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Superior Diversification on a Shoestring Budget

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We’ve been preaching the merits of wide stock market diversification for many years, and the advantages should be painfully obvious these days after the bear market that started in 2000. Any investor who loaded up on growth stocks or technology funds a few years ago should now be able to see the advantage of owning some other kinds of assets as well.

Proper diversification is not hard for investors who have enough money (and who have access to the right mutual funds, which unfortunately leaves out many people with the bulk of their portfolios in 401(k) plans).

However, we have been asked time after time: How can a small or beginning investor achieve the diversification benefits of the Ultimate Buy and Hold Strategy with a relatively small amount of money?

IMPERFECT DIVERSIFICATION IS BETTER THAN NONE AT ALL.
It’s a good question, and there’s no perfect solution. But those benefits are worth achieving – even if they are achieved imperfectly.

As our regular readers know, we believe strongly in diversifying well beyond the popular U.S. large-cap growth stocks that still dominate so many portfolios. We believe investors who diversify heavily into small-cap stocks, value stocks and international stocks will have better performance over the long run than those who invest mainly in U.S. large-cap growth stocks.

We recommend nine equity asset classes: in the U.S., large growth companies, large value companies, small growth companies, small value companies and short-term bonds; internationally, large growth companies, large value companies, small growth companies, small value companies and companies in emerging markets.

The best way to get these asset classes is through the institutional index funds of Dimensional Fund Advisors. However, these funds are available only through investment advisors, with a common minimum account size of $100,000.

For investors who can’t meet that minimum or who don’t want to buy through an advisor, Vanguard’s low-cost index funds do a very good job of most of the asset classes. Our Vanguard Model Portfolios are based on eight equity funds: 500 Index (VFINX), Value Index (VIVAX), Small Cap Index (NAESX), Small Cap Value Index (VISVX), Developed Markets Index (VDMIX), International Value (VTRIX), International Explorer (VINEX) and Emerging Markets Index (VEIEX). The fixed-income part of such a portfolio can be placed in Vanguard Short-Term Corporate (VFSTX), for a total of nine funds.

However, buying all those funds requires more money than many beginning investors have available. In regular accounts, Vanguard’s $3,000 per-fund minimum means it would take $30,000.

In IRA accounts, Vanguard’s $1,000 per-fund minimum makes diversification easier. But a pesky $10 per-fund annual fee for small accounts takes some of the sharp edge off Vanguard’s famously low costs.

Despite the difficulties, there is no question in our minds that proper diversification away from large-cap U.S. stocks is worthwhile. Here are three things that we know from history:

  • Small-cap stocks have outperformed large-cap stocks. From 1926 through 2001, stocks of the smallest 20 percent of U.S. public companies compounded at 12.9 percent. The S&P 500 Index over that time compounded at 10.7 percent. A small difference, you think? Over 30 years, $10,000 invested at 12.9 percent grows to $380,906; at 10.7 percent, it grows to only $211,071.

  • Value stocks have outperformed growth stocks. From 1926 through 2001, large-cap value stocks compounded at 12.8 percent. Large-cap growth stocks compounded at 9.8 percent. Over 30 years, that’s the difference (on a $10,000 investment) between $370,914 and $165,223.
  • Small-cap value stocks have been particularly productive. From 1927 through 2001, small-cap value stocks compounded at 14.9 percent. Compared with the S&P 500 Index, that’s the difference over 30 years (on a $10,000 investment) between $645,061 and $211,071.

And while international stock markets don’t necessarily outperform the U.S. market, we know that the risk of an equity portfolio is reduced by including non-correlated assets. In the great majority of the last 32 calendar years, the returns of international stocks have been significantly different from the returns of U.S. stocks.

In nine of those years, international stocks (measured by the Morgan Stanley Europe Australia Far East Index known as EAFE) have beaten the Standard & Poor’s 500 Index by 10 or more percentage points. Here are three examples:

  • In 1977, the S&P 500 Index lost 7.2 percent; EAFE gained 18.0 percent.

  • In 1986, the S&P 500 Index rose 18.5 percent; EAFE was up 69.4 percent.
  • In 1993, the S&P 500 Index gained 10 percent; EAFE was up 32.6 percent.

Even the smallest investors can gain from such diversification. But unfortunately there is no single mutual fund that provides it.

So what is a beginning investor to do?

I’m about to give my best advice to an investor who’s just getting started. If you are fortunate enough to have enough money so you can diversify properly without this advice, I hope you’ll give this article to somebody who could use it.

Assuming that you’re working, your first investment dollars should go into your 401(k) (SEP IRA, Simple IRA, 403b, etc) account. Almost every 401(k) plan has multiple options, and you can start getting some diversification even with your very first $100. Even if all you can do is diversify into two equity funds and a bond fund, imperfect diversification is better than none. (However, beware of funds with different names yet similar portfolios. An “equity income” fund may be extremely similar to a “growth and income” fund.)

Particularly if you receive matching funds from your employer, fund the 401(k) fully and regularly. To the extent you can make automatic savings a lifelong habit, you will not be sorry.

For guidance in maximizing your plan, I recommend you study “Successful 401(k) Investing in 12 Easy Steps,” published in November 2002 and available online in our article library at FundAdvice.com.

Unfortunately, relatively few 401(k) plans have good investment options that cover small-cap, value and international stocks. Therefore, you will probably need to rely on other investments to give you the asset classes you can’t get in your 401(k).

You should think of all your long-term investments as making up a single portfolio – and strive for having the right overall balance. For example, your 401(k) may contain an excellent U.S. small-cap offering but not an international small-cap fund. In this case, use your IRA or a taxable account to invest in an international small-cap fund.

Incidentally, if you and your spouse each have a 401(k) plan, you can treat the two of them as one for allocation purposes. His may be strong in one asset class, hers in another. As simple as this is, in all my years of working with investors, I have met only one couple who studied their two plans and figured out the best way to build them together using the strongest options in each plan. If you can do that, I hope you will.

Aside from 401(k) accounts, the most common vehicle for retirement savings is the IRA. Even though contributions are limited to $3,000 per year for most people, an IRA gives investors almost unlimited flexibility in choosing asset classes.

I’m often asked how I would obtain proper diversification in an IRA, starting with the first year of contributions. My advice follows, and it applies equally to taxable accounts being used to emulate the Ultimate Buy and Hold Strategy.

By definition, long-term investors have plenty of time to achieve their goals. You don’t have to have an optimally diversified portfolio on Day 1. I recommend a patient, methodical approach, starting with the asset classes that have in the past been most likely to produce high long-term returns. That means value stocks and small-cap stocks.

To keep expenses low and efficiency high, I suggest investing in a single asset class, represented by one fund, each year.

In a Roth IRA with $3,000 annual contributions, here’s how I would do it, step by step:

Year 1: Invest $3,000 in a U.S. small-cap value fund. My first choice is Vanguard Small-Cap Value Index. Among actively managed funds, a choice worth considering is Third Avenue Small Cap Value (TASCX). Result: Even in this very first year, an investor has representation in both the value and small-cap areas.

Year 2: Invest $3,000 in an international small-cap value fund. Vanguard doesn’t have an index fund that precisely covers this asset class, but Vanguard International Explorer is a fine choice that we use in our Vanguard Model Portfolios. Result: By the second year, the investor has representation in small, value and international.

Year 3: Invest $3,000 in a U.S. large-cap value fund. My first choice is Vanguard Value Index. Among actively managed funds, one worth considering is Dodge & Cox Stock (DODGX). Result: This adds representation into the most popular (if not the most productive) part of the market, U.S. large-cap stocks.

Year 4: Invest $3,000 in an international large-cap value fund. My first choice is Vanguard International Value. An alternative worthy of consideration is Oakmark International (OAKIX).

Year 5: Invest $3,000 in an emerging markets fund. My first choice is Vanguard Emerging Markets Index fund. Result: The investor has now reached deeper in search of companies that have big future potential.

Year 6: Invest $3,000 in a U.S. small-cap blend fund. My first choice is Vanguard Small-Cap Index (NAESX). Two other worthy choices include Third Avenue Value (TAVFX) and T. Rowe Price Small Cap (OTCFX).

Year 7: Invest $3,000 in an international small-cap fund, either blend or value, whichever was not done in Year 2. If you want an all-Vanguard portfolio, add more money to International Explorer. My second choice in this category, Oakmark International Small-Cap (OAKEX), is closed to new investors. A relatively new fund, offered by a fund family with an excellent track record in U.S. small-cap investing, is Wasatch International Growth Fund (WAIGX).

Year 8: Invest $3,000 in a large-cap international fund. My first choice is Vanguard Developed Markets Index. Among actively managed funds there are also worthy candidates for such a fund, including T. Rowe Price International Stock (PRITX) and Fidelity Diversified International (FDIVX).

Year 9: Invest $3,000 in a U.S. large-cap fund such as Vanguard 500 Index. Many people think of this as the first fund to own, because it represents what so many investors think of as “the market.” I’m listing it last because I expect large-cap U.S. stocks, despite their popularity, to be the least productive of all these asset classes.

This plan requires at least eight full years to implement until full diversification is achieved. During this build-up time, the portfolio won’t have an ideal balance of assets. But to a young person, eight years of imperfect balance is not likely to be fatal. And at the end of this time, a very well-balanced portfolio will be the reward.

An investor who starts this plan on his 25th birthday will achieve full diversification by his 33rd birthday. With a projected retirement age of 60, that leaves 27 years for the portfolio to grow with its proper balance. An investor who’s now in his mid-20s has a high chance of living to age 80 or beyond, giving this properly balanced portfolio the potential for half a century to reward its owner.

We don’t have enough data to back-test this strategy very well, because some of the funds we recommend don’t have long track records. However, we did go back almost four years to see how this approach would have stacked up in the recent past with the first four asset classes I have listed.

We assumed an investor started by investing $3,000 in the Vanguard Small Cap Value Index Fund at the beginning of 1999 (the fund’s first full calendar year of operation), then added $3,000 at the start of each of the next three years in the other Vanguard funds we recommended above, one at a time. By the end of November 2002, these investments would have been worth $10,667.

For comparison, we calculated the returns of the same string of investments made in the Vanguard 500 Index Fund, which tracks the S&P 500 Index. At the end of November, those investments would have been worth only $9,052.

The past four years are not necessarily typical, and in the future, anything is possible. But not everything is probable. We think investors should make their decisions based on what’s probable, not what is merely possible. All the evidence I’m aware of make me think it’s probable that other asset classes over long periods of time will continue to outperform the S&P 500 Index.

My job is to inform you of the facts and give my assessment of how you can take advantage of them. You now have that information, and I hope you’ll use it.

One other topic should be covered here, and it could be called the desire for ultra-simple investing. For some investors, even the eight equity funds we recommend are simply too much.

I am sometimes asked what I would suggest for someone who was going to invest in only one mutual fund for a lifetime. I don’t like the question, because there is no single fund that meets the needs of every investor. But recently in a column I wrote for CBSMarketwatch.com, I allowed myself to be pinned down on that topic.

To some people, the logical answer to this difficult question might seem to be Vanguard Total Stock Market Index (VTSMX). However, that fund would not be my choice, for two reasons. First, it’s an all-equity fund and lacks any fixed-income component to reduce the volatility of a stock market portfolio. We don’t believe most investors should be 100 percent exposed to the stock market after they are retired.

Second, even for an all-equity fund, Total Stock Market Index is not the best one-fund choice. While it owns most publicly traded stocks, it’s very heavily weighted toward giant companies, with only minimal exposure to small-cap companies and virtually none to international stocks.

For someone making a one-time investment that must last a lifetime, I would prescribe a fund from Morningstar’s “domestic hybrid” category that maintains a portfolio in the neighborhood of 60 percent in stocks and the rest in bonds and cash.

This 60/40 asset mix is what corporate America has decided is appropriate for pension funds. Pension funds are a good model for individuals to study, because a pension fund has much more incentive to avoid major losses than it has to achieve a higher return than some other pension fund.

A 60/40 asset mix is likely to provide a high enough return in the good times that investors won’t be likely to jump ship in favor of high-flying growth funds. In the bad times, this mix will limit losses, presumably discouraging investors from bailing out of the market altogether at what is likely to be the wrong time.

Your money won’t work nearly as hard for you in any single fund as in a properly diversified portfolio. But if you must have only one fund, look for one that will give you low costs, low turnover (thus low tax exposure) and a portfolio run by some of the best managers in the business.

I know of two funds that fit this profile. One is Vanguard Wellington (VWELX). The other is Dodge & Cox Balanced (DODBX).

How to choose between them? My first choice would be Wellington, primarily because I like its lower expense ratio of 0.36 percent, vs. 0.53 percent for Dodge & Cox Balanced.

Over the past 10 years, Dodge & Cox Balanced has had higher returns than Wellington, probably because the Dodge & Cox portfolio is slightly more oriented toward smaller companies and value companies. This has made it more than worthwhile for shareholders to pay Dodge & Cox’s higher expenses. Whether this higher performance will continue is impossible to know, but I think it’s safe to predict that Wellington’s expenses will remain lower.

Neither of these funds will set the world on fire. But when I think of the thousands of investors I’ve talked with over the years, I can’t recall more than a few who wanted to be exposed to the risk of a one-year loss greater than 20 percent.

Either one of these funds should keep its shareholders well within that limit.

Paul Merriman is founder and president of Merriman Capital Management in Seattle and editor and publisher of http://www.FundAdvice.com. He is the author of two books on investing and writes a weekly column on mutual funds for CBSMarketwatch.com.

Superior Diversification on a Shoestring Budget
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