Monday, February 18, 2008

Profit Like Yale: Breaking It Down

I'm sick as a dog today and spending a little more time than usual catching up on the online news. One of my stumbles was the Times article, Keep It Simple, Says Yale's Top Investor. The "Investor" happens to be the guy who runs Yale's endowment, David F. Swensen. Last year when everyone else's portfolios were toeing the precipice (yours truly included), he killed the market with a 28 percent gain, bringing the portfolio up to $22.5 billion. E-effing-gads.

So his advice to the little guys and gals is exactly what the title suggests.

    For most people, he recommends a very basic approach: use index funds, exchange-traded funds and other low-cost instruments, and stick to your long-term asset allocation — even when the markets are in tumult.

    Don’t be distracted by market forecasts, he said. “You have to diversify against the collective ignorance,” he said. “I think nobody is in a position to react to these big macro-issues. Where is the dollar going to be or what is G.D.P. growth going to be in China? For every smart person on one side of the question, there is another smart person on the other side.”

To translate the first paragraph, index funds are mutual funds that track an index. And to translate the translation-- a stock index is like a book index. So let's take a cookbook. Everything under the Soup section of the index is the contents of the book that are soup. An index lists contents, that's all.

So a stock index of the S&P 500 is a listing of the contents of the S&P 500; the 500 largest market cap (what they're worth) companies publicly traded on the NYSE and NASDAQ. So how would a mutual fund track the index? The same way a book would, two pages for vegetable soups, one page for green eggs and ham stock. Microsoft 2% of the S&P and Apple 1 %-- I totally made those numbers up. So with an index fund you will never beat the market, but you are the market, so you'll never do worse (within hundreths of one percent, perhaps, because the math is never perfect). And if you'd rather be worried about beating that other bidder on eBay, rather than beating an index return on the New York Stock Exchange, then index funds are for you. They also cost less, sometimes a lot less, than actively managed mutual funds. Paying fees on your investments eats away at your earnings; you pay 2 percent and gain 1 percent, you just lost 1 percent. You pay .018 of 1 percent and gain 2 percent, you just gained- well, you do the math. Over the course of a few decades, the hundreds of dollars turn to tens of thousands.

His next suggestion was ETFs, Exchange Traded Funds. The short answer to what is an ETF is that an ETF is an index fund traded on an exchange (the stock market). While mutual fund companies create their own index funds and you buy from them, ETFs are index funds that you can buy or sell like stock, for example through an online broker like Sharebuilder or Scottrade. A more detailed description of their differences can be found here and here.

So that was a long explanation for a simple investment strategy, but that's partly why Swensen advocates for them. Their low costs boost your returns, their built-in diversification spreads your risk, and the index tracking removes the headache of stock picking.

    He proposes a portfolio of 30 percent domestic stocks, 15 percent foreign stocks, and 5 percent emerging-market stocks, as well as 20 percent in real estate and 15 percent each in Treasury bonds and Treasury inflation-protected securities, or TIPS.

So here's an easy example for illustrative purposes only, I do NOT suggest you go out and do this. Let's use Vanguard's ETF page, Vipers, as an example. Let's say you have $5,000 in a savings account. So you would transfer money to an online broker like Scottrade and fund a ROTH IRA account to the annual max, buy $1500 of VTI (30% domestic), $750 of VEU (15% foreign), $250 VWO (5% emerging markets), $1000 of VNQ (20% real estate), and $750 EDV (15% Treasury Bonds), and 15% TIP (not Vanguard, but Lehman's TIP ETF, 15%Treasury inflation protected securities). In this example, ETFs make it easy to plug in asset allocation.

So I decided to compare my largest ROTH IRA holding, T. Rowe Price Retirement 2040 Fund. This is not an index fund or an ETF, it's an actively managed mutual fund, but one of those target funds I like to rave about. Again, target funds should be for your own retirement date. This fund is for a targeted retirement date of 2040 and its asset allocation is as follows:

    Domestic Stock 65.5%
    Foreign Stock 22.3%
    Domestic Bond 8.4%
    Cash 3.2%
    Convertibles 0.4%
    Foreign Bond 0.2%

Swensen's domestic allocation is a little low, and I'm kind of okay with mine (yes, I realise I've never gained 28% annually on my quote unquote portfolio), but I did discover I have no real estate, particularly REITs (Real Estate Investment Trust), which is kind of a big deal. So I think I'll sell off one of my overweights (too much of a percentage in my asset allocation pie) and buy Vanguard REIT Index ETF (stock ticker VNQ), which is, shocker of all shockers, way off its 52 week high so I'll definitely be buying low. Which brings us to his other piece of advice. Rebalance. The market value of your stocks and bonds changes all the time, so at least once a year just buy and sell shares to bring your asset allocation back to target.

If all of this sounds like a lot of work, it's really not. Even if you don't follow his exact percentages, and I don't think you should follow any one person's exact percentages (especially mine!!), the idea is right on the mark, there's a lot of white noise out there for some very simple ideas. And speaking of white noise, I do love when he takes Jim Cramer down a notch.

    When possible, he said, rebalancing should be done in a tax-sheltered account, like an I.R.A. or a 401(k), to avoid tax liabilities. “When you are putting fresh money to work,” he said, “you put it in an asset class where you are underweight and take money out of a class that is overweight.”

    He says it is fruitless for individual investors to pick stocks. “There is no way that an individual can go out there and compete with all these highly qualified and compensated professionals,” Mr. Swensen said.

    HE criticized the approach of Jim Cramer, the CNBC host, who encourages investors to trade stocks in strategies that Mr. Swensen says cost heavily in commissions and taxes.

    “There is nothing that Cramer says that can help people make intelligent decisions,” Mr. Swensen said. “He takes something that is very serious and turns it into a game. If you want to have fun, go to Disney World.”


Ms. M&P said...

I'm bookmarking this for when I'm ready to invest ;) Great post!

Guerilla Investor said...

Swensen sounds like a pretty smart guy. He beat me last year with his 28% compared to my 16%. Still I disagree with a few things. Seems to me the average investor should now have a little weighting in precious metals. Also for anyone with at least half a brain I believe it is not that difficult to catch the major turning points in the markets with a little study.

PiggyBankBlues said...

thanks m&p! i know, it's a long ass post...

guerilla investor- welcome! you make interesting points, and congrats on that 16% return last year :)

i definitely agree that the average active investor should have a little weighting in precious metals, but i think if you're more passive at most an index perhaps? i know that The Sun's Financial Diary has gone through metals a little, but i confess i don't own any and i'd need to learn more. do you have any suggestions?

as far as catching the markets' major turning points, i think in broad terms it's possible. but to transfer that into portfolio returns is not just half a brain of effort, or a lot of booms/busts would have been avoided, and a lot more people would have higher returns.

swensen also has an incredible amount of resources at his disposal. i think if you flatten the playing field you might have beat him last year :)

Alisa said...

Nice post. Thank you for sharing this!

Be well.