Millionaire Teacher (13 page)

This kind of rebalancing is common practice among university endowment funds and pension funds.

Usually investors don't need to address their stock/bond allocation more than once a year. But when the stock markets go completely nuts—dropping by 20 percent or more—it's a good idea to take advantage of it if you can.

Having a Foreign Affair

Americans should have a nice chunk of money in a U.S. index; Canadians should have a good-sized chunk in a Canadian index; and so it should follow for Australians, Brits, Singaporeans, or any other nationality with an established stock market. An investor's portfolio should always have the home country index represented. After all, it makes sense to keep much of your money in the currency with which you pay your bills.

After adding a government bond index to your portfolio, you really could stop right there.

But many investors (me included) like having an international component to their portfolios. The U.S. stock market makes up just 45 percent of the world's stock market exposure. There are stock markets in Canada, Australia, England, France, Japan, and China, just to mention a few, and it's advantageous to get exposure to the other 55 percent of the world's stock markets.

A total international stock market index would fit the bill.

There are many trains of thought relating to how much of your stock exposure should be international. To keep it simple, you could split your stock market money between your home country index and an international index.

In that case, a 30-year-old American investor (without an upcoming pension) would have a portfolio that looked like the one on
Figure 5.4
:

Figure 5.4
Investment Portfolio Percentages

If you're making monthly investment purchases, you need to look at your home country stock index and your international stock index and determine which one has done better over the previous month. When you figure it out (hold on for this!) you need to add newly invested money to the index that hasn't done as well to keep your account close to your desired allocation.

What do most people do? You guessed it. Metaphorically speaking, they sign long-term future contracts to empty their wallets each morning into the toilet—buying more of the high-performing index and less of the underperforming index. Over an investment lifetime, behavior such as this can cost hundreds of thousands of dollars.

Over my lifetime, the total U.S. stock market index and the total international stock market index have performed similarly. There's less than one percent compounding difference between the two since 1970.
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But there are times when one will lag the other. Take advantage of that.

Please note that I'm not talking about chasing individual stocks or individual foreign markets into the gutter. For example, just because the share price of company “Random X” has fallen doesn't mean that investors should throw good money after bad, thinking that it's a great deal just because it has dropped in value. Who knows what's going to happen to “Random X.” It could vaporize like a San Francisco fog.

Likewise, you take a large risk buying an index focusing on a single foreign country, such as Chile, Brazil, or China. Who really knows what's going to happen to those markets over the next 30 years? They might do really well, but it's better to spread your risk and go with the total international stock market index (if you want foreign exposure). Within it, you'll have exposure to older world economies such as England, France, and Germany, as well as the younger, fast-growing economies of China, India, Brazil, and Thailand. Just remember to rebalance. If the international stock market goes on a tear, don't chase it with fresh money. If your domestic stock index and the international stock index both shoot skyward, add fresh money to your bond index.

If that sounds too complicated, Scott Burns has popularized an even simpler strategy.

Introducing the Couch Potato Portfolio

A former columnist with
The
Dallas Morning News
, Burns now works with AssetBuilder, a U.S.-based investment company that manages money with indexed strategies. Recognizing that actively managed mutual fund purchases didn't make sense (thanks to high fees, high-tax consequences, and poor performance), he popularized a simple investment strategy called The Couch Potato Portfolio.

It's comprised of an equal commitment to a U.S. total stock market index and a total bond market index. In other words, if you were investing $200 a month, you would put $100 a month into the stock market index and $100 a month into the bond market index. You don't even have to open your investment statements more than once a year if you don't want.

After one year is up, look at your investment account and figure out whether you now have more money in stocks or bonds. If there's more money in the bond index, sell some of it to get equal weighting in your portfolio, buying the stock index with the proceeds. If there's more money in the stock index, sell some of your stock market index and buy the bond index with the proceeds.

Without allowing yourself to fall victim to the crazy “ups and downs” of the markets, you would be buying low and selling high once a year.

With a 50 percent bond component, this would be a pretty conservative account. If the stock markets fell by 50 percent in a given year, your account would fall far less than that and you would have a chance to even out your account 12 months later by buying the underpriced stock index with proceeds from the bond index.

Such a strategy, despite its very conservative nature, would have averaged 10.96 percent annually from 1986 to 2001.
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This would have turned $1,000 into $4,758.79 over that 15-year period.

But a drunken monkey tossing darts at the stock market page could have made decent money from 1986 to 2001 because most of the world's stock markets rose significantly during that time. How did the indexed couch potato strategy perform when stock markets went through their gut-wrenching dives and rises (and dives again) during the past 10 years—a decade that many stock market investors have coined “the lost decade”? For starters, the indexed couch potato strategy let investors sleep more soundly during market drops, thanks to the large bond component.

During 2002, the U.S. stock market was hammered and the average U.S. stock market mutual fund declined 22.8 percent in value. In other words, an investment of $10,000 would have fallen to $7,723. But during that devastating year, the markets were only able to knock the couch potato strategy down 6.9 percent. A $10,000 investment would have dropped to $9,310.
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Between the beginning of 2003 and the beginning of 2008, the U.S. and international stock market indexes rose dramatically, gaining 91 percent and 186 percent respectively.
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If you had money in the markets during these five years, you probably would have increased your portfolio size exponentially, no matter who was managing it. But let's have a look at one of the ugliest years in modern financial history: 2008.

With the global economic crisis, world stock markets took a beating. Of course, long-term investors would have been gleefully rubbing their hands as they took advantage of the lower stock prices, but let's see how the average U.S. mutual fund and the couch potato concept would have fared during that falling market.

If you thought the average professional could have weathered the storm, you'd be disappointed.
Table 5.1
shows that the average actively managed stock market mutual fund (comprised of stocks, without bonds) dropped 29.1 percent in 2008, compared to a drop of 20.4 percent for the indexed couch potato portfolio. And how about the average actively managed balanced fund? Balanced funds don't have the same kind of exposure to the stock market that regular stock market mutual funds have. Balanced funds are usually comprised of 60 percent stocks and 40 percent bonds. When stocks fell dramatically in 2008, the bond component of the average actively managed balanced fund should have cushioned the fall. But that wasn't the case. The average actively managed balanced fund dropped a whopping 28 percent during 2008.
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Why did the average balanced fund manager lose so much money even though 40 percent to 50 percent of their funds' assets were in bonds? The only explanation is that they were afraid, and they sold stocks when the markets fell. As mentioned in my previous chapter, nobody can predict the short-term movements of the stock markets. It's likely that most of the actively managed balanced fund managers in the U.S. were trying to do exactly that—with expensive consequences for their investors, as they sold stocks when prices were low. Following a disciplined couch potato strategy is likely to be far more profitable than allowing a fund manager to mess with your money.

Table 5.1
The Couch Potato Portfolio vs. the Average U.S. Mutual Fund in 2008
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Another nice thing about using the couch potato portfolio strategy is that (despite the market crash of 2008–2009) you would have still made money from 2006–2011. During this five-year period—when many actively managed balanced mutual funds lost money—a $10,000 investment in the couch potato portfolio would have grown to more than $12,521.56 without adding money to it. That's an overall gain of 25.2 percent.
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As an investor, I loved the stock market decline of 2008–2009. But as a consultant, it was disheartening. Many people brought their portfolios to me during the economic crisis, revealing investments that had collapsed 40 percent or more in value.

When I looked at their investment holdings, I found something pretty shocking: their investment advisers obviously had little respect for bonds. Most of the people who showed me their statements were older than me, so they should have had bond components that equaled or exceeded mine. But none did. In some cases, they had no bonds at all! Their accounts fell far further than mine when the markets declined and they couldn't take advantage of cheap stock market prices because they didn't have any bonds to sell.

Investors in their 50s and 60s, especially, require bonds in their portfolios. It would be tough to find an investment book that didn't include this fundamental principle. But many of the accounts I saw were fully exposed to the market's gyrations without a protective bond component.

I teach with one fellow whom I refer to as a “cowboy investor.” He's in his mid-50s, and won't have a pension because he spent his career teaching in private schools overseas. He says bonds are for wimps, so he doesn't own any. Buying whatever rises in value (after it rises) and selling whatever falls (after it falls) gives him the distinction of a cowboy who'll never have enough money to leave the ranch.

Combinations of Stocks and Bonds Can Have Powerful Returns

Even when stock markets are rising, a portfolio with a bond component isn't the “party pooper” most cowboy investors think it is. Financial author Daniel Solin notes that from 1973 to 2004, an investor with an allocation of 60 percent in a U.S. stock market index and 40 percent in a total bond market index would have earned an average return of 10.49 percent annually.

An investor taking much more risk and having 100 percent of their portfolio in a stock index would have returns averaging 11.19 percent annually during this period.
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The cowboy investor would have taken on more risk, and for what? An extra 0.7 percent annual return? He would need to have a strong stomach.
Table 5.2
demonstrates that his worst year during this 31-year time period would have seen his account plunge by 20.15 percent. In contrast, an account with 40 percent bonds and 60 percent stocks wouldn't have fallen further than 9.15 percent during its worst 12 months.
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Table 5.2
Mixed Bag of Stocks and Bonds

If that extra 0.7 percent return annually is worth the stomach-churning volatility, then go for it. But keep in mind that doing so won't allow you to rebalance your account by taking advantage of cheap stock prices when they offer a sale.

When bonds whip cowboys

The premise of rebalancing stock and bond indexes doesn't just work in the United States. The fundamental principle works no matter where you're investing.
MoneySense
magazine's founding editor, Ian McGugan, won a Canadian National Magazine Award for an article adapting the couch potato strategy for Canadians. His method was simple. An investor splits money evenly between a U.S. stock market index, a Canadian stock market index, and a bond market index.