Reasoning behind SCV+EM instead of Total Market

[D]

What's Paul's and Swedroe's reasoning behind going with SCV+EM instead of total market?

[craigr]

Pros:

- Possibly more volatility on the upside in good markets.
- Currency risk with international funds can outperform if the dollar is falling which helps performance.
- Backtested performance shows potentially more gain over the years.

Cons:

- Possibly more volatility on the downside in bad markets.
- Currency risk with international funds can underperform if the dollar is strengthening hurting performance.
- Backtested performance is highly time dependent.

I hold TSM as my primary stock holding with a very small allocation to total international personally. I wouldn't overweight emerging markets. I don't think many EM countries are trustworthy enough to put a lot of money in them. In the long run, I suspect a TSM portfolio and international portfolio of stocks will be largely a wash excluding currency fluctuations. I think that Bogle saw the same things in his research.

The primary diversification from the portfolio is the stocks, bonds, cash and gold split. Adjusting the stock allocation is secondary in terms of diversification benefits.

Having said all that, if you are going to split up your stocks you should use an index fund for it. I think Paul discussed the reasons for his modifications in one of his podcasts but I don't remember which one. He can maybe fill in the details.

[KevinW]

(Craigr posted while I was typing, I'll post anyway...)

Here's the 5 minute version:

There is an idea from modern portfolio theory that the risk/return profile of a company's stock is not only explained by the fact that it's a stock ("beta"), but also the company's size ("market cap") and position on the growth-value spectrum.  This idea was originally put forth by authors Fama and French so you see it described as the "Fama-French model" or "three-factor model."

In this model, small stocks and value stocks have higher risk and higher return than average.  So a smaller allocation to small cap value stocks has the same statistical properties as a larger allocation to the total market.  So you could build a portfolio with a small allocation to highly volatile equities, e.g. the "Swedroe concentrated" portfolio which is something like:

15% domestic small cap value
15% high-risk foreign stocks, e.g. emerging markets
70% short term treasuries

Backtesting shows that a portfolio like that has similar returns to a 60/40 total stock / total bond portfolio, but with low volatility in the same league as the PP.

This approach shares the PP's aversion to drawdowns, and I think it has merit.  However I have the following concerns:

- I am convinced that the small-cap premium and value premium exist, however I am not convinced that they necessarily exhibit themselves over a typical investor's time horizon.  I am confident they show up over 100+ years but worry that those stock sectors could be flat for decades, in which case you have a portfolio of short term bonds which probably don't grow fast enough to meet investing goals.
- Value stocks tend to have large dividends which are taxed unfavorably, so if you are accumulating in a taxable account, much of the value premium gets eaten up by taxes.
- A portfolio like that will have lots of tracking error, just like the PP.
- The allocation arises from a backtesting black box, so there is no common-sense story for why it works.  By comparison each PP asset is there for a reason, so any time you hear bad news you can point to the asset that will protect you.  Psychologically makes it easier to stick with the PP.
- Emerging markets carry a shocking level of political, regime, currency, and corruption risk.  This is frequently dismissed and I am not convinced these risks are compensated by the market.

[KevinW]

Also, I'll add that I used to work at an unassuming S&P 500 company, and they did a lot of business in emerging markets, on both the production and sales side.  Upper management was constantly jockeying to take advantage of shifting economic and currency conditions.  So I think Bogle is basically right, that you won't miss out on anything by holding the TSM.  American CEOs are already pulling their hair out making daily decisions about how much capital to allocate outside the US, so as an investor it's fine to sit back and let them earn their pay worrying about that.

[Wonk]

D,

I believe on p. 21 of the giant PP thread on the bogleheads board, you should find a discussion on including SV with the PP.  Also, do a search on "permanent portfolio redux" and you should find another thread for a good discussion. 

Personally, I like the simplified 4-fund UBH suggested by TrevH on p21 of that big thread and elsewhere on the same board.  It doesn't suffer the same underperformance relative to TSM that SV sometimes has over extended periods.  Just like substituting 1-3 year bonds to juice the cash, I'm convinced 4FUBH will juice the stock portion going forward. 

It all depends on how much complexity you want to add to your portfolio.

[BobS]

There's a real-life small cap fund that's has been in existence since 1961 - PRNHX, T. Rowe Price's New Horizons fund.  Probably a good choice to
look at, historically.  As it's part of my 401K, I'm invested in it as the only other small cap choice I have isn't something I like.

As for TSM funds, there can be problems with them - the market cap rated funds tend to move and behave like the top 10 funds in their index,
plus they are very light on mid and small cap equities, thus may not actually reflect the total market.  There's an article that discusses this over at -

http://etfdailynews.com/blog/2010/09/27 ... f-rsp-eql/

Because of the limited exposure to small and mid caps in TSM funds, some (like myself) prefer to add a small cap to pull in the total stock market.

But doing so means understanding what's actually in each fund.  From the homework I've done a couple of examples are -

  VTI is completed by VXF

  PRF is completed by PRFZ

Looking at returns this year - 31 Dec 2009 to today, and using a PP of $10K with $2.5K devoted to stocks, the returns for each type are -

VTI/VSS (75%/25%) - 7.69%
VTI/VXF/VSS (50%/20%/30%) - 9.13%
VBR/VWO (50%/50%) - 12.56%
VBR/VSS (50%/50%) - 13.69%
PRF/PRFZ/VSS (45%/45%/30%) - 11.2%

From the above, while backdating caused Paul to use - VWO, short term results shows that developed international markets return slightly more
at the moment when VSS is used.  And I don't know if Paul noticed it, but any time a large cap is added, it will dampen down the swings a small
cap will make.

For example, taking VTI/VXF/VSS and swapping the percentage to - 20%/50%/30%, the YTD return becomes - 11.25%

When looking at the contents of a particular small cap like PRFZ, one finds that 35% of it is in the value side of the chart,
with 33% blend and 22% growth  It also has 7% mid-cap and 2% large-cap.  And is designed to complete PRF.

VXF has a different weighting that covers a smaller section of small cap - 18.62% value, 19.23% blend, 19.54% growth, the
rest mid-cap and around 8% large-cap.  Thus more of a compliment to VTI which is mostly large cap - 26% value, 26% blend,
26% growth, and 11% mid-cap, with approx. 10% small cap.

VSS does have an emerging market component to it - it includes equities from Brazil, China, and India.  But the closest it gets to Indonesia is
Singapore.  It includes 1421 stocks.

VWO picks up South Africa and Malaysia, but completely misses Vietnam and has a lot of exposure to Taiwan, which is not emerging. And neither is
the United States nor the United Kingdom.  It includes 539 stocks.  Also, it has too much China exposure for my tastes - too much risk there.

[MadMoneyMachine]

What's Paul's and Swedroe's reasoning behind going with SCV+EM instead of total market?

Harry Browne talked about investing for each of the 4 economic conditions. For deflation, he said the maximum "safe" gain would be found in long term treasuries. For prosperity he recommended stocks, but didn't really talk about strategies for maximizing "safe" gain during prosperity. In his book, written in 1999, he recommended using three stock funds among eight that he recommended in an appendix. That was before he recommended index funds. Later on his radio show he recommended a total stock market fund or an S&P 500 index. He liked to keep things simple.

In my readings I understand that Fama and French said that small cap and value stocks outperformed large cap and growth stocks over the long term. Lots more info about that here: http://www.ifa.com/12steps/step8/step8page3.asp

Here is a chart that shows the percentage of time that Small Value beats Large Blend:
http://www.ifa.com/Library/Support/Data ... omparisons

So I wanted to go beyond Harry's easy pick and find a stock index that gave maximum "safe" gains during prosperity. So riskier stocks like small value and emerging market should do better. Using Simba's spreadsheet to back-test various Vanguard fund portfolios, I determined that a mix of Small Value and Emerging Market had the biggest bang for the buck. I think Harry liked the simplicity of TSM and he probably would never have wanted to try to explain the Fama and French Three Factor Model and why folks should small-value tilt their portfolios.

Bottom line: my reasoning is both for theoretical and back-tested reasons. And I do like the small amount of added currency diversification as well.

Answering CraigR's cons:
1. More volatile? Not much according to 38 years of data.
2. I don't see increased currency diversification as added risk. I see being 100% dollar (really 75% dollar, 25% gold) as a risk.
3. Backtested performance covered 38 years and I also looked at many, many subsegments of that time span. IFA data looked at 82 years of data. I like my odds.

But I'm not angry if someone doesn't want to do SCV and EM and just want to do VTSMX. SCV + EM wasn't really that big of a gain for the pain and anguish it may have caused those who don't believe the theories.

There will be times when SCV and EM underperform Large Cap Blend. I'm OK with that.

I do appreciate the additional suggestions on better stock index combinations. I have not exhaustively looked at all possible combinations. I limited myself to funds in Simba's spreadsheet. It was good enough for me at the time. But as my analysis capabilities grow, I would like to examine more scenarios and more theories.

BTW: I don't know the genesis of Larry's portfolio, but I suspect it is a result of back-testing.

Paul

[BobS]

I have spent a lot of time looking at some of the threads overs at the Boggleheads.  Backtesting reminds me of the audio spec wars of the '70s. 

I played a bit with Simba's and Paul's spreadsheets (thanks Paul!), but they weren't useful to me.  I require that beyond making it work and developing
some understanding of it, that it work with real data -  the etfs or funds I'm looking at.  Given I'm no academic nor financial guru, I fall
back to setting up test portfolios, looking for similar etfs and comparing them - looking at the trade offs of each, as well as looking at the composition
of each. 

I also do some real-world testing in my variable account just to get a feel for how some things work.  While I'm willing to change my way of seeing
things, too many years in the Tech industry prevents me from accepting that things work, in theory, because someone created a model and tested
it against historical data.

Gold I have no problem with and have owned it for awhile now.  I watched TLT and TUZ over a few weeks in real time.  So while bonds still throw me
when they go up when the interest rates go down, it's ok.  I just don't have an intuitive feel for them.

Equities - If, unlike Craig, one is holding equities in a 401k or IRA, then moving and adjusting the mix or tossing an entire fund shouldn't create the
controversy I see in different forums.  It simply amazes me.  More than anything else, equities are pure gambling, they should be treated as such.

And there is context - I don't care how something worked over the past 100 years.  At this point even 40 years is way too long to care.

While reading what Clive is doing is like being a 2D person looking through a window into a 3D world,  he's not the first I've read about re-adjusting
if you're down.  Only he's quantified it at -7%.  I haven't put together something that directly tests that in the real world, but it's something I
need to do.

Thus while Paul came to be comfortable with the risk/return of VBR/VWO, I would caution that even though China is a key emerging market, the
accounting standards and transparency isn't there at this time, thus the risk is pretty high - one of the firms cooked it's books - Duoyuan Printing
(DYP:nyse).  And Brazil has changed it's land ownership policies.  But then U.S. Large caps as found in TSM funds are fine - if one ignores Enron,
Woldcom, GM, etc. 

Backtesting theory is great as is Boggle's  RTM (Return to the Mean) proof of how one should just follow an Index fund and not slice and dice.
But reality means one needs to watch the 25% in equities.  That means developing an exit strategy should it come down to it.  It also means
adjusting it when conditions warrant it.  Of course, the good news is that 25% can't go below 0%, much like all those stock options that I
received have done.

To quote Yogi Berra - In theory there is no difference between theory and practice. In practice there is.

[MediumTex]

But reality means one needs to watch the 25% in equities.  That means developing an exit strategy should it come down to it.  It also means
adjusting it when conditions warrant it.  Of course, the good news is that 25% can't go below 0%, much like all those stock options that I
received have done.

I'm not following you on developing an exit strategy for equities.

The PP has you buying equities once they breach a rebalancing band in a market selloff. 

In general, the exit and entry strategies are built into the PP strategy.  There is no need to come up with additional entry and exit points.

***

In general, I sense in your posts a belief in your ability to make accurate forecasts regarding the direction of markets.  If you truly believe that you have the ability to accurately forecast the markets, then I am surprised something like the PP would interest you.  Alternatively, if you acknowledge that the markets are fundamentally unpredictable, then why waste time trying to develop additional buy and sell points on top of the already well-reasoned buy and sell points that are part of the basic HB PP strategy?

In my view, trying to improve upon the PP strategy through ad hoc tweaks and adjustments is an easy way to waste a lot of time and energy with very little return to show for it.

[Bonafede]

In my view, trying to improve upon the PP strategy through ad hoc tweaks and adjustments is an easy way to waste a lot of time and energy with very little return to show for it.

MediumTex....I couldn't have said this further. Honestly, keep the PP simple. I spent countless hours trying to reconcile a more traditional 'Bogle-esque' porfolio with the PP. While I believe Bogle and Brown advocate much of the same things (e.g. balanced diversified portfolio via low cost index funds), the PP is really designed as just that....a PP. Keep this one simple and play around with the VP. I'm telling you...your wife and fam will thank you for it, and you'll enjoy life that much more. Invest with intention, keep it simple, and live!

[BobS]

Exit strategy - risk management.  Feel free to call it timing the market, call it whatever you want.  If what I own has a large exposure to
China or Brazil or somewhere else and the government of that country changes policy, I will consider if reducing my holdings or changing funds
is appropriate - not wait until the next re-balancing.

Same with the mutual funds I own - if they change management or radically change what they are holding, I, as the manager of the portfolio,
need to determine what to do to limit any downside risk.

Or, if something goes wrong with the stock market, and there are warnings.  Just sitting by while the value of the equity part of the portfolio goes
down isn't an acceptable option to me.

In 2008 when everyone lost half the value of their equity position, I lost nothing because I got out of equities and into cash.  Sure, had I had
a PP at the time, LT bonds would have covered, but why lose half the equity position if it can be prevented?

Events like 2008 don't happen all the time, neither do governments changing policies.  And the mutual funds tend to be pretty stable but have
different annual dates - July, September, and December.  Thus the need to do risk management doesn't happen a lot.

And one other minor thing - I can't re-balance the equity side, it's all in the 401k.  The IRA holds the other three components.  Money cannot
be moved between the two.  Thus any major loss in the equity side is gone.  There is no easy - re-balance.

Regardless of what happens at the macro level with the PP, it seems prudent to minimize large losses in the equity side if the oncoming disaster is
seen before it strikes.  It has nothing to do with increasing gains, only preventing major losses.

[MediumTex]

Exit strategy - risk management.  Feel free to call it timing the market, call it whatever you want.  If what I own has a large exposure to
China or Brazil or somewhere else and the government of that country changes policy, I will consider if reducing my holdings or changing funds
is appropriate - not wait until the next re-balancing.

Same with the mutual funds I own - if they change management or radically change what they are holding, I, as the manager of the portfolio,
need to determine what to do to limit any downside risk.

If we are talking about the PP here, there shouldn't be any China, Brazil or actively managed funds in the portfolio in the first place.

Or, if something goes wrong with the stock market, and there are warnings.  Just sitting by while the value of the equity part of the portfolio goes
down isn't an acceptable option to me.

In 2008 when everyone lost half the value of their equity position, I lost nothing because I got out of equities and into cash.  Sure, had I had
a PP at the time, LT bonds would have covered, but why lose half the equity position if it can be prevented?

The overall PP did fine in 2008.  That's the point--it didn't require you to correctly guess when it was time to exit the stock market and then decide when to re-enter.  Trying to guess those things correctly is at the opposite extreme of what the PP is premised upon--i.e., avoiding the need to guess.

The PP certainly isn't the only game in town, and you may have success with your strategy, but I don't know if what you are describing is a PP approach, either in spirit or in practice.

[BobS]

The overall PP did fine in 2008.  That's the point--it didn't require you to correctly guess when it was time to exit the stock market and then decide when to re-enter.  Trying to guess those things correctly is at the opposite extreme of what the PP is premised upon--i.e., avoiding the need to guess.

The PP certainly isn't the only game in town, and you may have success with your strategy, but I don't know if what you are describing is a PP approach, either in spirit or in practice.

If I understand what you are saying, you contend that once a PP has been established then one should not be concerned about the other
rules HB put forth?

I was under the, perhaps mistaken impression, I was following the rules?  Such as -

Rule 15 - Ask the Right Questions

15.1 "Is there any risk?"

• In what economic circumstances is the investment's price likely to go down?
• Are other investments in your portfolio likely to take up the slack by gaining in those same circumstances?
• What is the most you can lose on the investment?

15.2 - "Is this investment safe?"

• Under what circumstances could I lose substancial share - 20% or more - of my investment?
• Under what circumstances could my entire investment be lost?
• Would I have any residual liability - that is, can I lose even more than the cash I invest?

And, what seemed to be HB's highest priority rule -

Rule 17 - Whenever You're in Doubt, Err on the Side of Safety

[MediumTex]

The overall PP did fine in 2008.  That's the point--it didn't require you to correctly guess when it was time to exit the stock market and then decide when to re-enter.  Trying to guess those things correctly is at the opposite extreme of what the PP is premised upon--i.e., avoiding the need to guess.

The PP certainly isn't the only game in town, and you may have success with your strategy, but I don't know if what you are describing is a PP approach, either in spirit or in practice.

If I understand what you are saying, you contend that once a PP has been established then one should not be concerned about the other
rules HB put forth?

I was under the, perhaps mistaken impression, I was following the rules?  Such as -

Rule 15 - Ask the Right Questions

15.1 "Is there any risk?"

• In what economic circumstances is the investment's price likely to go down?
• Are other investments in your portfolio likely to take up the slack by gaining in those same circumstances?
• What is the most you can lose on the investment?

15.2 - "Is this investment safe?"

• Under what circumstances could I lose substancial share - 20% or more - of my investment?
• Under what circumstances could my entire investment be lost?
• Would I have any residual liability - that is, can I lose even more than the cash I invest?

And, what seemed to be HB's highest priority rule -

Rule 17 - Whenever You're in Doubt, Err on the Side of Safety

HB proposed the PP as an answer to all of the criteria for a safe investment that he outlines in his rules in "Fail Safe Investing."

I don't think he was saying to use the rules he outlines as a rationale for tinkering with the PP once it is established.

As I said above, there is nothing wrong with tinkering, if that's what an investor wants to do, but the PP is a strategy that doesn't require any tinkering--it is a turn key solution.  When one takes a turn key solution and then begins to tinker with it on an ad hoc basis based upon personal intuitions and perceptions of market psychology what we are talking about is no longer a "permanent" portfolio, but rather a market timing strategy that is vulnerable to all sorts of dangers.

I want to be clear here--there is nothing wrong with actively managing your investments, but when applying the principles HB outlined, this active management should only occur on the VP side.  The PP should only contain money that you can't afford to lose and which you are comfortable not tinkering with.

[MediumTex]

Let me offer another perspective on the idea of applying HB's rules for investing safety from "Fail Safe Investing" to the PP itself.

I don't think it is an unreasonable thing to apply HB's own logic to the allocation he recommends for safety in the form of the PP.  However, I think that applying HB's rules for investing safety should be applied to the PP as a whole, not to its individual components.

Thus, if the PP as a whole began to experience large drawdowns over a multi-year period (e.g., 10%+ per year over a two or three year period or longer) or underperform other conservative asset allocations, then it might make sense to revisit the decision to use the PP, because the PP would no longer be providing the safety that it was advertised as providing. 

However, the activity within one PP asset class is, to me, totally irrelevant to the question of whether or not the PP meets HB's criteria for a safe investment.  Thus, if stocks lost 90% of their value I would look to see how the overall portfolio was doing.  Similarly, if bonds or gold were tanking I would want to know what the overall portfolio was doing, because it's the performance of the overall portfolio that really matters.

This is the approach that HB took as well in evaluating the history of the PP.  During the period beginning in 1972 and ending at various points later when HB was tracking PP performance, he always noted that there was one or more PP assets that were struggling--stocks and bonds in the 1970s, gold in the 1980s and 1990s, etc.  However, no matter how poorly a PP asset was doing, HB never suggested that it would have been appropriate to exit that asset entirely or otherwise tinker with the PP.

I believe that HB's goal in creating the PP was to truly create a "permanent" asset allocation that would provide safety and stability and allow one to enjoy life without having to be endlessly babystitting his investments.  To a great degree I believe he succeeded.  However, in order for one to enjoy the benefits of HB's success in developing such a subtle and effective strategy, one must accept that the design is solid and not subject to improvement through ad hoc tweaks and idiosyncratic departures from the core approach.

BobS, I appreciate you raising the topic, because I think it provides an opportunity to touch on these points, which I think really go to the heart of what the PP is all about, and how effective it can be for investors who are tired of trying to predict the future or find the market wizard who can.

[hrux]

I would love to see Paul and Craig on a podcast to discuss the merits of VTI/VEU versus Small Cap Value/Emerging split?