Asset Allocation: Building a Better Balanced Portfolio (Personal Finance Symposium IV - 2012)

the fourth and final speaker and maybe before I say anything else about the fourth and final speaker I've already got three really good ideas for speakers for next year by asking you guys for them so I thank you I just need one more and I'm home free this is great but but the forest speaker was also an old friend of mine he was a colleague of mine here at the University of Missouri for 14 years and he is now a colleague of other lucky people at Brigham Young University where he teaches personal and family finance to over 1200 students each year which is not that much more than we teach here at the University of Missouri I might add but that's okay Craig ezreal sin' received his bachelor's degree in agribusiness and his MS in agricultural economics from Utah State University if and again prior prior to being here oh I'm sorry he got his PhD at Brigham Young University before he came to our faculty back in 1991 I believe it was so he was here from 1991 to 2005 craig is married to Tammy Trimble they have seven children I think if I can read all these names Sarah Andrew Heidi mark Nathan Emma and Jared his hobbies include I love this it include running biking swimming woodwork in a family vacation he has run in the Boston Marathon five times but he has never won the Boston Marathon which is something I've never rubbed in on him because I've never run a marathon I used to run but my knee decided to quit the other thing I'd like to say about Craig not only is he is is he an old friend and a in a colleague but but back back in the days that he was here and Ed Metzen was the founding chair of our department back in the back in the 60s the 1960s and it had a certain you know development because of Ed and his interest in people and the money and helping people reach their goals you know Craig actually wouldn't went when he came in into the department I actually provided real I guess I was like a spiritual leadership for lack of a better word that he actually his presence was felt by the students his advice that he gave to students the people that would seek him out just for the talk about everything including myself were were numerous and so I'm delighted to have Craig is Wilson back here today well he's been here for two or three days to speak to us about his research and his books that he's written about investment allocation so please join me in welcoming my friend Craig is Wilson my live okay thank you people have asked how I'm enjoying this and it's like dying and these are the people you meet when you cross over the veil that's what it feels like honestly so to have lunch with Edie and Anita and Tuesday night was and Melanie their daughter my former students back in early 90s was really a rich experience I know a lot - okay I owe a lot to Edie and Anita want them to know of my love for them and my colleagues that are here this is harder than I thought it would be so I appreciate when I say colleagues I mean those that I worked with B Smith Veronica and Brenda just so many and I include my students as my colleagues I believed early on and I still believe that I need to behave myself because one of my students might hire me someday and I know that that can happen I want to be worthy of their trust so I'd like to talk about asset allocation very impressed with the presentations that preceded this Margie I know that Margie probably had another four hours of material as she could have presented and I hope that some time I can go visit her and talk about that what does salsa have in common with asset allocation we all know about salsa we grow a lot of tomatoes in Utah and we make a lot of salsa the commonality I believe is that salsa is six or seven or eight different ingredients and then we combined them and in the combination there is a magic that happens which is different than if we line up all the ingredients of salsa separately in separate bowls here's the here's the diced up tomatoes here's the cilantro here's the onions here's the garlic salt whatever lime juice and say to our guests get a big chip and dip it in it you know this is going Brendan get a big chip and dip it in each Bowl and then quickly chew it up in your mouth and it'll become salsa and that's not how we do it there is a magic in the combining of the ingredients beforehand and they kind of settle in to each other and that is asset allocation so if you can think about salsa in terms of a recipe metaphor you now understand asset allocation because the phrase asset allocation is it's fraught with this supposed complexity and there's some complex elements to it but the metaphor is quite basic it's quite straightforward so here are the assets that we combine to make a portfolio we have these quotes salsa ingredients I trust you familiar with these but this is about as far back as we can go in terms of the returns of these asset classes all of the prior speakers have spoken about assets and these are the ingredients of the salsa so from 1970 through 2011 the best performing asset or salsa ingredient was real estate now bear in mind that when when I say real estate it's not uncommon for a person to think oh my house that's not the the Dow Jones us select real estate index that's commercial this is a commercial real estate figure and based on where you live you might have had a good experience as a real estate investor Santa Anna not so much in Fargo of course lately Harvey was pretty strong but so this is commercial real estate the annualized return since 1970 through 2011 is eleven point three at percent that's a it's a staggeringly high return and just that's just what that single that's the tomatoes so to say the standard deviation nineteen point six five growth of ten thousand so then us small stock us large stock commodities international stock and Margie delivered a treatise on international stocks and as I stand here I'm I'm just contemplating how I incorporate what I learned from our G today that's the ephah index the Margie spoke of Aoife stands for Europe Australasia and the Far East and that's an index produced by Morgan Stanley Capital International MSCI that Aoife index is a developed market index and Margie really Illustrated that developed so you have a range of eleven point three percent annualized return that the geometric mean return down to eight point eight seven and then aggregate bonds at just a touch below that at eight point two eight and then cash and it's it's staggering to consider that cash has a 42 year average return five point seven percent when cash today is what point and whenever you start a return with the word point that's not a comfortable conclusion and so you know the expel the negative expressed cash is trash and so forth it's possible that cash has always been designed to be a safe haven asset and if you get a positive return over inflation you're just lucky if we rethought what cash was intended to do might be we wouldn't be so hard on it when it's not producing you know five point seven percent but that's the true that's the Treasury bill a three months t bill return last 42 years I want to point something out that I'm sure you all already know the standard deviation for the five assets in the blue is roughly twice as large as the average return so I could take off the titles I could take off the word words real estate US small stock u.s. large stock I could take those off and you would still know that those are equity like assets because you would look at the correlation between the geometric mean and the Sigma and if one is twice as large as the other you would know that that's a risky asset that's how we know is the correlation between the mean return and the volatility of returns the two fixed income bonds in cash look at the relationship the standard deviation is two-thirds the size of the return that informs us it's a fixed income asset class so in salsa some ingredients are kind of neutral like salt it doesn't it's really important but it's it's not very exciting oh yeah I love our salt the normal really don't right so some of the ingredients of a portfolio aren't on their own very exciting their job is not to be exciting their job is to neutralize and to dampen and to buffer those are the indexes Bob Albany and I were talking because he was asking it listening to Margie why don't more probably all asking this why don't more fund managers or pension managers or whatever add more emerging markets stock into the overall portfolio you know kind of spice up the salsa well it's because in my opinion too many portfolios here in the states use as their performance benchmark the Standard and Poor's 500 well I have nothing against the S&P 500 it's just an all US large cap equity index we're talking about building a multi-asset portfolio since when do we compare salsa to ground-up Tomatoes that's a ridiculous comparison but that's what happens every day and it's called tracking error or benchmark error and pension managers freak out when they have a lot of tracking error against a well known sort of deified index that's a real problem though that's what prevents adequate in my estimation adequate diversification now just a quick different take on risk so we have the the largest one-year gain of these seven portfolio asset classes and we have you know commodity seventy four point nine percent that's an impressive one your gain that means you're in a Europe you're in a rollercoaster car they can go that high will if a rotation hit you can finish that sentence right okay so the worst one-year loss all of those worst one-year losses in the blue section Jack 2008 right so did it really matter which equity kind of asset you were in no they all took a beating more to say about that as to how they took the beating because these are just the numbers at the end of the year yours don't happen all at once they happen day by day and that David I experience is important to understand the asset class then the worst three-year cumulative return notice that in this forty two year period there are forty three year returns correct in a forty two year span there are 43 year rolling periods what's the worst three year totals start to finish return of bonds well it was six point one five percent there was never a three year period where you had a return start definite not not per year return total return of less than six percent now what are we not factoring in inflation why are we not factoring in inflation because published returns never do so if you go to Morningstar if you go to Lipper SP wherever you go for data there are five assumptions that underlie every piece of published return data and here they are the first assumption there was a lump sum investment how many people invest which is one lump sum okay essentially yeah very few most of us invest systematically through a 401k plan or an annual IRA contribution or something along that line second assumption there was no additional money put in third assumption no money was taken out fourth assumption no taxes fifth assumption no inflation in other words when you when you present returns to the world you can't all have different assumptions there has to be a governing set of assumptions and those are the five so these numbers are then affected by those assumptions cash never had a three-year return a three-year period of a negative number start to finish so those are buffering assets the the equity assets and equity like commodities and real estate or equity like when I say equity that typically is a synonym for stock because as we buy stock we're an owner and equity is a word for ownership all right so those are the ingredients of the salsa there's nothing finer than an XY chart that was a joke so the 42-year risk return analysis you can think of it as a constellation this is the night sky and in the in the northeast corner of the sky are the risk on the x-axis the return on the y-axis those are the coordinates so it's a separate constellation the big equity the little equity dipper whatever you want to think of it that's a constellation of risk return coordinates in the southwest portion of the sky are the risk-return coordinates or characteristics of fixed income over the last 42 years okay each of these dots represents an asset class but a portfolio is a mixture of asset classes that's why we call it asset allocation isn't that stunning so how do we allocate these assets I understand that the red dot has 500 securities in it but is 500 if you grind up 500 tomatoes do you have salsa no you have 500 ground-up Tomatoes uh-huh and that's not salsa if you put it if you pawn it off a salsa somebody's disappointed so we we have created what is a a misperception of what diversification is the SP 500 is a diversified set within a single asset class that's not true diversification that's intra diversification that's depth that's not breadth we would need to get both depth and breadth that's true diversification so when we do that if we do asset allocation right the ideal is to move a dot into that zone because whether your client or whether you can articulate it or not we want to be in a portfolio that has relatively high return where we've cut the risk down that's the that's the objective if there's nothing else so the task now is it can asset allocation in an appropriate model and Margie actually presented one the regional model I wrote it down it's affecting how I think I just want to come back just for a second this the bond figure one more slide the bond return of eight point two eight here's a return of 8.28 percent annualised that's the average return per year for 42 years for bonds okay that's a big number that's a big bond return you have to appreciate the last 40 years in fixed income has been the best 40 years in the history of this world that we have recorded okay so you have to bear that in mind and this is a picture of that phenomena the Green Line are rolling 40-year returns each square is a 40-year average annual return during the this was back to 1926 so the first end of a 40-year period if you start in 1926 is 1945 so the 40-year average return for bonds from 1926 1945 was 3% the next 40 years 3% it was perpetually about three three and a point seven percent return bonds were not viewed as a growth asset the last 40 years that has changed and I think underlying a lot of the comments and presentations Matt John is that we'll fixed income US bonds maintain this average return of about 8% that's the underlying concern this is the history but will it will it continue will perpetuate the blue is the sp500 notice how erratic even over 40 year period you think over 40 years you'd have a pretty smooth function like 40 years would smooth the SP when you have big drops you know - 37 - 29 that can really really move the needle even on a 40-year period and then the red is a 60-40 the classic 60/40 balanced approach 60% ba US stocks 40% bonds that was just an aside that was a freebie you didn't pay for that to be diversified this is this an assertion this is my assertion to be diversified a portfolio must combine multiple ingredients that have low correlation with each other that's the salsa effect salsa all the ingredients of salsa are typically quite different from each other onions are not like tomatoes just try slicing some for your kids here have some sliced onions just you know put some salt on it it's not gonna go well okay so this low correlation and we're trying to get at okay how are these ingredients different well if it's salsa our taste buds tell us how it's different how been in the portfolio is it taste buds no it's a correlation matrix and that sends chills down all the folks who didn't enjoy statistics so we'll pass over it quickly this is a correlation matrix so over the past 42 years the relationship between large US stock the sp500 and the Russell 2000 the Russell 2000 is produced by Russell and it's mm smaller stocks S&P is produced by standard poor's it's 500 stocks and and just a point that Margie made when the Morgan Stanley figures out the China is not exactly an emerging country what what a stunning revelation that will be and then they modify the ephah index to incorporate China it comes out of the e/m index and what you said was very prescient which is there's a whole lot of products that now have to make a change so this is my sub point is there any product when we say an index fund is passively managed do you really buy that an index fund is managed by S&P Morgan Stanley it's managed people make decisions as to what the inclusion criteria are there's really very little if any that's just totally you know passively managed by robots these are managed by human beings either bright mitii by rules just a little sub-point 78% is the correlation between large US stocks and small US stocks that means 78% of the time this is a crude way to describe it 78% of the time if the SNP goes up the Russell 2000 goes up and likewise down is that a high correlation or what's the maximum correlation one what's there's actually two maximums what's the other maximum minus one if there's two maximums what's the minimum well it's the midpoint at zero so a zero correlation is quite wonderful what's a minus one correlation does it exist theoretically it does and if what's called an inverse fund an inverse fund is designed to move inversely or opposite to say the sp500 well think this through for a second the sp500 tends to have positive returns about seventy percent of the time if you build a perfectly inverse fund aren't you guaranteeing essentially a negative return 70 percent of the time I mean it's kind of funny that's why people don't do that they build in their inverse funds but they tend to sort of quote cheat when the market is positive they try to be inverse when the market is negative and that's the goal of an inverse fund ultimately so 78% correlation coefficient is a fairly high correlation meaning that the russell 2000 is not a very good diversifier of the S&P 500 that's all it means and so we have to go looking elsewhere for diversification okay so the point six six point six six is the correlation between non-us companies and the S&P 500 that's better it's better because it's lower but it's still fairly high and it's not point six six this year it's about point nine seven so in recent years the correlation between S&P 500 and Aoife has just increasing which in part explains the explosion in the number of ETF's exchange-traded funds and the concomitant explosion actually it's the indexes should come first the new indexes that are evolved then once you have an index you have justification for a new product or ETF and these ETFs are surgically precise the norwegian leisure equipment left-handed fund right that's the kind of etf's we're seeing they are incredibly precise why what are they looking for they're looking for low correlation you're trying to find an asset in this case a sub sub sub asset that has a low demonstrated correlation to the SP because the SP is the deified index that's my take on why we have such precise ETF instruments now it's the search for low correlation notice commodities commodities have a extremely delightful presence in a portfolio because of their historically low correlation to the other every other asset class commodities are what you think they are primarily energy okay these these data points the commodities represents the goldman sachs which is now the standard report goldman sachs come out of the index that's the least diversified commodity index that exists that's where we have the data so that's what I'm using there are a lot of commodity indexes and if you're looking for one the Deutsche Bank liquid commodity index is a better commodity index than goldman sachs so its petroleum it's natural gas its grains its pork bellies its orange juice futures it's that kind of thing precious and industrial metals so this this little salsa batch has seven assets in it and the average correlation is 0.2 one and if zero means a random coral a and then point to one is a very desirable correlation in the aggregate and then we kind of a new idea we tend to look at correlations specific to two assets I'm more interested in how the salsa tastes which is the aggregate correlation so meaningful portfolio diversification requires depth and breadth mutual funds and ETFs are depth instruments with one ticker you get 500 tickers right you buy an ETF it's a single ticker it's a single purchase and you get five hundred two thousand six hundred and eighty whatever it is individual tickers in it that's why they were invented it's for its for the facilitation of diversification but we can't get lulled into a kind of a complacent state where we think that one ticker because it has 500 large kept US companies is adequate diversification it's not so now we need some number of tickers each of which so we need breath in our tickers understanding that each ticker has depth under it so this is a fun sequence of slides because it shows off my ability to do funny things and impressive things with PowerPoint of course I had help so here is the different presentation of this XY graph kind of approach remember this is a 42 year period so there are 43 year periods so we have 43 year returns for cash right 43 year periods what's the average of those 40 numbers they're all three returns oh for cash just under six percent what was the 42 year average we looked at 5.7 so the average of 43 years is very close to the average over all of the 42 year as it should be because why because it has a low standard deviation it's a tight bell curve those two should be similar well let's say that we we add some bonds now we have a 50/50 portfolio this is our first experiment in ass allocation we've added tomatoes and onions we feel very daring it's a 50/50 portfolio rebalanced every year well in this kind of graph what is the ideal this graph is the rightmost coordinate in the in the 4 coordinate Cartesian map we usually focus on just one 25% of you know the carts vision of things the best dimension or zone in this graph is the upper left quadrant right the northwest quadrant so if we ever move straight north but not East that was a good outcome we picked up return and didn't add risk so adding bonds now we have a two asset portfolio and we stir it we stir this also once a year rebalance we move straight north good outcome now we add stock now we have a three ingredients also so our asset allocations become more sophisticated we move to the north and to the east we inextricably are brought in to higher return and remember standard deviation is a measure of volatility of returns some of the reasons we can have higher standard deviation is we had more higher returns clients aren't bothered by that listen we had too many high returns over the past ten can you kind of tone things down hey that's not a typical conversation I don't think with a client so remember that Sigma Center deviation is the child of up and down returns you have a lot of up returns you could still have a higher standard deviation but it's a different there's a tone and a color difference in you have to study Sigma to really see what it's saying to you now we add small stock non-us stock real estate for the students what does this shape resemble let me give you a hint his name with Tarka wits and he won a Nobel Prize his first name is Henry Henry Markowitz this is the efficient frontier and this is not the way he built it he had two assets and his model was 100% of this asset zero of this 90% of this asset ten of percent of this and that constellation formed the inverted Nike this is a very different approach this is a multi asset approach but still there's an underlying reality that emerges right what is it it's the efficient frontier it's the notion that the most fascinating part of the efficient frontier is the first part we actually moved back a little bit you recall the efficient frontier cuts back and then goes northeast this is the only entertaining part everything else we would expect of course you add risk to take on the chance for higher return this is the fascinating part here where you move north west and then we add commodities and commodities moves us to the northwest why because it has low correlation it this salsa just past the taste test we did something unusual we added what's perceived as a risky asset and moved to the left how can you add a risky asset how can you add jalapeno peppers they're sufficiently hot to melt a person's face hey how can you add them to something you will then eat well you don't just eat the jalapeno you add it to other stuff that it tends to neutralize it enhance it and for all the nutrition and dietetics students I know that something amazing happens when you add beans and rice I don't recall what it is but it's something amazing okay nutritionally speaking that that we might call sort of a a Dietetics energy or a food synergy can portfolios have synergy where you get more than anticipated because of the combination of the things yes and we can measure it by correlation we can measure it by the risk-return attributes on a scatter graph such as this so just I guess what I'm trying to say is that commodities have been viewed as extra ordinarily risky which totally ignores their correlation to the other asset classes and that's just a really unfortunate thing because low correlation is really the whole deal when you're building a portfolio so that the next two slides violate everything that we know about PowerPoint slides so there we go just take a gander at it for a few moments and all of the numbers will make sense to you all I wanted to portray is that we really do have the annual data on the performance of all of these assets back to 1970 I just wanted to just like you know due diligence there's the data and I wanted to illustrate this far right column these numbers right here in the far right column represent the salsa in other words let's take all seven assets blend them together and see what happens and they're all equally weighted this is where the salsa metaphor fails a little bit this means you have equal Tomatoes with jalapenos equal amounts of salt I wouldn't go there so just suspend for a moment the salsa metaphor relax the conditions in 73 and 74 those were pretty tough years US stocks large and small non US stocks had pretty significant losses an equal weighted 7 asset portfolio asset allocation had a return of you know 1.5 or 1.6 percent -5 that's pretty impressive because you had other asset classes such as commodities Wow 75% that's fun bonds you know four point six cash seven-and-a-half the whole point is that US stocks or non US stocks don't always have to carry the load other other asset classes can carry the load some years more recent years everyone's going to immediately look at 2008 so let's just go there 2008 us the S&P 500 lost 37 percent Russell 2000 - 33.8 Aoife - 43 bonds positive 5.2 now that's an these are all indexes these are raw indexes these are not products you can't invest in an index you can only invest in a product that mimics an index and products are not free products have expense ratios so but ETFs have low expense ratios and so you're close to the raw index to the extent that the maker of the product is true to the index and that is not always the case that's what we call index tracking error either based on high cost or different ideas about what you ought to do relative to the index so cash one and a half percent which by today's perspective looks rich ohhow perspective changes real estate - 39 commodities - forty six and a half I would like to now tell the story of how 2008 played out 2008 by the end of the third quarter September 30th large US stocks small US stock and non-us stock the ephah Morgan Stanley Aoife we're pretty deep in the tank - 18 - 22 % in that range by the end of q3 three-quarters of the year and o8 real-estate the Dow Jones US select read index commodities the goldman sachs commodity index by september 30th the year-to-date return of those was still positive what happened was in the first six weeks of q4 things blew up so when you yell fire in a theater bad things happen that's what happened in our theater it was a theater of conflict and when we have panic we tend to see asset classes move in sort of a herd and so there was an expression in the countryside that all correlations went to one technically that's not true unless you're monitoring correlations in like fifteen minute periods it's not a terribly valuable period that's like looking at a young child who's misbehaving and then extrapolating yep they're gonna be a bad human this past ten minutes has been horrible that's an inappropriate extrapolation and so we've seen some inappropriate extrapolations in my estimation of correlations over very micro time frames this is a very long time frame we were looking at 42 years so things did break down the first part of the fourth quarter and these year and numbers did occur my point in revealing or talking about you know what happened through three quarters of the year is that real estate in commodities for a person may be your client if they were panicking and forced you as an adviser to sell them out and you didn't want them to you're the adviser you could have quote sold out of real estate in commodities up until the end of the third quarter without a year-to-date loss in those assets not that you're encouraging that in fact you might be encouraging them with whatever money they have things are on sale right now I'm telling you that might be another approach 2000 2001 and 2002 these were more normal bear markets Oh for the old days when we just lost money the old-fashioned way notice that a multi asset approach was quite impressive during a more traditional weakness in equities so when built correctly a multi-asset portfolio achieves equity like returns with bond like risk again some clients may actually ask for that we may all want it yeah I'd like equity like returns but I don't want the risk well that's the whole point of of building a portfolio with multiple assets so in summary in summary of these data the here's the the 42 year return for all of the separate asset classes the SP 500 has averaged nine point eight percent return for the last 42 years 1970 through 2011 a multi-asset portfolio that has 1/7 large US stock 1/7 small US stock 1/7 non-us stock and so forth 10.26 average return higher than some of the individual ingredients that's quite fascinating to me but then I don't get out very often these things excite me so the 42 years Sigma ten point four seven what's different about that relationship well the Sigma is the same size as the Geo mean have we seen that before we haven't that's a new result we have seen the relationship between Geo mean and Sigma that's two to one two Sigma's to one mean return for the equities we've seen a sigma to mean return in fixed income of two thirds to one now we see in an asset allocation model a one-to-one correlation between risk and return I'll take it I'll take a one-to-one I can live with that because I kind of want the equity like return now bear in mind you don't have to take approach for your whole portfolio this idea could be some portion of a portfolio if you've done a good job saving over the years do you need a 10% return you don't so take less risk the portfolio that we design should be largely influenced by how much we have saved if you save more either you save 10% and earn six or you save 2% and have to earn fifteen which one do we control well I think we should be able to control a bit more how much we save and that not pass on to the portfolio the heavy lifting of hey you got to get me fit you know 14% to get 14% you have to dial up the risk meter and that's where things blow up well enough on that year-to-year here the year-to-year returns of a multi-asset portfolio since 1970 this is how bizarre 2008 was you see it graphically you can see how dramatic 2008 was as we hope it was an anomaly hey now let me let me superimpose against this bar chart the returns of just one of the ingredients the S&P 500 so the blue is now the SP 500 notice how many years one single asset class beats the aggregate portfolio it must be that 12 times which one has the higher average return over 42 years The Tortoise because and this is this is purely mathematical when when the single asset does more poorly it does more poorly more often and it's more severe and if you lose a hundred percent for example excuse me if you lose then then bad things happen if you lose fifty percent how much do you have to earn to break even a hundred percent a fifty percent gain does not bring you back to hole after 50% loss this phenomena is purely governed by math and nothing else so a large loss is and it's nonlinear by the way this relationship is nonlinear the larger the loss the proportionally non linearly the gain has to be higher so the rule number one of a portfolio is try to avoid large losses and try to minimize the frequency of losses per se that's what a multi asset approach does a single asset can in any one year beat a diversified approach do you see how many times the blue bar is higher this is a problem because in those years the client says hey you're losing to the sp500 that's like saying hey this salsa tastes different than then eaten just big wads of cilantro really I would have never guessed you're comparing salsa to a single ingredient how ridiculous is that we would never do that hey this salsa tastes different than just grant up Tomatoes what's going on that's a ridiculous thing to say and we know it's ridiculous it's just as ridiculous to compare a portfolio of blended assets to a single asset class but it happens every day and that single asset class is called the S&P 500 it's the de-facto benchmark for nearly everyone's portfolio and if we could just stop doing that we would make some progress so how did our asset allocation then end up in a that get us into this zone this ideal risk return zone it did we're now inside the loop so to say we have a return of over 10% with a risk that's in this middle ground it's not as low as fixed income but it's certainly not as high as the single ingredients and those standard deviations below it is the classic 60/40 portfolio 60% u.s. stock 40% bonds okay that was all introduction I know that's a horrible thing to say and so I'll say two other things I'm almost done and I know that the brain can absorb but the butt can endure so we really are almost done I would like to introduce what I have come to call the 712 portfolio and the word 712 the title 712 indicates seven core asset groups and twelve underlying products twelve mutual funds 12 ETFs well whatever you want but those are the typical ingredients that we would use here's the model this is the part margin I'm rethinking this has a u.s. bias so here's the first ingredient large US stock it has 8.33% because 1/12 is 8.3 percent the next ingredient is a mid-cap US stock mutual fund or ETF and then a small one develop non-us emerging non-us but Margie was talking about each having 1/12 now what if you wanted I like the regional thing by the way what if you wanted to invert this and have a non-us bias then do it this is a recipe how many people follow a recipe to the letter I don't know I have no I could make up a statistic and Ruth can you make one up okay is it 98 percent of all statistics are made up on the spot yeah that's the joke okay so real estate 112 natural resources and commodities commodities are it's a commodities mutual fund they own futures contracts natural resources is a mutual fund that owns stock in companies those are two different things well you have to a futures contract that's one thing when you are long meaning you own the stock of a company that's a different thing these companies in the natural resources sector are companies that mine refine package transport commodities so they're linked to commodities but these two mutual funds these two ETFs have a lower correlation than these two ingredients that's the interesting part so we have eight eight ingredients that are equity like it's a two-thirds one-third model kind of like the old 6040 for ingredients our fixed income US bonds inflation-protected bonds these typically go by the little acronym tips Treasury inflation-protected securities tips these have been in the US since 1998 they've been in Europe longer than that non-us bonds and cash that's the model 12 ingredients equal did two to three and third overall split and it represents a balanced portfolio with a US bias that I can change I found that I could make a three-dimensional pie chart and I couldn't resist that's the only reason I have this because I already said all that I recently read a sense by Thomas Paine I would recommend it but to balance Thomas Paine you would want to read some of John Adams just in all fairness they had they had different views the more simple anything is the less liable it is to be disordered my contention is this is pretty straightforward the model dictates the allocations and the model dictates a lot of diversification so the performance over the last ten years I'm comparing it against a 60/40 model so a diversified approach and these of course these slivers or slices of the pie are rebalanced every year and rebalancing is done a variety of ways if you add more money just add more money to which slices well the ones that have fallen below eight point three percent isn't that a forced buy low protocol rebalancing this is I'm not an advisor I deal with a lot of advisers but I'm not an advisor the client comes and says do something make it all better of course the portfolio band-aid you say okay I'll do something I'll rebalance all right good enough that's the funny part you're gonna do that anyway right so do what you're gonna do maybe do it now as opposed to in six weeks and that may be enough to satisfy the client that we did something if so it's it's a a built-in rebalancing is it built in doing something you were gonna do in any event so eight point five seven versus four point eight seven so not quite four hundred basis points of additional return which is quite significant two thousand eight two thousand two thousand eight it's like Waterloo so this this particular seven twelve model use uses actively managed funds actively managed funds the next the passive seven twelve model uses ETFs or index funds it doesn't matter they're the same thing then there's the Vanguard balanced which is a 60/40 and then the Vanguard 500 which is the SP 500 over the ten years to 2002 through 2011 nine point two eight five seven point seven to eight to now ten years has been a fairly rough ten years it could be even worse if we had 20 2001 through 2010 it's just it depends how you slice the 10-year window but 2008 - 28 - 24 - 22 - 37 all pretty horrible all qualifies train wrecks over the last three years here's an example over a three-year period this is not a diversified portfolio this is one asset class and it beat it beat this 60/40 it beat those you know 12 asset models that is an expected characteristic of diversification you will lose over short timeframes - the best individual asset in that time frame and that is where education is vital if the client does not understand that this diversified approach will lose to the star player in any given year they will misunderstand it and they will bolt they will leave because they don't understand the rules of diversification and what it imposes on a portfolio it's a long-term win not necessarily a short-term win oh the expense ratio costs matter using the active funds that I happen to choose for the model it's about 68 basis points so that's I may put it in perspective if you have $100 in this portfolio that means that every year 68 cents comes out as the expense ratio 31 cents per hundred dollars comes out and it comes out daily of course not all at once 26:17 I chose a Vanguard balanced and Vanguard 500 because they are very low cost I didn't want to pick a high cost comparison to sort of stack the deck you know against in favor of the 712 a simple pie chart illustrating the growth of 10,000 but remember this is a single to positive 10,000 no additional deposits no money taken out and so forth and that's a reasonably attractive margin of victory over a 10-year period now how do we modify the seven how we modify any portfolio to account for people to have different risk appetites just scale up just scale up on the tip scale upon the cash just overweight those according to their age usually but age isn't always the same as risk profile you can have two sixty year olds that have very different risk profiles one sixty year old has a pension they've saved 1.7 million dollars they have good health they have no debt that's 160 year old the next six year old they have a lot of debt no money in a 401k no pension they're caring for sick parents they're both 60 that's the only thing they have in common their portfolios might be very different that's why age just I I want you to acknowledge that age is not a very good indicator of how designed a portfolio it's just it's the most generic way to present it on a slide like this so in 2008 for example a really risk neutralized version where you have a 40% commitment to the 712 model 30 percent and tips 30 percent cash lost about 9 percent it's still horrible but it's a lot better than minus 30 something or 40 something this is the most compelling so I would like to describe this and then I shall be nearly done you may have noticed that we live in a aging population base you may have noted that I'm already getting AARP materials I was so proud so that's that's an Association for Retired Persons and they think they think forward this is the big deal for those of you students or otherwise who are reading stuff in the journals reading stuff in the magazines financial advisor magazine financial planning wherever you're reading most of the articles pertain to how do we build portfolios for that retirement part of life when we're taking money out of the portfolio that's the big deal so I have to ask is the sequence of returns of a portfolio important with a single lump sum investment you invest one chunk of money then wait 40 years does the sequence of returns along the way have anything to do with the ending result now if you're not in your head yes you're correct on emotional terms but you're not correct on mathematical terms the sequence of returns makes no difference over 40 years if it's a lump sum investment now listen you make investments every year let's take a 401 K does the sequence of returns make a difference of course it does because you'd want better returns late in the cycle wouldn't you well you have a bigger balance of course so that makes a difference how about when you're taking money out of a portfolio does the sequence of returns make a difference yes only totally it makes a huge difference if you retire then in that first year if your portfolio loses 28 percent and you also take money out you're in trouble so the sequence of returns is vital as we analyze retirement portfolios so when I subjected the 7:12 model to that test I assumed a quarter million dollar starting balance a nest egg sadly the employee benefits Research Institute or ebrary indicates that the average 401k balance for a 65 year old is about $70,000 that's not solvable with asset allocation let me repeat that an inadequate balance is not solvable with investment theory or asset allocation it's just not fix it we have to know what we can do what we can't do and we can't fix that the individual will likely have to continue working and you maybe you don't want to tell them that so you write a letter I don't know so but so if there's adequate money maybe there's a quarter million and I don't know if that's adequate or not if they have no debt maybe it's adequate so then in this scenario there was a 5% withdraw rate and if if there any of those in this room who are looking for a thesis topic there are plenty of things you could read about safe withdrawal rates I would consider Jim Otte are one of the smartest guys in that topic bill baingan has written quite a bit about that so anyway for those who are looking for a thesis topic 5% withdraw rate that draw rate or that cash amount withdrawn increases 3% a year that's known as a Cola cost-of-living adjustment so after 10 years under that scenario under these assumptions what was the ending balance well the starting balance was a quarter million right here this line is the starting balance if you just invested in the sp500 ten years later after making ten withdrawals took ten chunks out your balance was about a hundred and sixty thousand that a two hundred and twenty thousand and Vanguard balance your balance was larger than your starting balance in a more diversified approach and this is during admittedly a very difficult ten year period that to me is the most persuasive aspect of broad diversification rebalancing basically do it over the five year period 2007 through 2011 108 basis points benefit to rebalance the portfolio annually once a year most advisors charge one percentage point or a hundred basis points if the only thing you did which it isn't the only thing you do but if it was the only thing you did if you just rebalanced your clients you would earn them in this particular case you earned back your your fee if that's the only thing you did but there's a lot more to do over ten years it wasn't that large is about you know 40-something basis points but still half your fee I wrote a book there it is it's it's very clever I did not think of the title cover but can you see 712 in the Roman numerals yeah took me hours my twelve-year-old daughter saw it immediately oh cool dad what what you don't see it what right so the white is the seven and then twelve whole thing I wish I had thought of it I did not my vision of the cover was a bunch of salsa ingredients and frankly some years ago I had hoped to persuade a publisher to use a title that I still would like to use which is investment soup for the chicken soul hasn't worked out yet there is I put quite a bit of information on my website 712 portfolio com you're just welcome to download whatever you want there's a spreadsheet that you can download that's kind of fun if you have no life you go through that kind of stuff questions comments that's the last slide I guess we have this one before yeah yeah I just wanted to see if you had a chance to look at any of the data if you rebalanced on a 6-month basis or three times a year and what effect that would have yeah I can tell you that balancing monthly tends to be the worst performance it's kind of like stirring the rice too often I don't know anything about rice I shouldn't have said that apparently not supposed to store rice very often I guess sticky or something or it turns into macaroni I don't know what happens but monthly is the worst quarterly and annual or the best and we're talking about margins of difference of maybe 30 to 50 basis points so is it dramatic no I don't know I think I think 50 basis points is actually pretty dramatic so and plus monthly is more work we all want to avoid that oh I'm sorry yeah you want the plot if we if we rebalance monthly our returns tend to be about anywhere from 80 to 30 basis points lower than if we rebalance quarterly or annually so I would just suggest annually rebalancing is the best protocol in fact I've had clients ask me about that in the general financial planning over the last five to ten years has actually had articles that proves long academic articles that proves rebalancing monthly is is not good for your portfolio but I'm also very much aware that there were firms in this country even in this state that sell the idea to the client we will rebalance monthly for you and they're full of okay now he put it more academically but I'm telling my clients the truth I have read a hundred books in the last 43 years that I've been doing this work on asset allocation models I still only have about 60 of them on my shelves behind my desk this is the best one I've ever read and I even hand it out to a lot of my clients who want to do it themselves so I love it thank you thank you Bob appreciate that give you a twenty later you did don't bring books to sell and why not that seemed oh I thought about it but I didn't want to check a bag not oafish oh yeah I appreciate your saying that if you will go on my website I sorry that was out loud I purchased a large number of books because they were John Wiley is the publisher and they wanted I guess to move some out of a warehouse so as I buy them or they burn them okay I'll buy them and so if you'll just email me I can sell them for a rent it's about 26 on Amazon or my email circled right above it and I'm happy to sell at my cost plus whatever like maybe it's 12 bucks with shipping or something I'm happy to do that I appreciate your asking another question yeah I was really impressed with there was 40 year rolling charts of yours I wonder if you'd ever looked at the changes in the correlation of each asset class against all the others over 40 years and have there been changes and here's the 40 year here's the rolling ten-year court I took these slides out because I was going to be I think pressed for time so to your question here's the rolling correlations of large stock to small stock 10-year windows so each black dot is a ten year rolling correlation so small stocks and large stocks tend to have a pretty consistently high correlation is this what you're asking close it's it's the the allocation of large US stock to the other all of the other classes oh yeah coral and then optimizing the dollars that go into each asset class based on the correlations yeah that's a great question I can do that I haven't done that optimizing is a trick because to optimize based on historical correlations is not too unlike driving by looking through the rearview mirror which I think my kids do actually on occasion uh so it's it's not it's it's historical optimizing is what that would be and it's not it's not a bad approach we just have to understand that and it's not really Fork and it's risky and every door well has there been much change in 40 years time maybe that's a simpler way to put it okay but yeah this is not exactly what you asked because this is these are binary correlations 1 2 1 verses 1 to 6 which is what you're asking yeah but here's the US stock to the International stock look at what's happened in correlations over the last say 15 years that's the spiking in the correlation pattern that has led to like I mentioned earlier lots of very precise ETFs that have almost nothing here's a Norton mean you have X shares in New York and they have the Iceland ETF I mean nowhere Iceland is right and so it's not even and I don't see maybe it's in the ephah I don't know where it is but it's a very specific application outside the US and probably has a lot lower correlation because we don't know where it is yet right we can't locate it so here's the correlation from stocks to REITs really a volatile pattern of correlation so when people say look at the correlations right now how high they are look back here how high they were there's really nothing new Under the Sun we just have more precise ways to do it commodities a very volatile correlation pattern so when they're high it's not as if they've never been high before we've seen it before it's just when they're high it bugs us because we're alive now and we weren't maybe alive back then so we don't care about that bonds it's a very intriguing pattern correlation to bonds almost looks like a huge sign you know sine wave kind of potential correlation pattern great question if you will email me I can quickly run that correlation of the the rolling ten of the S&P to the other six thank you and I'll put in a plug for your recent book - oh thank you I'm out of twenties other questions comments concerns sure yeah Gordon don't have any observations to make as to what would be the effect on applying the approach you're presenting if you use a responsibly social screen on the underlying funds excellent yeah this is Gordon Bivens by the way I have a partial 712 that I've built there's SR I investing or socially conscious investing you don't have s RI funds in all twelve categories but you do have it in a u.s. large cap non-us large cap you have it there there's maybe four or five categories of the twelve and Gordon if if you can just remind me I will send you that model the tickers the tickers of that model okay I will say that socially responsible investing the three most typical industries or industries that it shuns are alcohol and tobacco and casinos slash gambling so Alcohol Tobacco and gambling those are the three most common filters that an SR I fund would move out interestingly those industries are quite profitable and so when you move those out then there's room for other industries and there's other filters the companies that test shampoo on dogs and just a variety of things and you may be more sensitive to one filter versus another hiring practices and there's a lot of really valuable filters so that maybe that in some cases an SRA funds mutual fund has a little bit lower performance and that was true 15 years ago it's less true today since we have more exposure to more industries both here and abroad we fill on those gaps that are now created with the filters with other reputable more admirable based on your perspective industries so the gap is closing SR I is less painful if you just are looking only at returns compared to 20 years ago I know that I stand between you and total happiness thank you you

Channel: Mizzou HES

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Length: 75min 4sec (4504 seconds)

Published: Thu May 24 2012