was intrigued by the $500 minimums for its funds, but shocked by the quarterly fees of up to $40 for small accounts! And while Fidelity does not sport these onerous fees, she found its selection of index funds too limited.

Obviously, there's a tradeoff here between diversification and expense. Yvonne would like to own all of the a.s.set cla.s.ses shown above, but does not wish to pay up to 1% per year in extra fees for the benefit of owning a lot of small fund accounts. Even worse, it will be at least a few years before she can save enough to meet the $1,000 minimum for the 11 funds listed. For this reason, setting up a retirement account for a young person is a th.o.r.n.y problem. Yvonne can theoretically get around this by buying an "a.s.set allocation fund" that invests in many different a.s.sets, but it is my opinion that these vehicles do not offer adequate diversification and often perform poorly. It is better to use a proper a.s.set-cla.s.s-based indexed approach from day one.

Here's how Yvonne should proceed. The first dollars of her savings should be placed in an emergency money market account. This should be a taxable taxable account, so that penalties will not be incurred if she needs the money. Vanguard's Prime Money Market Reserves has about the lowest ongoing expense ratio of any money market, but it also has a $3,000 minimum. Not infrequently, fund families, in an effort to attract funds, will waive the expenses on their money market funds to boost yields and attract a.s.sets. Don't fall for this-eventually, the fees are reinstated and the yield falls. So most of her first year's savings will go into the emergency money fund. With the remaining $1,000 from her first year's savings she can purchase only one fund in her IRA. The logical choice is the Vanguard 500 Index Fund. So her initial target allocation will be split between just two a.s.set cla.s.ses-taxable cash and sheltered S&P 500. account, so that penalties will not be incurred if she needs the money. Vanguard's Prime Money Market Reserves has about the lowest ongoing expense ratio of any money market, but it also has a $3,000 minimum. Not infrequently, fund families, in an effort to attract funds, will waive the expenses on their money market funds to boost yields and attract a.s.sets. Don't fall for this-eventually, the fees are reinstated and the yield falls. So most of her first year's savings will go into the emergency money fund. With the remaining $1,000 from her first year's savings she can purchase only one fund in her IRA. The logical choice is the Vanguard 500 Index Fund. So her initial target allocation will be split between just two a.s.set cla.s.ses-taxable cash and sheltered S&P 500.

Each year thereafter, she plans to contribute the maximum allowed in her IRA, placing the excess in her taxable money fund for emergencies. And thanks to the Tax Relief Reconciliation Act of 2001, the amounts that she can contribute to her IRA will increase from $3,000 in 2002 to $5,000 in 2008.

At what point does she start to diversify into other a.s.set cla.s.ses? I've already mentioned the tradeoff between diversification and fees; each a.s.set cla.s.s will provide her with additional diversification, but will also cost her the $10 per year fee for fund accounts of less than $5,000. There are many ways to approach this problem, but a reasonable compromise would be to add an additional fund for each $5,000 contributed. This will initially result in 0.2% extra expense-not a bad price to pay for the diversification obtained. I'd recommend adding in a.s.set cla.s.ses/funds in the following order: 1. $0$5,000 added: Start with Vanguard 500 Index Fund.2. $5,000$10,000 total contributions: Add Vanguard Total International Fund.3. $10,000$15,000 total contributions: Add Vanguard REIT Index Fund.4. $15,000$20,000 total contributions: Add Vanguard Small-Cap Value Fund.

Note that we are not adding $5,000 to each fund in sequence. For example, Yvonne's a.s.set allocation calls for a total of 13.2% foreign equity (the sum of the four international funds) and 6% REITs. So, of the second $5,000 added, only $1,500 will go into the Total International Fund. The other $3,500 is divided between the 500 Index Fund and the money market. And by the time $15,000 is added, only $1,000 will be put into the REIT Fund.

As the years pa.s.s, she will want to add in the Value, Small-Cap, and Precious Metals funds. Initially, however, her taxable emergency money market account will be considered to be the bond portion of her portfolio. But when she has convinced herself that she has enough emergency money saved up-say $10,000-she will want to add in the Short-Term Corporate Fund and TIPS fund and into her retirement account to maintain her targeted stock/bond ratio.