Investors have to decide how they will invest their money and who will help them do it. Most investors choose the do-it-yourself (DIY) route. For these investors we suggest a simple, yet well-diversified Two Fund Portfolio made up of one stock fund and one bond fund. The stock fund is the Vanguard Total World Stock Index (ticker: VTWSX). The bond fund is the Vanguard Total U.S. Bond Index (ticker: VBMFX). The key decision for the DIY investor is how much risk can and should she take. That decision dictates how much of one’s portfolio to put in the stock fund and how much goes into the bond fund. Last week’s article, the Two Fund Solution, explores this question in more detail.
One alternative is to hire a professional financial advisor to develop a well-thought-out financial plan and invest in alignment with that plan. We’ll restrict the universe of financial advisors to those who are fiduciaries (legally required to put the client’s best interest ahead of their own) and who build portfolios based on academic evidence. These advisors do not speculate in individual stocks, market timing schemes, hedge funds and the like.
Currently, the best academic evidence demonstrates that capital markets are reasonably efficient (the price of a stock or bond reflects all information at that moment). The evidence also shows that risk and return are related; to get higher returns you must take more risk. Research also has identified three factors that contribute to stock market returns. These three factors are being invested in stocks vs. bonds; holding smaller company stocks, and holding value stocks (that have relatively low price to book value ratios).
The following table compares the Two Fund Portfolio to the Focus portfolio that we build at Vestory. The analysis is for 60% stock/ 40% bond portfolios for the period from January 1, 1970 through July 31, 2014. Figures are net of the funds’ internal expenses, and the Focus portfolio has 0.9% deducted annually for the advisory fee.
The professionally managed Focus portfolio outperformed the DIY managed Two Fund portfolio by a wide margin (1.44% annualized) over a 44 year period. Remember that fees were deducted from the returns.
Why did the Focus outperform over the long-term? The Focus portfolio is a bit riskier than the Two Fund portfolio. It holds more small cap and value stocks than the Two Fund portfolio. As a result, it has slighty higher standard deviations and and the worst one and three year losses exceed those of the Two Fund portfolio. In the long run, investors were rewarded for taking that risk. Keep in mind that the returns in both portfolios required that investors stay invested at all times and rebalance back to the 60/40 allocation each year.
The right professional financial advisor can add value to an investor by developing a solid financial plan, building an efficient risk-adjusted portfolio, and working with a client on a continual basis to make sure the investor doesn’t panic and make the wrong moves (bailing out of stocks AFTER they have had a large decline).