WE LIVE IN A WORLD rife with intolerance—and that intolerance, alas, has infected the once-civilized world of index-fund investors.
Back in the 1990s, we indexers were such a small minority that simply owning index funds was a common bond. But now that more than half the fund market is given over to index funds, internecine skirmishes regularly erupt, with folks debating what’s the right way to index and belittling those who take a different approach.
Want to know what’s the “right” way to index? Arguably, you should own the ultimate in diversification, which is the global market portfolio—every stock and bond, U.S. and foreign, weighted according to its market value. This is the mix that reflects the collective judgment of all investors everywhere and should offer the highest risk-adjusted expected return.
In theory, depending on your goals and risk tolerance, you could change this portfolio’s risk and expected return either by adding risk-free investments—think Treasury bills—or by borrowing at the risk-free rate to leverage the portfolio. Do you invest this way? As far as I know, almost nobody does. But arguably, if you don’t, you have no standing to claim that your approach to indexing is the right one.
Why don’t folks own the global market portfolio with varying degrees of leverage? For starters, there’s no agreement on what the global market portfolio looks like. Should you include commodities, collectibles and real estate? Should your real estate exposure consist solely of commercial properties, or should you also add residential real estate? And what about private companies?
Trickier still is the question of leverage. The fact is, most of us can’t borrow cheaply enough to make leverage a winning proposition and, indeed, short-term borrowing rates today would likely match or exceed the yield on the global market portfolio’s bond allocation, plus there’s always the risk of a margin call.
Even if you throw out the use of leverage and ignore commodities, collectibles and other alternative investments, today’s global market portfolio might include 36% U.S. stocks, 24% foreign shares, 21% U.S. bonds and 19% international bonds. It would be easy enough to replicate that mix by combining 60% in Vanguard Total World Stock ETF (symbol: VT) with 40% in Vanguard Total World Bond ETF (BNDW).
To be sure, if you’re a purist, even this mix comes up short—because the foreign bond exposure is currency hedged. But forget such quibbles. Let’s face it: How many U.S. investors own a portfolio that looks anything like this investment mix, especially the 19% allocation to foreign bonds?
The bottom line: Almost nobody indexes in the theoretically correct way. Instead, we make all kinds of judgment calls as we wrestle with eight key questions:
Have you answered the above eight questions? Next come questions where your answers could get you labeled not just as a fool, but as a heretic. We’re talking about questions like: Is it okay to own a few individual stocks? What about actively managed stock funds? I own neither. But I know plenty of indexers who do, in part because they need an outlet for their speculative urges. Is that so terrible, assuming it’s a small part of someone’s portfolio?
The bottom line: Every indexer makes judgment calls. Yes, there may be choices that are more sensible than others. But there’s no one index-fund portfolio strategy that’s right for everyone. Instead, the right portfolio is the one that works for you. Those who denounce the approach of others aren’t smarter or more faithful to the indexing creed. Instead, their only distinction is their greater intolerance.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.
Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our twice-weekly newsletter? Sign up now.