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Pick Your Own Asset Allocation

A reader writes in (regarding last month’s article about “total market” investing):

“Your article made me feel much more comfortable with my market-cap weighted portfolio!

However, after reading your email, a news story came out about Wealthfront. Burton Malkiel has written extensively about the merits of market-cap weightings. He and Charlie Ellis helped me build my simple portfolio!

However, it just came out that Malkiel is ignoring his own advice, and has decided to add smart beta ETFs to Wealthfront portfolios. This is a crushing blow. It seems more and more of my favorite investing authors are abandoning the plain vanilla portfolios they have written about for decades, and instead are embracing momentum, value, and small stock overweights in hopes of beating the market.

I am trying very hard to keep it simple and stay the course. But it seems we are losing members of the plain vanilla club every day! Losing Malkiel and Ellis was not fun for me to read about this morning.”

Firstly, advisory firms (including robo-advisors) have an incentive to make their portfolios look smart/complicated. If it’s a simple total market portfolio, people might wonder: why not just handle it on their own? Or why not just use a less expensive target-date fund?

The more important point, however, is that there are no clubs or teams here. It doesn’t work to weigh the names on one side of an asset allocation debate against the names on the other side.

Ultimately you have to weigh the evidence and arguments on each side of the debate and then decide for yourself.

If you decide based on the names on each side, it will always be a struggle to stick with the plan, because on any asset allocation debate there will be experts — credible ones — who disagree with you, regardless of which side of the debate you’re on. And they’ll have convincing-sounding arguments and data backing them up.

For instance on the topic of bonds, several parties I respect greatly have made different arguments.

Personally I would find it impossible to weigh the credibility of one of those parties against the credibility of the others.

In addition, if you decide based on names, you always have to revisit your portfolio decisions whenever a) an expert changes opinion or b) you encounter a new expert with an opinion on the matter.

Conversely, once you’ve made the decision for yourself, you can put it out of your mind and move on with your life.

Reading a new expert opinion or reading about an expert changing their opinion should be roughly as impactful as reading a list of “Top 10 Cities for [People of Your Generation]” in a magazine. Even if your town isn’t on the list, you don’t consider moving. You’ve already made an informed decision, so the writer’s opinion has no impact on where you choose to live.

In short, with any asset allocation decision, regardless of what you end up choosing, the goal is to take your time with the decision, so that ultimately it’s your decision, and you can be confident/content regardless of who agrees or disagrees with you.

Is It Time to Overweight Energy Stocks?

A reader writes in, asking:

“What do you think of an Energy Mutual Fund such as Vanguard’s Energy Fund for a 3-5% position within one’s stock portfolio at this time?

Some investors such as Buffet have suggested that the time to invest in markets when there is “blood in the streets”, and there is crying from obvious pain.  Do you think the rapid price decline of oil and related energy stocks is a good investment through an energy fund, or should one be satisfied with the percentage of energy and related stocks through an S&P 500 fund or total market index fund?  Is there enough pain and blood in this sector to warrant at least a look at an energy fund for a longer term hold of at least one to three years?”

As of 12/12/14, the Vanguard Energy Fund is down just over 30% from the peak it reached in June of this year.

For an investor considering a temporary overweighting of this industry (relative, that is, to the portion of the overall market that it makes up), the question that must be answered is whether this 30% decline is an overreaction, an appropriate reaction, or an underreaction to the decline in oil prices. It would only make sense to overweight this industry if you were convinced that the recent price decline is an overreaction to the news (i.e., share prices have gone down more than they really should have, making today an opportunity to buy at bargain prices).

So, how would you determine whether the price change is an overreaction?

In short, you’d have to do some math (and a lot of research).

Specifically, you’d have to calculate your expectation for the industry’s future earnings given the new lower oil price (which would necessitate, among other things, an estimate of how long the price of oil will stay where it now is). And then you’d have to calculate what you consider to be a fair value of the industry, given those new earnings expectations.

As for me personally, such calculations and estimates would be well beyond the sort of thing I could do with any significant degree of confidence.

But if you don’t actually take the time to do the research and math, all you’re really doing is guessing.

You could make the case that, yes, it’s a guess, but if you make many guesses of this nature over the course of your investing career, you’ll be right more often than not given that investors tend to overreact to news. But there are, in my view, at least three compelling points against such a strategy:

  • Monitoring the news and moving in and out of various funds is quite a bit of work, relative to a simple buy-hold-and-rebalance strategy,
  • It involves higher costs, due to transaction costs and/or owning funds with higher costs than broad-market index funds, and
  • There’s evidence of a “momentum effect” in most equity markets, which might suggest that investors actually tend to underreact to news at first.

Waiting to Invest Doesn’t Make Things Any Easier

A reader writes in, asking:

“We have an undesirably large sum in cash at the moment, nearly a third of our total financial assets. Interest rates can go nowhere but up, but who knows when? Is it best to invest this money right away, or given the current situation, should we wait until we know better what’s happening with the market and interest rates?”

To start with, I think it’s a mistake to think that interest rates have nowhere to go but up. Right now, interest rates are significantly higher than they were at the beginning of this year. (For example, as I write this, the yield on 10-year TIPS is a full 1.3% higher than it was on January 1, 2013.) Given that rates were lower just a handful of months ago, I don’t see why they couldn’t go that low again.

Unfortunately, with interest rates, we’ll never know where they’re headed next.* For example, imagine a scenario in which interest rates rise by 2% over the next year. That would put them at a more historically normal level, but there would be no reason they couldn’t rise further. In other words, no matter how long you wait to see what interest rates do, there’s no knowing what they’ll do next.

And, as it turns out, the same goes for the stock market — waiting doesn’t really give us any useful information about what the market will do in the future.

That is, neither stocks nor bonds become any more predictable (i.e., less risky) simply as a result of waiting to buy them. So, in my opinion, the primary question is simply: How much risk are you comfortable taking right now with this money? (And, for reference, I think it’s perfectly reasonable for investors with a low risk tolerance to include cash as a significant part of their long-term allocation.)

Once you have decided on the allocation you want to use for the long-haul, there tends to be little to gain from delaying your move toward that allocation — with, of course, the exception of situations in which the delay results in a predictable advantage, such as allowing you to make the switch at a lower cost due to a short-term capital gain becoming a long-term capital gain.

*Even the market as a whole tends to be unable to successfully predict interest rate movements. (See Figure 7 from this Vanguard research paper for a striking visual representation of just how often the market gets it wrong.)

What to Do About [Recent Economic Event]

One of the most common types of emails I receive is the email asking what to do about a particular economic event in the news (e.g, various actions by the Federal Reserve or, more recently, the Detroit bankruptcy).

My training in economics consists of precisely four undergrad courses, so I have no insights about macroeconomics that your next-door neighbor doesn’t have. And it would be downright silly for me to think that I’d somehow be able to read about a piece of economic news, foresee some consequence that the market cannot foresee, and be able to recommend a portfolio adjustment that will offer market-beating results. And frankly, I think most investors are in a similar situation.

So unless there is an obvious way in which you will be directly impacted (e.g, the news in question is the Detroit bankruptcy and you are a retiree with a Detroit city pension), I don’t see a great deal of benefit* to spending much time thinking about these things, especially not when there are so many other things that you could spend time and energy on that would have a higher probability of improving your finances (without requiring you to predict stock or bond market movements). Things like:

  • Reducing the costs of your investments,
  • Making sure your portfolio is sufficiently diversified,
  • Making sure the level of risk in your portfolio does not exceed your risk tolerance,
  • Protecting yourself against behavioral investing mistakes,
  • Tax planning,
  • Social Security planning, or
  • Making efforts to increase your earnings potential.

At a broader level, that’s the fundamental problem with most efforts to outperform a simple passive investment strategy. To be worthwhile, they not only have to have a greater than 50% likelihood of success, they have to have a greater expected payoff than the payoff you would likely get from spending a comparable amount of time/energy/money on the above list of objectives.

*Personal finance-related benefit, that is. Staying up to date on economic news can of course be worthwhile for other reasons (e.g., to be a well-informed voter). Just don’t expect it to help your portfolio in any meaningful way.

Beware of Backtested Market-Beating Strategies

As a general rule, if somebody is recommending a given strategy to you as a method for outperforming the market, you should neither be surprised nor impressed to learn that the strategy has impressive historical results.

If you get to make up as many strategies as you want, then backtest them all to see how they worked, you will come up with something that performed well. But that doesn’t mean anything about your skill at outperforming the market. Nor does it mean anything about the likelihood that the historically-winning strategy will continue to be successful in the future.

For example, if an advisor is trying to sell you a portfolio of actively managed funds, you can bet that the funds will have market-beating track records. But, if all we care about is historical results, it would only take a few minutes to come up with a portfolio of 3 individual stocks that beats the pants off the advisor’s active-fund portfolio. Does that mean that, going forward, the 3-stock portfolio is a better bet than the advisor’s mutual fund portfolio — and that both options are a better bet than an index fund portfolio? Of course not.

What if there is a convincing explanation for the historical data?

Consider the following piece of information:

Fund manager age and fund performance have a significant positive correlation. (On average, for each additional year of age, performance improves by almost 0.09%.)

Interesting isn’t it? That’s a sizable difference. And it’s easy to think of reasons why this effect might not be purely random (e.g., older managers have wisdom that comes with age, they have more developed social networks that allow them to get information more quickly, etc.).

Well, guess what?

I lied. (Please forgive me; I’m trying to illustrate a point.) According to the only study I’ve found on the topic, it’s actually the younger managers who tend to have better performance. And now that I’ve told you that — despite it being the exact opposite of what I said above — it’s still easy to come up with a credible-sounding explanation (e.g., younger workers have more energy and motivation to get ahead in their careers, they’re more up-to-date with various useful technologies, they’re more willing to take risks, etc.).

By definition, even if it’s the result of pure randomness, some age range is going to have the best-performing fund managers. And no matter what age range it is, our human brains will have no trouble coming up with an explanation for why that phenomenon makes sense and why it could be expected to continue.

As humans, we look for patterns. And when we find one, we try to identify a cause — even when there’s no cause to be identified. We’re naturally susceptible to being “fooled by randomness.”

Maintain Your Skepticism

If a person has anything to gain by convincing you of his ability to beat the market (e.g., a commission, your assets under his management, or your subscription to a paid newsletter), it would only be surprising if he did not have a strategy with impressive historical results and a convincing explanation.

Investing Based on Economic News

A reader writes in, asking:

“I am a recent retiree looking to balance protection and income in my investment portfolio in this difficult economy. Given the recent troubles in the eurozone and the news that the UK might leave the EU, do you think US investors should be moving away from european stocks?”

Generally speaking, I do not think it makes sense to adjust one’s allocation to a given stock, industry, or country based on economic news.

The reason I don’t think it makes sense to make such changes is that new information about a stock (or a group of stocks, such as a country or region) is typically reflected very quickly in the stock’s price. (This is what people mean when they say the market is “efficient.”)

As a result, investing based on economic news is an “early bird gets the worm” sort of thing. And, if you found out about the news in question by reading it on CNN, Google News, or some other website with many thousands of readers, you are not the early bird.

In fact, you wouldn’t even be the early bird if you were the journalist writing the story. If you were the source the journalist called to get information about the story, then you might be the early bird. (Or rather, you might have been the early bird, if you had acted on the information several days or weeks ago.)

In other words, you can reasonably expect to earn extra returns by reacting to economic news only if you have reason to think that the rest of the market:

  1. Doesn’t know about the news (though you would then want to be careful of insider trading rules), or
  2. Is interpreting the news incorrectly (and therefore pricing the stock or group of stocks incorrectly).

And given how many analysts there are paying attention to every corner of the market, such situations don’t arise terribly often for most investors.

I think Vanguard Chief Economist Joe Davis gave excellent advice in a 2012 interview for Vanguard’s client newsletter:

“I encourage our clients to try to minimize the attention they pay to economic news, because I think that can actually lead to the pitfall of wanting to react.”

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