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How to protect against inflation:

1. Don’t stick cash under a mattress.

2. Avoid long-term bonds (which get killed by inflation).

3. Gold is a great inflation hedge, but is a terrible long-term investment. Other commodities are similar.

4. TIPS (e.g. VISPX) make excellent inflation hedges AND long-term investments.

5. Short-term investments, like money market funds, short-term bonds, and short-term CDs, protect well against anticipated inflation. If people expect 4% inflation, these investments need to pay more than 4% in order to get people’s money.

6. Stocks and real estate protect against inflation over long time periods (5-10 years), but not over short periods.

In other words, most investments do fine with inflation. Physical cash and long-term bonds are the real risks.

The sleep test: lessons from a bear market

Unless you’ve completely avoided the news for the last few weeks, you know the global economy is in trouble. No one knows how bad it will be, when the bottom will hit, or how long it will take to recover. But plenty of “experts” think they know the answer.

So what is an investor to do during this time? It’s pretty obvious what an investor shouldn’t do - sell in a panic (read: “low”), and buy when the market picks up (read: “high”). Remember that investors who stayed in the market during the Great Depression did just fine over the long run. And those who weren’t investing for the long run shouldn’t have had much in the stock market in the first place. In other words, your best bet during a market like this is probably to stick tight.

Unless you can’t sleep. If the 14% drop in the US stock market is keeping you up at night, you have too much invested in stocks. This is “the sleep test.”

The sleep test is a handy way to figure out your risk tolerance. If the market drops 14% and you panic, then your asset allocation exceeds your risk tolerance. After all, if you’re only 20% in stocks, the 14% dip is only a sleep-worthy 3% decline, potentially offset by your other investments. And if you can’t sleep following a 3% decline, then you should seriously rethink whether equity investing is for you. For most people, there is probably somewhere between 20% equities and 100% equities at which they can sleep well in the midst of an economic crisis. This is your risk tolerance.

So if you can’t sleep, consider decreasing your equity holdings. But there’s a catch. You can’t buy more stocks when the market picks up. You’ve got to stick with your asset allocation even if we see a 20-year bull market. Anything else is performance chasing.

Personally, I’m going to stick tight. I understand that we’re in an unprecidented financial crisis, but every crisis is unprecidented. And I think it is extremely likely that the US business climate will be strong overall for the next 20 years, which means that it is extremely likely that stocks will do well. So instead of panicking or chasing performance, I’m going to stick to my 75%/25% asset allocation.

HSA as a multi-purpose investment account

At my company (Tumblon), our health insurance plans are high-deductable + HSA. This is a great option for us, though it isn’t perfect for everyone. If you find yourself with a HSA, how should you think about it?

1. Minimally, it is a savings account for near-term medical expenses with some tax advantages. You deposit some of your income, pre-tax; and you can write checks or use a debit card against the account when you have medical expenses. These expenses are then tax free. You might want to put away at least enough to cover your high deductable for a year (at least $1,100 for an individual, and $2,200 for families) - that way, a year of major medical expenses won’t eat into your other finances.

2. But you might also want to look at it as a long-term medical savings account. So you’re healthy now, and you may not have many medical expenses this year; but what about 10 years from now? 20? Money you put away into an HSA is yours forever. Remember too that you can only contribute to an HSA in years when you’re covered by a high-deductable plan, but you keep the HSA forever. So if you work for a few years at an employer who offers a high-deductable plan, and then you move to another employer with a traditional plan, you can’t contribute any more to your HSA. But you still have it, and can use it to pay for co-pays, deductibles, eye exams, dental work, contact lenses, etc.

3. For this reason, you might want to think about your HSA as part of your emergency funds. Everyone should have money readily available for an emergency, like losing your job. 3-6 months is good. While you should probably have at least 3 months of this in cash (or a money market fund), your HSA could supplement these liquid funds. After all, medical expenses represent one major category of financial emergencies.

4. One step further: a HSA can actually be used as a tax-advantaged retirement account. Your HSA provider will usually give you some investment options where you can put some of your funds, just like a 401k. After you turn 65, you can withdraw these funds without a penalty. You have to pay tax on them when you withdraw, just like an IRA; so it isn’t a free lunch. But it is almost as good as an IRA, letting your HSA serve multiple purposes.

Two caveats.

First, HSA providers generally choose your investment options for you, so a HSA isn’t quite as flexible as an IRA. And just like a 401k, your options may be limited to high-fee mutual funds, so the HSA provider can get a nice commission.

Second, many HSA fees are high. Watch out for HSA accounts that charge $3/month + $50/year + 1% + $20 penalty if certain conditions aren’t met + $30 per investment.

The good news is that you can shop around. You aren’t limited to whatever HSA your employer recommends, and you can move from one HSA to another. So find one with low fees and investment options that you like, and you’ve got a flexible account that serves at least 4 purposes.

Take a look at the US Treasury HSA FAQ website for more.

International asset allocation: how much is just right?

I’m a big believer in international diversification. The days when international stocks were considered “risky” should be long over. An investor who only invests in his or her home country is taking a much greater risk, as Japanese investors realized in 1989.

The case of Japan

The Japanese stock market is still down from its peak after 19 years. So what has happened to various Japanese portfolios during this time? Here are some details, thanks to bpp on the Bogleheads forum.

• 60% Japanese index, 40% bonds, rebalanced annually lost 7% from 1989 to 2007, with a trough of 38% in 2002. $1,000,000 invested in 1989 would be $930,000 in 2007.
  
• Without rebalancing, this 60/40 portfolio would be down 13% from 1989-2007, down 30% at its low point in 2002. $1,000,000 invested in 1989 would be $870,000 in 2007.

Now imagine that a Japanese investor was invested 50/50 in domestic (Japanese) and international (North America and Europe, mostly) stocks. How would this investor perform?

• 30% Japanese index, 30% international, 40% bonds, rebalanced annually: up 93% from 1989-2007. $1,000,000 invested in 1989 would be $1,930,000 in 2007.

That’s still pretty lousy performance, but people who invested gradually throughout the 80’s and 90’s would have done much better than those who invested a lump sum at the peak of the bubble.

And its peak, the Japanese market had an average P/E ratio of over 100. In hindsight, it should be clear that it was dramatically overvalued. Even at the peak of the internet bubble, the S&P 500 had P/E ratio of 46. It’s currently far lower than this. So barring a huge bubble, it seems unlikely that a developed nation’s market would follow Japan’s trajectory over the last 19 years. We’ll come more to this talk of high and low prices in a bit.

But this highlights the importance of international investing. Don’t risk everything on a single country’s health.

How to invest internationally

So how much should I devote to my home country, and how much internationally? There are several approaches.

1. Overweight domestic stocks. Most investors do this. The US market is maybe 40% of the global equities market (by capitalization), so a US investor who only devotes more than 40% of his equity allocation to the US is overweighting US stocks. There is a good reason to consider doing this, and it’s not that US stocks are better or less risky. It’s that US stocks are held in US currency, and unless you’re retiring to another country, you need to preserve your purchasing power in your home country, in US$. So if the dollar rises dramatically and you hold a lot of international stocks, or if the US sees higher inflation than the rest of the world, then a high international allocation will mean you have less spending power back home.

Of course, a healthy US bond allocation can help protect against this, as can domestic REITs or cash.

2. Keep it simple. Invest 50/50 in domestic and international stocks. This will generally overweight your country, though it isn’t too far from the US market capitalization of the last few decades. But it is simple and makes rebalancing easy, which is almost more important than finding the “perfect” allocation. And it is a nice balance between the previous approach (preserving your local purchasing power) and the fourth approach (avoiding bubbles - see below).

3. Follow the market capitalizations. As of this summer, the US stock market had about 41% of the global market. Canada was about 4%. Europe was about 29%, Pacific developed stocks were about 15%, and emerging markets were 11%.

Holding a portfolio that matched this basically means indexing the entire world. And in fact, there are new funds that try to do this (like VT). They don’t do it perfectly, and typically don’t include many small or mid-cap stocks. And the expense ratios are typically higher than just holding separate ETFs. But man, they make global investing easy!

The downside of this approach is that it doesn’t protect you from bubbles - if there is an emerging markets bubble, or another Japanese bubble, you’ll rise and fall with the markets. Of course, that is true of any cap-weighted index: a S&P 500 fund suffered the same problem with the bubble in tech stocks in a decade ago.

4. Follow fundamental weightings. There is a bit of controversy in the investment world today about fundamentally-weighted indexes, offered by companies like Powershares and DFA. These indexes don’t hold their stocks based on cap weighting, but based on fundamentals (like earnings, assets, etc.). This means that they are less prone to bubbles - they will own less of a high-priced stock than a cap-weighted index, and more of a low-priced stock.

These fundamentally-weighed indexes effectively give a value tilt to stocks, which should help their returns over the long run. But they are not without their critics. Amongst other things, whoever designs the fundamental weighting may be prone to performance chasing and backtesting, and these funds typically have higher expense ratios than cap-weighted funds.

A similar strategy could be used for international weightings, but with regular  funds. This eliminates the second problem (higher expense ratios), and can be done in a relatively simple manner.

Here is what that would look like. These examples use P/E, but you could also use other measurements, like the price/book ratio used by Fama-French to quantify value.

• US - 41% market cap - 13.7 P/E - 37.8%
• Europe - 29% market cap - 10.82 P/E - 33.8%
• Pacific - 15% market cap - 13.41 P/E - 14.1%
• Canada - 4% market cap - 13.91 P/E - 3.6%
• Emerging - 11% market cap - 13.02 P/E - 10.7%

The biggest outlier here is Europe, with a relatively lower P/E ratio. This means that one overweights Europe slightly, while underweighting everything else a bit.

These numbers change frequently, and aren’t exact. It would be a lot of work to stick to this closely, so you’d probably be best off revising this infrequently, maybe on an annual basis, or perhaps even less frequently than that.

5. Overweight emerging stocks. These markets are likely to have higher volatility than developed markets, so if you can handle that and want to bet on higher return, you might want to overweight emerging market stocks.

And of course…

Remember that there is no perfect allocation. David Swensen recommends 30% US stocks, 15% developed, and 5% emerging. This overweights the US (60%) relative to international stocks, and overweights emerging stocks relative to other international stocks. Others recommend other things. You can’t know ahead of time what work best, but you can know that rebalancing to a reasonable plan is better than adjusting your allocation every few years.

So invest domestically, diversify internationally, and stay the course!

Why is volatility risky?

A bit of theory for you. Modern Portfolio Theory states that markets are efficient, and that returns can be explained by risks. The most common definition of risk is volatility (or beta). [1]

I’ve never been comfortable with the idea of volatility, and only volatility, as risk. It just doesn’t sit right with me. It seems that volatility is only risky over the short term - if something fluctuates wildly on a rapid upward ascent, is it really risky? And aren’t there are other forms of risk, like the risk of underperforming over the long run or the risk of not having enough money available when you need it?

So while I don’t think that volatility = risk and risk = volatility, there is some relationship between risk and volatility.

Specifically, I think there are two ways in which volatility is risk.

First, volatility is risky if you will be withdrawing from your portfolio. If an asset is volatile, and you need to sell it when it is down because you need the cash, then you’ve just lost money.

This especially applies when you’re nearing retirement; if a volatile 50% of your porftolio decides to take a 10-year dip when you turn 70, it doesn’t matter if it’s going to be dramatically up during the following 10 years - you’re selling an investment low.

But it is a risk even if you’re 40. What if you lose your job and have to draw upon your investments? Or what if you have unexpected medical expenses?

Second, volatility increases the risk of tracking error, which is a behavioral risk. If I hold an asset that fluctuates wildly, and it is down significantly (especially compared to some benchmark), I may decide that it is a dog and sell it. This is a risk that I will make a bad decision, worrying about the short-term performance of an investment rather than sticking it out for the long term

Each of those is a legitimiate risk. But beyond that, call me a MPT heretic, but volatility just doesn’t seem that risky. If you told me that an asset would swing wildly but have great long-term performance, I would call it less risky than a non-volatile stock that may or may not make money.

[1] MPT deals with non-diversifiable risk. You can take a big risk by not diversifying, e.g. only buying one stock. But this risk can be removed by diversifying - e.g. holding a basket of 50 stocks, or a mutual fund, or an index fund.

Fama and French on small/value premiums and risk

What is the nature of the small (SmB) and value (HmL) premiums proposed by Eugene Fama and Kenneth French? Does this mean that markets aren’t efficient, or is there a Small and a Value risk (“distress risk”) factored in to these premiums that leaves markets efficient? In a 2007 interview with Journal of Indexes, Fama and French discuss this question. And disagree.

Journal of Indexes (JoI): The market has been through some wild rides since you wrote your seminal paper in 1992. Has anything altered the views you have vis-à-vis the sources of return in the market?

Kenneth French (French): I don’t think so…

Eugene Fama (Fama): No, I don’t think so.

French: Actually, I take that back. Initially, we thought the value premium was associated with distress risk. I’m not so confident of that any longer.

What’s clear is that the value effect is a catch-all for differences in expected return. Without pernicious assumptions about expected growth, any differences in expected return will show up in ratios like book-to-market, earnings-to-price, or cash flow-to-price. Take a company with a high expected return. When you discount its expected future cash flows back to the present, the high expected return (which is also the discount rate) gives you a low price relative to the expected cash flows. As long as the fundamental metric—the book value, earnings, etc.—is a reasonable proxy for the expected cash flows, you’ll also get a low price relative to the current fundamental. This simple discount rate effect implies that differences in expected return are almost certainly linked to ratios like book-to-market.

Notice that I didn’t say why there are differences in expected return; I just said that if there are differences in expected returns, they will show up in ratios like book-tomarket. That means the value effect is a catch-all that captures any differences in expected return—whatever their source.

I think the differences in expected return are the result of an amalgamation of different risks, plus some mis-pricing. And I don’t think we have the technology to distinguish between those two.

Fama: I don’t know about the mispricing. I don’t know that there is mispricing.

French: There has to be some mispricing. I’m certainly not saying it’s all mispricing. I like to tell people that it’s 87.38 percent risk.

Fama: I don’t know about the mispricing part. I think he’s wrong there.

French: To get back to distressed companies … the typical high book-to-market company is distressed. But if you hold book-to-market fixed and you sort companies by financial distress, you don’t get much difference in average returns. So something else is at work.

The rest of the article is worth a read, as they discuss fundamentally-weighted indexes, and more.

The ideal portfolio

Investors of all stripes spend a lot of time worrying about the ideal portfolio. Financial magazines covers (“7 Best Mutual Funds”, “8 Stocks to Buy Now”) beat out fitness and glamour magazines when it comes to airbrushed deception. Others look for the hot stock tip that will pull a Cisco. (The unprecidented growth, not the unprecidented decline.) Still others worry about the right mix of assets: 12% or 15% REITs? Should I favor small/value stocks? What type of bonds should I own?

A sensible person would tell you that there is no ideal portfolio, no secrets, and no silver bullet. That there are better and worse portfolios, and better and worse investments, but chasing perfection is silly. That ideals often collide - simplicity vs. optimization, market-tilt vs. value-tilt, ETFs vs. mutual funds, frequent vs. annual rebalancing. That the ideal is only known after the fact and can’t be predicted, even with the help of backtesting. That you should work out a good plan and stick with it, rather than seeking the idea.

Forget that. There is a perfect portfolio. It is the one where you keep investing lots of new money regularly.

Of course, your underlying asset allocation should be reasonable for this to be the ideal portfolio. A simple lazy portfolio will do fine, like the 3-fund Margarita portfolio (1/3 US Total Stock Market, 1/3 International Total Stock Market, 1/3 TIPS) or David Swensen’s 6-fund portfolio (30% US TSM, 15% Developed International Stocks, 5% Emerging Market Stocks, 20% Real Estate, 15% TIPS, 15% Treasury Bonds).

But choosing between these portfolios, or fine-tuning your asset allocation, is less important than saving.

Let’s take an example. You have a small nest egg of $20,000 at the age of 30. You invest it and manage a respectable 10% returns for 30 years. You spend exactly what you make for the rest of your life - no debt, but no savings either. What do you end up with? $340,000. Adjusted for inflation, this is maybe $150,000 in today’s dollars. You’re in trouble, despite the miracle of compound interest.

Now imagine that you save regularly, to the tune of 10% of your annual income. If your income is $50,000, you now have over $1.2M. Double that, and you have $2.1M.

This is far more than the $340,000 in the previous scenario. But more importantly, you can control this part - if the market only returns 8%, or 6%, your additional savings are still there, and become an even more important part of your portfolio.

Compound interest is powerful, and higher returns can make a big difference over time. But the “ideal” asset allocation can’t be known ahead of time. What you can know is the benefit of every additional dollar that you put away.

Should I tilt towards small/value stocks?

Fama and French found that in the past, small-cap stocks and value stocks have performed marginally better than the rest of the stock market, when controlling for risk.[1] This is their Nobel-winning three-factor model to describe stock market performance.

We know that there was a small/value premium in the past. What we don’t know is whether or not it will continue, especially now that it’s been identified. And we won’t know until after the fact. Smart people think that the SV premium still exists, and smart people think it’s done. So what’s an investor to do?

Brian1984 asked this question on the Bogleheads Forum today. Some good answers were given, and here’s my advice.

1. We don’t know if SV stocks will outperform. At minimum, they probably won’t hurt you over the long run (though they may be more volatile).
2. This decision is relatively unimportant compared to others. Make sure the rest of your portfolio is in good shape, and then consider a SV tilt.
3. Watch for expenses and portfolio complexity. If adding a small/value tilt will make your portfolio harder to manage, or will increase your expenses, it may not be worth it.
4. Saving more is far more important than having an ideal asset allocation. You’ll probably be better off saving an extra $50 or $100 a month than “optimizing” your asset allocation.

[1] Update: looks like there is some disagreement on this. Fama thinks that the small and value premiums are attributable to risk, while French doesn’t. More on this.

Take your risk with stocks, not bonds

Some investors determine an asset allocation, like 70% stocks/30% bonds, and then try to maximize to maximize returns from each asset class. You can do this on the bond side by looking for higher-returning bonds. Corporate bonds or government-backed mortgage bonds, for instance, tend to return a more better than treasury bonds, the most boring (and safest) kid at the dance.

This is a bad idea.

Corporate bonds and junk bonds may generate higher returns than treasury bonds, but they do so at the price of higher risk. Of course, that’s what investing is all about, right - risk vs. reward? Yes, but you’re much better off taking your risk on the stock side than on the bond side.

Let’s break it down. If your 30% bond allocation is made up of corporate or high-yield bonds, your portfolio is going to have a higher risk and a higher return than if you own 30% “boring” bonds. In fact, it might perform like a 72%/28% portfolio, or even a 75%/25% portfolio.

This isn’t good if you want a 70%/30% portfolio. And if you actually want a 75%/25% portfolio, buy a 75%/25% portfolio! Stocks tend to reward risk better than bonds, so you’ll do better.

There are a few other reasons to avoid high-yield or corporate bonds. First, they tend to be more highly correlated with stocks, which means that they provide less diversification benefit. Second, they are exceedingly tax inefficient, which means that you really shouldn’t own them outside of a tax-advantaged account, like an IRA or 401K. So riskier bonds are less efficient with tax-advantaged space.

What should you buy for your bond allocation? Some - maybe half - of your bond allocation should be devoted to inflation-indexed bonds, like TIPS or I-Bonds. For the rest, check out the following types of funds.

• Short-term US treasuries (like FSBIX or VBISX). Low return, but the lowest risk you can find short of cash.
• Intermediate-term US treasuries (FIBIX or VBIIX). Slightly more return, and not a lot more risk. Some investors consider this the “sweet spot” of bonds.
• Total bond market (like VBMFX or FBIDX). This will include a mix of every type of bond, including a bit of the ones I’m recommending against, so the risk and return may be a little higher. But in a broad bond index fund, this doesn’t have a huge impact.
  

It doesn’t really matter which one you choose. When you retire, this will have a far smaller impact on your portfolio return most other decisions you make as an investor. So go with what’s available - if your 401K has one of these types, that’s fine. Just go with a low cost index fund; when you’re only dealing with a 1-3% return after inflation and taxes, a 1% expense ratio on an active fund is an absolute killer.

Remember: let stocks drive your returns, and use bonds to reduce volitility.