For serious buy-and-hold investors, asset allocation and diversification are by far the most important decisions. They are more important than selecting the right mutual funds and individual stocks. They are more important than exactly when you get into the market and when you finally exit.

In a Newsweek column June 7, 1999, financial writer Jane Bryant Quinn summarized the case for diversification this way: "Diversification steers away from luck." Diversification also reduces your risk of losses and helps insure that when (not if, but when) the top performing assets are no longer large U.S. stocks, you’ll already have some of your money poised to take advantage of the next winning asset class.

There’s no single investment mix that’s right for every investor. Quinn suggested an extremely simple portfolio of only three mutual funds: Vanguard Total Stock Market, Vanguard Total International Stock and Vanguard Total Bond.

For the casual investor who wants simplicity above all, that’s not bad. Those three funds cover the entire investment waterfront of stocks and bonds. Whatever you need in order to have an effective portfolio, those three funds will insure that you have some of it.

But that approach is a little bit like going through an elaborate food buffet and taking equal portions of every item on the table. If your doctor told you to emphasize certain foods and to minimize or avoid others, the one-scoop-of-everything method isn’t very effective. Instead, you’d probably want to focus on the foods that are likely to do you the most good.

Likewise with investing. Research has identified certain kinds of assets that are likely to provide superior returns. Two examples are small-cap stocks and value stocks. One very simple way to emphasize those asset classes would be to have half of your equity portfolio in a total stock market fund and 25 percent each in a value fund and a small-cap fund. We don’t necessarily recommend that, but it shows that you can own the entire spectrum while you emphasize certain parts of it.

After decades of managing investments for thousands of investors, we have not found any way to allocate assets and diversify a buy-and-hold portfolio better than by using Dimensional Fund Advisors asset-class index funds. These funds allow investors to pinpoint the most productive asset classes and avoid those (for instance mid-cap U.S. stocks) which are less likely to provide superior returns.

However, DFA funds are available only through investment advisors, who charge advisory fees and whose minimum account size may be $100,000 or more. (For DFA funds, the advisor fees with which we are familiar range from 0.8 percent to 2 percent annually. In the portfolio results we show for the DFA portfolio, we assume a 1 percent fee prorated for seven months.)

For investors who don’t have $100,000 to commit to a buy-and-hold strategy, our Model Portfolios include three other buy-and-hold plans made up of no-load mutual funds available to anyone.

We’ve decided it’s time to start tracking comparative performance of these four buy-and-hold portfolios, each of which has wide international diversification. Twice a year we’ll update the comparisons. In Table 1, we show the four portfolios and how they performed in the first seven months of 1999. That’s not a long enough period to be meaningful, but it’s a start.

In each case, we weighted the portfolio 40 percent in bonds, 60 percent in equities, with individual funds weighted in line with the recommendations in our Model Portfolios.

(We made the calculations, which aren’t shown in the table, for Jane Bryant Quinn’s three-fund portfolio, with an assumed 30 percent each in the equity funds and 40 percent in the Total Bond fund. In the first seven months of 1999, the Vanguard Total Stock Market Fund was up 14.1 percent; the Total International Stock Fund was up 8.6 percent and the Total Bond Market Fund was down 1.3 percent. The three-fund portfolio’s weighted return was 6.3 percent.)

The allocation in these portfolios is based on solid research that has identified the asset classes that are likely, over long periods of time, to be the most productive for each dollar invested.

Ideally, the fixed-income part of our buy-and-hold portfolio is equally weighted between one-year and five-year bonds. This combination provides the best balance of stability and yield. Each portfolio that we show approaches this in a slightly different manner, depending on what funds are available.

The best way to allocate the equity part of our buy-and-hold portfolio is with an even split between U.S. and international stocks; within each of those divisions is a further even split between large companies and small companies and another split between value companies and growth companies. On the international side, we want to see a dose of emerging markets as well.

Our recommended DFA portfolio comes closest to this ideal mix, with half the equity portfolio divided evenly among four U.S. funds and the other half divided equally among five international funds. We have tried to follow this as closely as possible with funds available at Fidelity, Schwab and Vanguard.

How should you choose among these portfolios? For starters, don’t base your choice on performance in our table. Seven months is much too short a time to be meaningful.

Over the long term, of course, performance is what you want. Two factors that you can measure are likely to contribute significantly to the performance of these portfolios. Most important, look for funds that invest in the preferred asset classes with as much accuracy as possible. For example, if you’re after small-cap performance, don’t invest in a fund that buys mid-cap stocks along with the small-cap issues. Second, look for funds with low expenses. Every dollar a fund pays in administrative and trading expenses is a dollar its shareholders never get.

If you can meet the minimum account requirements, we think the DFA portfolio is the hands-down favorite in both these respects. DFA funds concentrate your money in the most desirable asset classes better than the funds in any of the other three portfolios.

If you can’t qualify for a DFA account, our second choice is the Vanguard portfolio. Vanguard is renowned for keeping expenses low, and its funds do a fairly good job of pinpointing our target asset classes. Our third choice is the Schwab portfolio, which allows investors to pick and choose among the offerings of many fund families. We believe the Fidelity buy-and-hold portfolio will be the least effective of those shown in the table. But some investors may need or want to stick to Fidelity, and the funds in this recommended portfolio should do a good job for patient investors.

 

 

Discover how professional money management can help you.  Get a Free Consultation from a Merriman financial advisor.