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Doing Nothing About a Market Decline

A reader writes in, asking:

“The performance in my Roth IRA has been all over the place lately. I recently had a day where literally all four of my funds went down. What do you do differently during periods when nothing is performing well?”

I’ve gotten a few questions like this lately. And you can see the same thing happening on the Bogleheads forum too. For anybody who started investing in March of 2009 or later, they’ve never really experienced a bear market. So little bumps like we’ve seen lately are new and scary.

And to be clear, what we’ve experienced in the last few months is just a little bit of bumpiness. Vanguard Total Stock Market Index Fund is down about 5% over the last 3 months. But it’s still up, year-to-date. Compared to the 2008-2009 decline during which the market fell by more than 50% (or the 2000-2002 decline during which it fell by very nearly 50%), what we’ve seen in the last few months is nothing.

Nothing at all.

And as it happens, that’s also the answer to the reader’s question about what we’re doing differently with our portfolio as a result of the recent bumpiness: nothing.

My wife and I are just contributing to our accounts and buying the same LifeStrategy fund as always.

If you have an appropriately diversified portfolio that is suitable for your risk tolerance, there are only a few things to do during a market decline:

  1. Rebalance, if your plan calls for such. (Quick note on definitions: rebalancing is not changing your targeted allocation. It’s moving your current allocation back to your targeted allocation. It is not a change in plan, but rather an implementation of the already-existing plan. Rebalancing generally means buying more of whatever has been performing the worst recently.)
  2. Tax-loss harvest if you have holdings in taxable accounts.
  3. Cut spending, if you’re retired and spending from your portfolio and your retirement plan calls for such.

That’s it. Obsessively checking your portfolio to see whether it’s up or down from yesterday doesn’t help. And trying to predict whether it will be up or down tomorrow doesn’t help either.

In our case, we use an all-in-one fund that is automatically rebalanced, so there’s no need to worry about that. And essentially all of our holdings are in retirement accounts (we have high contribution limits, due to self-employment income), so there’s no need to worry about tax-loss harvesting. There’s no need to do anything at all.

Don’t Forget About Disability Insurance

A fundamental principle of financial planning is that insurance comes first. If you don’t have the proper insurance, you can do everything else exactly right — save a large percentage of your income, invest that savings wisely, engage in excellent tax planning, etc. — and still end up financially ruined if you find yourself on the unlucky side of a large uninsured risk.

Of course, you don’t need every type of insurance. For example, if there is nobody else who is financially dependent upon you — as would be the case for many people with no children — you most likely have no need for life insurance.

But if you have a job, there’s a good chance you are dependent upon the income from that job — and therefore have a significant need for disability insurance.

A 2014 “actuarial note” from the SSA estimated that, for a person who reached age 20 in 2013, there is only a 6.5% chance of dying prior to full retirement age but a 27% chance of becoming disabled prior to full retirement age.

And the above estimate uses the SSA’s definition of disabled, which states that you must be unable “to do any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months.” There are plenty of people who incur injury or illness that meaningfully reduces their income yet who do not qualify for Social Security disability benefits.

In addition to being difficult to qualify for, Social Security disability isn’t particularly generous in terms of amount paid. You can get an estimate of what your Social Security disability benefits would be (if you became disabled right now) by signing into your online SSA.gov account. The average monthly Social Security disability benefit is $1,172. That’s a heck of a lot better than nothing, but even with other forms of government assistance, we’re talking about a serious financial struggle in most cases.

So how many people actually have private disability insurance? Last year an article by Stuart Heckman in the Journal of Financial Planning looked at the 2013 Survey of Consumer Finances from the Federal Reserve Board to answer that question (and many other related questions). Heckman found that only 30% of households had private disability insurance (i.e., insurance beyond that provided by Social Security). Interestingly, he also found that people who use a financial planner are not significantly more likely to own disability insurance.

My overall point here is just to provide a basic reminder: don’t forget to consider disability insurance. Do you have it? If not, should you?

If you do end up shopping for disability insurance, you should know that there’s a lot of variation from one policy to another. This Bogleheads wiki article provides a brief explanation of the most important considerations.

“Total Market” Investing and Multi-Factor Models

A reader writes in, asking:

“I would like to ask you about factor investing. For background, I am a plain vanilla investor. I use the Vanguard Market-cap weighted Total World Stock fund. As simple as it gets!

However I have been reading literature about the case for factor investing. There seems to be a broad consensus that multi-factor models explain returns much better than the CAPM. [Mike’s note: the Capital Asset Pricing Model is an older model in finance that states that a portfolio’s expected return is a function of how sensitive the portfolio is to market risk. More recently, various multi-factor models have said that a portfolio’s expected return also depends on other things, such as how much of the portfolio is allocated to small-cap stocks (as opposed to large-cap stocks) or to value stocks (as opposed to growth stocks).]

I have heard many recommending tilting to small and value stocks.

Do I need to be concerned about my plain vanilla strategy? Am I potentially missing out on much superior returns over the long run?”

It’s true that there is, roughly, a consensus that multi-factor models explain returns better than CAPM. That isn’t an argument for or against a “total market” portfolio though.

To back up a step, a one-factor model such as CAPM tells us that stocks are riskier than bonds and should therefore usually have higher returns. But that’s not an argument for an all-stock portfolio (or any other particular stock/bond allocation). It all depends on your own personal balance of desire for return and willingness to take stock market risk.

Similarly, in multi-factor models, value stocks and small-cap stocks are generally considered to have higher risk and higher expected return than their counterparts. But that’s not an argument for any particular value/growth allocation or small/mid/large allocation. Again it all depends on your personal balance of desire for return and willingness to take risk.

In my experience, it’s usually the salespeople (e.g., certain advisors or purveyors of mutual funds) who argue that a given allocation is better, while the academics are much more neutral on the matter. For instance, Eugene Fama (one of the two people originally behind multi-factor research) was super clear in a video interview on Dimensional Fund Advisors’ website. The video disappeared when they restructured their site a few years back, but here’s the relevant quote:

Interviewer: Some people cite your research showing that value and small firms have higher average returns over time and they assume that you would recommend most investors have a big helping of small and value stocks in their portfolios. Is that a fair representation of your views?

Fama: Um, no. (Laughs) Basically this is a risk story the way we tell it, so there is no optimal portfolio. The way I like to talk about it when I give presentations for DFA or other people is, in every asset pricing model, the market portfolio is always an efficient portfolio. It’s always a relevant portfolio for an investor to hold. And investors can decide to tilt away from that based on their personal tastes.

But that’s what it amounts to. You can decide to tilt toward more value or smaller size based on your tastes for these dimensions of risk. But you needn’t do it. You could also decide to go the other way. You could look at the premiums and say, no, I think I like the growth stocks better. Then, as long as you get a diversified portfolio of them, I can’t argue with that either.

So there’s a whole multi-dimensional continuum here of efficient portfolios that anybody can decide to buy that I can’t quarrel with. And I have no recommendations about it because I think it’s totally a matter of taste. If you eat oranges and I eat apples I can’t really quarrel very much with that.

As far as still-available interviews with Eugene Fama, here are two:

In the first video, Fama talks about the origin of the 3-factor model. While he doesn’t explicitly get around to portfolio construction in this interview, he does state very clearly that his view is that the higher returns are the result of higher risk. (Around 5:26 is where the conversation leads to this point.)

The second video is longer and covers a lot of topics. The video’s publisher explicitly requests that it not be quoted, so I won’t quote it. Instead, I’ll just point out that around 28:45, Fama says things very similar to the interview that I quoted above. And at 35:28 he says something very clear about holding a market portfolio and whether he thinks it’s a good choice or not.

In my view, overweighting small-cap stocks or value stocks in your portfolio is a perfectly reasonable thing to do. But on occasion you’ll encounter people who indicate that doing so is the smart way to invest and only an uninformed investor would say otherwise. But that’s clearly not true.

Evaluating the Vanguard International High Dividend Yield Index Fund

Quick housekeeping note: My wife and I are in the middle of a move from Colorado to St. Louis. As a result of that and a minor medical issue (nothing to worry about, but it’s taking up a fair bit of time), there will be no articles until Monday 11/7, at which point the publishing schedule will resume as normal.

A reader writes in, asking:

“Have you looked at the new international high dividend yield index fund that Vanguard released earlier this year? I think it looks appealing, but it’s new so hardly has any track record. I’d be interested to hear your thoughts.”

With regard to dividend strategies in general, there’s no economic advantage to receiving dividends rather than an equal amount of price appreciation. (And in fact, there’s a disadvantage, if the fund is held in a taxable account because the dividends will be taxed immediately whereas capital gains tax isn’t incurred until holdings are sold. And capital gains tax can sometimes be avoided completely if the holdings are left to heirs.)

So a dividend strategy is only useful if there’s some reason to think that dividend stocks will outperform other stocks of similar risk.

Overweighting high-dividend stocks relative to their market weight often results in a portfolio that is heavy on value stocks — because value stocks tend to have higher than average dividends.* And both Vanguard and Morningstar do classify the new Vanguard International High Dividend Yield Index Fund as an international “large value” fund.

So how does the new fund compare to Vanguard’s existing foreign large value fund (i.e., the Vanguard International Value Fund)? The following chart (made with the Morningstar website) shows how the two have performed since the inception date of the new fund. The blue line is the new International High Dividend Yield Index Fund, and the orange line is the older International Value Fund.

international-dividend

As you can see, they have tracked each other very closely.

As far as differences, the new fund does have a slightly lower expense ratio (0.30% for Admiral shares, as opposed to 0.46% for the International Value Fund), which is certainly a good thing.

And, unlike the existing actively managed fund, there’s no possibility that the new dividend index fund will experience outperformance or underperformance due to good/bad individual stock selection. Personally, I see that as a good thing. But others may disagree if they’re more optimistic about the value of low-cost active management.

In other words, if you’re looking for an international large-cap value fund to add to your portfolio, the new Vanguard International High Dividend Yield Index Fund looks like a perfectly good choice. I would not say, however, that it is anything particularly groundbreaking compared to Vanguard’s older offerings.

*Brief tangent: I recently encountered this article by Rick Ferri, which does a great job explaining why the value premium may be directly tied to dividends.

Why Is Currency Risk Bad?

A reader writes in, asking:

“I don’t see why currency risk is necessarily bad. Sure, sometimes the dollar will increase in value, making your foreign investments worth less. But sometimes the opposite will happen. It seems like, on net, this should neither help nor hurt over an extended period.”

As a bit of background information: “Currency risk” refers to the volatility that foreign investments (such as international stock funds) experience as a result of fluctuating exchange rates. For example, your international holdings will decline in value if the dollar increases in value relative to the currencies in which your foreign holdings are denominated. Currency risk is often cited as a reason for underweighting international stocks and bonds relative to the part of the overall world market that they make up.

This reader is correct that currency risk should, on average, neither increase nor decrease your returns. And that’s precisely why it’s an undesirable risk. After all, there are an assortment of risks that do increase the expected return of your portfolio: increasing your equity allocation, increasing the duration of your bond holdings, reducing the average credit rating of your bond holdings, etc.

So, if there’s a certain level of overall risk that you can tolerate, you might as well get as much expected return for that level of risk as you can. In other words, why take on any risks for which you would not expect to be compensated? (This is also, by the way, the reason that holding a concentrated portfolio of individual stocks does not typically make sense. It increases the risk relative to a diversified stock portfolio, yet it does not increase expected return.)

To be clear, the point here isn’t that including an international allocation is a bad idea. It isn’t. Most experts agree that including international stocks in your portfolio is still desirable, because it increases the total number of stocks that you hold, which improves diversification, and because it adds a component that has less-than-perfect correlation to U.S. stocks while still having similar expected returns. The point is simply that it likely makes sense to hold a smaller allocation to international stocks (and bonds) than you would if currency risk did not exist.

Why Do Risk-Adjusted Returns Matter?

A reader writes in, asking:

“Why do academics always talk about risk adjusted returns? I get that risk matters and you shouldn’t have a riskier portfolio than you can manage. But if I compare two strategies over a period, I’m better off at the end if I used the strategy with the higher return, not the one with the higher risk adjusted return. So why is risk adjusted return relevant?”

The usefulness of the risk-adjusted return concept is that we can use it to evaluate a proposed strategy to determine whether it has historically been a better way to increase returns (or reduce risk) than simply adjusting any of several other well known variables (e.g., stock vs. bond allocation, duration of bond holdings, credit quality of bond holdings, etc.).

For example, imagine that you currently have a 50% stock, 50% bond portfolio that uses simple “total market” index funds for both the stock and bond portions. But then you meet with a financial advisor who suggests that you would be better off if you got rid of your total market stock funds and switched to a portfolio of individual stocks, picked according to a specific set of criteria. And this advisor shows you historical data demonstrating that his hand-picked stock portfolio has had higher returns over the last several years than your total market stock funds.

Obviously, one problem here is the critically dubious implication that the past is a good predictor of the future. But let’s set that aside for the moment to focus on another problem: A portfolio comprised of a handful of individual stocks will generally have far more risk than a broadly diversified total market stock portfolio.

In other words, the advisor isn’t making an apples-to-apples comparison, and he has not demonstrated that his strategy is actually an improvement over a total market strategy. What needs to be demonstrated is whether the 50% bond, 50% hand-picked-stock portfolio the advisor is proposing has had greater returns than an index fund portfolio with the same level of risk.

For example, you might find that the advisor’s 50/50 strategy with handpicked stocks has historically had a risk profile comparable to a 70/30 stock/bond portfolio using total market funds but that its historical annualized return is closer to that of a 60/40 portfolio using total market funds. If that’s the case, then the advisor has clearly not added any value. All he has done is bump up the risk and return in an inefficient way. A 70/30 total market portfolio would have had higher returns with the same level of risk as what the advisor is proposing, and a 60/40 total market portfolio would have had the same level of returns, with less risk than what the advisor is proposing.

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