by Christine Benz
11-15-05
Everywhere you go, there's someone hawking free investment advice, often of
dubious merit. Sure, you know to tune out that talking head plugging a penny
stock on TV or your loudmouth brother-in-law touting the virtues of flipping
Florida real estate. Less obvious--but potentially just as detrimental to your
portfolio's health--are the old saws that are often cited as gospel in the
investment marketplace. Some of these kernels of conventional wisdom are
outdated, while others made little sense from the get-go.
In my columns for this week and the next, I'll debunk some of the investment
myths I hear the most often. (Please feel free to share with me any investment
advice you've learned you're better off without.)
Indexing Only Works for Large-Cap U.S. Stocks
I'll admit that this one makes intuitive sense. Large-cap U.S. stocks are the
most heavily researched securities in the world, so it stands to reason that
this would be the area where active stock-pickers would have the hardest time
beating their benchmarks (and in turn a ripe area for indexing). Nonetheless,
there are powerful arguments for indexing--shadowing a benchmark such as the S&P
500 rather than trying to actually beat it--across a broad swath of asset
classes, from small-cap stocks to bonds to international equities. Chief among
them are low expenses, which give index funds a big head start over actively
managed vehicles. And I'm not just talking about expense ratios (although those
are important)--I also mean trading costs, which aren't included in a fund's
expense ratio. Because index funds generally trade less than actively managed
vehicles, their total cost loads are generally substantially below those of
active offerings.
Indexing Means Settling for Average
Seriously, I haven't been kidnapped and brainwashed by Bogleheads. But before
moving on I have to address one more index-related myth: Indexing means settling
for average. (One of my friends even went so far as to call indexing
"un-American"!) Hard data suggest that index-fund returns are often well above
average. Although not every index fund is worthwhile (particularly many of the
new narrowly focused exchange-traded funds), most of the biggest index funds
(and by extension, the indexes they track) land well above the medians for their
peer groups. The 10-year returns of two of the largest index funds, http://im.morningstar.com/im/premIcon.gif Vanguard
500 Index VFINX and http://im.morningstar.com/im/premIcon.gif Vanguard Total
Stock Market Index VTSMX, for example, land in the top 25% of their peer groups;
ditto for http://im.morningstar.com/im/premIcon.gif Vanguard Total Bond Market
Index VBMFX. ( http://im.morningstar.com/im/premIcon.gif Vanguard Total
International Stock Index VGTSX hasn't been around for 10 years, but its
five-year return lands in the top 15% of the foreign large-blend group.) And
"survivorship bias," which means that lousy funds that have been liquidated or
merged out of existence aren't included in fund-performance rankings, makes your
chances of a choosing a fund that will beat an index offering look even better
than they are.
If a Fund Has a History of Good Returns, It Can Overcome High Expenses
Many investors have a hard time believing it ain't so, but past returns aren't
particularly predictive of future returns. Low expenses, on the other hand, are
the single-best predictor that a fund will be able to beat its peers. That means
a fund with a good track record and high expenses is less likely to beat its
rivals in the future than is a fund with a lousy track record and low expenses.
(We did a study a few years back that bore out this thesis precisely.) Sure,
it's tempting to trot out Bill Miller, who has delivered peer- and index-beating
returns on http://im.morningstar.com/im/premIcon.gif Legg Mason Value Trust
LMVTX, as an example of a manager of a high-cost fund landing on top. But for
every Bill Miller there are hundreds of other managers of high-cost funds who
have failed miserably in their quest to beat their peers. Do yourself a favor
and pay little attention to a fund's past returns and instead focus on a simpler
number: its costs.
Investors Should Allocate 15% to 25% of Their Portfolios to Foreign Stocks
Over the past few years, as foreign markets have been rockin', I've tried to get
to the bottom of what's an appropriate allocation to foreign securities. Along
the way, I've noticed that many advisors seem to recommend an allocation in the
neighborhood of 15% to 25% of one's overall equity portfolio; many
target-maturity funds (all-in-one funds designed to "mature" as the investor
nears retirement or some other goal) also have similarly meager foreign stakes.
While staking 15% to 25% overseas seems reasonable--it's large enough to not
seem provincial and small enough to not spook anyone--I fear that it has little
basis in empirical evidence. The U.S. market is roughly 50% of the global stock
market, yet most U.S.-based advisors--like their counterparts overseas--have an
inclination to systematically overweight their home market for no apparent
reason. Even if you're not ready to stake a full half of your equity portfolio
overseas, you should still ask yourself whether you have a good reason for
sticking with a substantially smaller allocation to foreign stocks than they
represent in the global market.
Subtract Your Age from 100 to Arrive at an Appropriate Equity Allocation
I'm all for investors trying to determine the correct allocation to stocks,
bonds, and cash, and this rule of thumb is easy to use and remember. However,
your age shouldn't be the only determinant of your asset allocation; instead,
you must consider how much you've saved so far, your savings rate, your risk
tolerance, and your time horizon until retirement, among other factors.
(Morningstar's http://im.morningstar.com/im/premIcon.gifAsset Allocator tool,
free to Premium users of Morningstar.com, takes these factors into account.)
Even more significantly, I'd argue that this rule of thumb would leave most
investors with an overly conservative portfolio asset allocation given that
investors--due to earlier retirements and longer life expectancies--will need to
grow their capital more aggressively than they have in the past. Thus, if you
need a quick and dirty rule of thumb to keep in mind when determining your own
asset allocation, subtract your age from 110 (or more) to determine your equity
stake.
http://im.morningstar.com/im/dot_clear.gif
Christine Benz is author of the new edition of the Morningstar Guide to
Mutual Funds: 5-Star Strategies for Success. She is also Morningstar's associate
director of fund analysis and editor of Morningstar Mutual Funds. Although she
reads every e-mail she receives, she cannot respond to each message individually
or provide individualized portfolio advice. She can be reached at christine_benz@morningstar.com.
