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Take It Away

Jonathan Clements  |  April 25, 2020

INVESTING IS A GAME of subtraction—and I’m not talking about this year’s stock market decline.

Wall Street sells the fantasy of market-beating returns, using it to seduce investors into adding new stocks and funds to their holdings. Result? Performance-chasing investors cobble together badly diversified portfolios that they imagine will beat the market, while overlooking the hefty costs that Wall Street charges. This is a strategy that’s almost guaranteed to make heaps of money—for brokerage firms and money managers.

Want to line your own pockets, instead of Wall Street’s? Forget addition and instead think subtraction. What do I mean by that? As you design your portfolio, try this two-step process:

Step No. 1: Subtracting investments. Start with the global market portfolio, which includes all stocks, bonds and other assets that are readily tradeable. This is the mix of investments that’s owned by all investors worldwide and reflects our collective judgment of what different securities are worth. What does the global market portfolio look like?

Phil DeMuth, a financial advisor and author, says you can replicate it with five exchange-traded index funds: 40% Vanguard Total World Stock ETF (symbol: VT), 21% Vanguard Total Bond Market ETF (BND), 33% Vanguard Total International Bond ETF (BNDX), 5% iShares Global REIT ETF (REET) and 1% Invesco DB Commodity Index Tracking Fund (DBC). The Vanguard Total World Stock ETF currently has 57% in U.S. stocks and 43% in international markets.

Taken together, these funds pretty much reflect the investments that we all own in the percentages that we own them, so arguably it’s the ultimate “neutral” investment mix and hence should be our starting point in designing a portfolio. If we stray from this mix, we’re effectively ignoring the collective wisdom of all investors and making a market bet. My contention: We should stray only if we have a compelling reason.

And, no, our hunch about which investments will perform best in the months ahead doesn’t count as a compelling reason. In fact, I believe we should deviate only for reasons of risk.

For instance, we might keep more or less in stocks depending on our time horizon, job security and stomach for market turbulence. Similarly, we may want to reduce our exposure to currency swings, because we’ll end up spending much of our nest egg on U.S. goods and services. That might lead us to keep less in foreign bonds.

Should we also keep less in foreign stocks? As I’ve noted before, many U.S. investors seem to believe U.S. stocks are both higher returning and lower risk. If true, this would violate perhaps the most fundamental rule of finance—that risk and expected return are inextricably linked. Still, if investors perceive foreign stocks to be riskier and they’ll be more tenacious investors if they have less in foreign markets, overweighting U.S. stocks probably isn’t too grave an investment sin.

Of course, most investors deviate even further from the global market portfolio, banking heavily on, say, blue-chip U.S. companies or perhaps just a handful of technology stocks. This may work out fine—but it sure isn’t guaranteed.

These folks are sacrificing diversification, which is one of the long-term investor’s greatest allies. Nobody knows which stocks, industries or even countries will prosper in the years ahead—and those who own narrowly focused portfolios could find themselves on the losing side of market history. That history tells us that a globally diversified portfolio has always recovered from bear markets and marched onward to new highs. What about more narrowly focused portfolios? History isn’t nearly so reassuring.

Step No. 2: Limiting costs. As we deviate from the global market portfolio, we don’t just increase the risk of rotten results. We also tend to drive up investment costs. Those increased expenses subtract from our investment returns—and further boost the odds of poor performance.

Suppose we skip total market index funds, and instead opt for funds that have a narrower focus or that are actively managed. The result is typically higher annual expenses and heftier trading costs, both of which will drag down performance.

In addition, more narrowly focused investment bets often generate large annual tax bills. Among investment costs, that’s potentially the biggest subtraction of all. Actively managed funds and sector funds trade their portfolios more than total market index funds, resulting in larger annual capital-gains distributions. Shareholders then have to pay taxes on those distributions, assuming they hold these funds in a taxable account.

Even if shareholders own investments that are reasonably tax-efficient, there’s a risk they’ll inflict tax bills on themselves. Suppose an actively managed fund or a sector fund lags behind the broad market averages. Disappointed investors will often bail out.

That’ll trigger a tax bill if they hold the fund in a taxable account and they have any sort of gain on their holdings. By contrast, unless something goes badly awry, owners of total market index funds shouldn’t ever feel compelled to sell because of market-lagging performance—plus these funds should prove to be highly tax-efficient.

What I would subtract. We should all strive to build portfolios in which we have great conviction, so we have the tenacity to stick with our holdings during rough markets. We can’t be sure any particular actively managed fund, sector fund or individual stock will bounce back from 2020’s market drubbing. But we can be fully confident that total market index funds will recover along with the broad market.

Total market funds are also less nerve-racking to own, because we don’t see all the carnage suffered by individual stocks and market sectors. Instead, all we see is a single share price that will move more sedately than most of the securities held within the fund.

That brings me back to Phil DeMuth’s five-fund portfolio. I’d toss out the real estate and commodity funds. They’re modest positions that won’t contribute much to the portfolio, and yet they increase the risk of bad investor behavior by adding complexity and extra worry. On top of that, the Invesco commodity fund—at 0.89% in annual expenses—is way too costly for my taste.

I’d also eliminate the international bonds. That would remove some of the currency risk from a portfolio destined to pay for retirement expenses, college tuition bills and other costs denominated in U.S. dollars.

Where does that leave us? We would own just a total world stock fund and a total U.S. bond market fund—an elegant two index-fund portfolio. My own investment mix is more complicated than that. My suspicion: If I sold everything I owned and bought these two funds, my portfolio’s performance in the years ahead would be just as good—and perhaps even better.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Back to BasicsGrowing Conviction and Facts of Life.

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