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Book Review: The Intelligent Asset Allocator

What’s your style of investing: Stocks, or Bonds? And if you say “Stocks”, are you fond of Small Cap or Large Cap, and would those be in the categories of Value or Growth, and in US, European, Asian, or Emerging Markets?

I’ve learned that readers of Mr. Money Mustache vary widely in their response to a question like this.

Some will immediately scoff at the simplicity of it, slicing each of the investment types above into further subcategories and then commenting on their appropriateness given our current position in the business cycle.

Others will discount stocks and bonds entirely, muttering something about “Federal Reserve toilet paper” and “Fiat money”, before talking about their portfolio of precious metals (and at the extreme end of this position, stockpiles of canned food, guns, ammo, defensible land and tinfoil hats).

And quite a few of us will say, “I have no effing idea – I just checked a few appropriate-looking boxes on my company’s 401(k) signup sheet and I’ve got the rest of my ‘Stash in cash  because I don’t feel comfortable enough to invest massively in stocks!”

One of the goals of this blog is to get the latter category of people to get off of their asses and start learning about real investing. You do this by reading books – you might even start with those mentioned in the Book Recommendations page right here on MMM. But you must do it.

The good news is, you don’t need to know anything about investing to start saving for financial independence and early retirement. Learning frugality and how to live an efficient lifestyle is by far the most important part. Paying off all your debt is a good first step. And after that, while your savings are still small, your loss from not investing is small.

The bad news is, every $100,000 you have sitting around in a 1% bank account is missing out on about $6,000 per year compared to what you’d get by investing it well. Right now, it is actually shrinking, since it is growing more slowly than inflation. Your hesitance to read a few investment books is costing you $500 per month, for each hundred thousand idle employees.

So I’m writing this post under the guise of a book review of The Intelligent Asset Allocator by William Bernstein, but it’s really more than that. An understanding of Asset Allocation is a useful and necessary brick in your understanding of stock market investing, and it is something I’ve never covered properly on this blog before, so here we go!

Let’s start with the concept. In a long-ago article on stock investing, I described the basic idea of an index fund and suggested that you don’t have to know anything about individual stocks. You just need to find the right index funds, with the lowest management fees. By using the Vanguard investment company (www.vanguard.com), you get this without any further research.

But in that old post, I oversimplified things by only mentioning the VFINX index fund – a fund that holds only very large US-based companies. That’s still a good no-brainer investment choice for long-term growth, but the concept of Asset Allocation takes it up a notch by offering less volatility (which we all understand thanks to the past decade) while sacrificing little or none of the long-term performance. To understand how this could be, check out the following example:

Imagine you start with a $1.00 investment.
Now you start flipping a coin. If the coin comes up Heads, your investment goes up by 30% For Tails, you lose 10%.

After one coin flip, you could be one of two places:
Up 30% so you have $1.30 : there’s a 50% chance of this
Down 10% so you have 90 cents : also a 50% chance

But what if we start over and split our money in half and add a SECOND coin, and bet 50 cents of our money on the outcome of each coin?
After one flip, you could be any one of four places:

Two Heads:
both of your fifty cent chunks went up by 30%. The are now 65 cents each, totaling $1.30.
Two Tails:
Both chunks are down to 45 cents each. You have 90 cents.
A Head and a tail:
One chunk is worth 65c, the other is 45c, you have $1.10
A Tail and a head:
One chunk is worth 65c, the other is 45c, you have $1.10

Note that each of these outcomes has an equal probability of happening: 25%. But notice how you now have a three out of four chance of making money, and only a one out of four chance of losing it on any given flip. Over time, flipping the single coin and the double coins will yield exactly the same long-term returns: an average of a 10% gain per flip. But flipping the double coins will provide much less volatility.

As it turns out, you can do almost the same trick with stocks by understanding the principles of Asset Allocation (also known as Modern Portfolio Theory) explained in this book. Although it’s not a new idea, it is still quite magical, because we are getting less gut-wrenching volatility without compromising on the long-term return.

The reason this works is because the results of the separate coin flips are uncorrelated. To re-create the smoothing effect of flipping two coins with stocks, investors need to find stocks (or “asset classes”) that are also not correlated.

At the most basic level, this is the idea of “diversification”. If you buy one randomly-selected stock on the stock market, and I buy twenty, on average we might be expected to earn the same annual return, but your stock will swing wildly while my mixture of twenty will tend to cancel each other out and move more smoothly.

But if you look more closely at a graph of the share prices of two large US company stocks, even in different industries, you will find that they are still heavily correlated. They zigzag up and down together in response to the short term diaper crappings of market speculators over irrelevant news headlines. Similarly, if you compare the movements of a stock index of ALL the large US companies and the movements of ALL the small US companies, you’ll see a similar correlation. With correlated assets, you don’t get the full benefits of the double coin flip, so you can’t shake the volatility.

But Asset Allocators have figured out a way around this. By studying detailed historical price charts of many types of assets (stocks and bonds of  multiple countries around the world), they have found an appropriate mix of healthy investments that tend to move much more independently of each other. Bonds, for example, often move in exactly the opposite direction of stocks.

The book offers interesting explanations on how this all works out mathematically, but let’s just skip directly to the end result: You get the best results by owning at least four asset classes.

If you only want four, the author suggests you might hold these ones, by simply plopping 25% of your investment portfolio into each:

US Large-capitalization stocks (as measured by the S&P 500 index)
US Small-cap stocks (the Russell 2000 index):
Foreign stocks (the Europe, Australasia, and Far East index, also known as EAFE)
US short-term bonds

If you wanted to do all your investing with Vanguard funds as I do, you might throw 25% each into VFINX, VB, VDMIX, and VBISX.

Now you’re nicely diversified and owning slices of thousands of companies across the world with only those seventeen capital letters. It is truly an amazing and convenient world we live in. But there’s one last step: rebalancing.

The book explains that due to various market manias, occasionally one of these asset classes will start to inflate into a bubble, even while others will drop in price. To take advantage of this, you sell the funds that have appreciated, and use the proceeds to buy the assets that have gone on sale. Once per year, you simply make the appropriate mix of sales and purchases to set all of your allocations back to 25%, and you have effectively done a “buy low, sell high” move without even knowing what companies you own.

To beginner investors, this sounds crazy, and to advanced ones, it sounds like “well, DUH!”. But if you read enough investment books, they will convince you that the math and statistics behind all of this show that rebalancing works out quite well over the long run. You get reduced volatility and increased returns, with very little effort.

And the convenience goes even further: there are even index funds that will do this asset allocation and rebalancing for you! Vanguard’s VBINX fund, which I have recommended in the past, automatically maintains a 60/40 split of US stocks and bonds. There are surely other funds out there which will do a full 4-way round-the-world allocation as well (if you know of one,  let me know and I will update the article).

So it’s a good book. Financial and engineering nerds will eat it up. But people who find even this article’s attempt at an introduction to the topic confusing will probably want to start with a more general-purpose investment book, like The Four Pillars of Investing, by the same author.

  • Britinmadrid August 5, 2015, 11:58 am

    Everything is correlated in a downturn or market crash. OK, US government bonds will usually go up if stocks decline, but most else will follow stocks down. This is about the only time I can recall where nearly all assets are overpriced. There is nowhere to hide except for (very uncomfortable) cash. There may be further speculative gains to be made, but it´s not what you make in the short term; it’s what you manage to retain over the complete cycle.

    Reply
  • Uncle Cheese-it August 7, 2015, 4:07 pm

    Hi
    excellent and detailed information! My problem about diversification is not about the security (stock) but has to do with the variety of investments. I have a Betterment account (Vanguard index funds), a regular stock trading account (which I review and work on every day), a life insurance (locked in for 5 more years), a relatively large saving account, a 401K and IRA and a couple of other minor investments accounts. I also own a rental property (which is paid off and generates good rent money ).
    Should I consolidate everything in, say, one large Betterment account (with the exception of the 401K probably)? or should I continue managing these multiple accounts for the sake of diversification?
    Thanks for your insight!
    – Uncle Cheese-it

    Reply
  • Tyler March 31, 2016, 5:03 am

    Please forgive me if I missed this in the comments or elsewhere on the blog. I am still new here, but why are we using mutual funds of vanguard when the ETFs seem to have lower expense ratios? From comparing these mutual funds with the ETF equivalents it also seemed like they have the same relative yield. Is it because we can automatically contribute to mutual funds and you don’t need to necessarily buy round numbers of stock at a time? I’m new to Investing, so any corrections are very welcome. Thanks!

    Reply
    • Alex March 31, 2016, 4:11 pm

      Hey Tyler,

      This post was made several years ago and ETF’s were not as popular or accepted as they are today. But you are on to something with the automatic investing and being able to contribute dollar amounts which for most people makes it easier to think about. Investing wisely is largely a behavior issue and ETF’s can make it a larger temptation to trade with them.

      Mutual Funds have all transactions happen at the end of the day, at one time. There is no intra-day trading. With ETFs you can buy and sell them throughout the trading day.

      ETFs are cheaper, however at Vanguard once you have 10,000 in the mutual fund they are exactly the same price. In the end it is up to you which way you would like to go. I just wanted to set up to automatically invest and not have to think about it I would use mutual funds. If you want to be able to trade during OR you want the low fees now and wont be trading anyway I would do ETF.

      Reply

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