Total Stock vs. Small Cap Value/Emerging Split

[craigr]

Please keep things civil.

[MediumTex]

Please keep things civil.

Ditto.

We are all friends here.

[moda0306]

I can see where Gumby's coming from.

Even though the mix you provided, because of the larger SCV piece, did well during the 1995-2000 stretch, because the EM part of it didn't do well, that does give people cause for concern as it's still a huge chunk of your prosperity piece.

For instance, if I were to (and I have, to some extent) suggest that other commodities besides gold should be used to diversify that piece, one could point to periods that gold performed much more in line with what a monetary metal should during times of inflation or even deflation... being invested in copper in 2008 would have been disastrous, while gold gained 4.5%.  This is because there are fundamental problems with other metals and how they behave on a macro-economic level.  Same could be said about different kinds of bonds and why/how they're unfavorable, even if they wouldn't have derailed the PP if used in limited portions, as EM are in your example.

Shouldn't we attempt to analyze EM the same way?  I feel its poor performance during 1995-2000 is a huge indicator that there is something fundamentally wrong with EM as it pertains to how it should be implimented in the PP, even if using it has proven ok in the past.

[Gumby]

Anyone who is considering using a SCV/EM split within their PP should realize that very few people actually have any money invested in that strategy.

Paul Boyer has done a wonderful job tracking the SCV/EM split within a Permanent Portfolio (which he has dubbed the "Paul Boyer Permanent Portfolio"). When I asked him about EMs during the late 90s, he was very up front about it — and I give him a lot of credit for his response.

Here's what he said:

It clearly wasn't a prosperous time for emerging markets. Yes, that was a more prosperous period for US Large Cap. At other times other countries and size companies will be more prosperous. Why not diversify?

Nonetheless, I do think most folks should just stick with the original HBPP and go with a total stock market fund. Perhaps that fund should even be a total global fund. I've studied the PBPP as more of an academic exercise to see if a small value and emerging market tilt can juice returns with low increase in risk. Sometimes it worked, sometimes as you point out, it did not work.

Invest at your own risk.

At the time he wrote that — this past October — he had yet to fully invest in his portfolio. My understanding is that he finally took the plunge just last month.

[MediumTex]

Anyone who is considering using a SCV/EM split within their PP should realize that very few people actually have any money invested in that strategy.

I'm surprised that this topic has gotten as much attention as it has.

Changing the PP stock allocation is similar to almost any other PP tinkering--it's probably not worth the trouble and may introduce additional levels of risk in the PP strategy that may not be obvious at the time that the tinkering takes place.

I think we can all agree that a simple U.S. stock index works fine in the stock portion of the PP.  I believe we can also agree that allocating up to 15% of the PP's stock allocation to an international index is probably not going to lead to a lot of future regret.

Beyond that, I would say just stick with the PP recipe and use the VP for investing in small cap value and emerging market funds.

Part of the appeal of the PP is that it is simple and one doesn't have to be a sophisticated investor to deploy it successfully.

[AdamA]

Does anyone think it may be worth it to replace an S&P or total market index with either a growth or value index?  I know HB's original rec was for a growth fund...right?

[Lone Wolf]

Does anyone think it may be worth it to replace an S&P or total market index with either a growth or value index?  I know HB's original rec was for a growth fund...right?

Total Stock Market or S&P 500 will work just fine.  These should generally have more attractive expense ratios and also eliminate the possibility of missing out on some sector that unexpectedly experiences more growth than had been anticipated.

In "Fail-Safe Investing" (my edition is from 2003), Browne recommended funds that emulate the S&P 500 while keeping expenses as low as possible.  It's reasonable to believe that Browne would have also thought Total Stock Market was a good option (if not better.)

Browne originally (in the late 80s) recommended picking volatile stocks.  In "Why the Best-Laid Investment Plans Usually Go Wrong" he recommended either high volatility stocks, mutual funds that invest in high volatility stocks, or warrants.  (I hadn't even heard of warrants before reading the book.)  Over time it became much easier to emulate the S&P 500 and he found that this worked just fine, so the recommendations from the 80s are obsolete now.

[MadMoneyMachine]

At the time he wrote that — this past October — he had yet to fully invest in his portfolio. My understanding is that he finally took the plunge just last month.

Yep, I took the plunge late 2010. I predicted that it would mark the peak of the PP and others should sell. :-)

But yes, I do invest in the "Paul Boyer Permanent Portfolio" because I believe that I want extra risk for my equities. I believe Fama and French when they say small cap value has more risk. And risk and return are generally correlated. I like Emerging Markets because it helps diversify globally and currency-wise. And the backtesting doesn't hurt. :-) I think I can stomach the non-correlation with S&P 500. And I tend to be idiosyncratic anyway.

I stick by my statement that MOST folks should just go US-TSM.

Of course another strategy might just be to increase the exposure to equities. As this posting showed, a 45% exposure to equities boosted returns 2% annually with 2% increase in risk (standard deviation).

[Lone Wolf]

But yes, I do invest in the "Paul Boyer Permanent Portfolio" because I believe that I want extra risk for my equities. I believe Fama and French when they say small cap value has more risk.... I think I can stomach the non-correlation with S&P 500.

I think that this summarizes the issue very well.  Fama and French demonstrated a premium on SCV and EM returns over time.  Furthermore, it's reasonable to believe that SCV and the general US stock market will correlate.

However, EM will not necessarily correlate with the US stock market.  This could mean funny behavior during "prosperity" in the US, likely proportional to the amount of EM held in the stock portion of the portfolio.

This means that replacing a portion of the stock allocation with Emerging Markets could yield greater overall Portfolio volatility.  While there may be other consequences as well, either positive or negative, this greater expected level of volatility seems like an intuitive one to expect.

None of this means that an SCV\EM mix is "bad".  On the contrary, anyone that has paid attention to the Paul Boyer Portfolio has noticed that it has done damn well over time.  I predict that it will continue to do well but will see more volatility than 4x25.  I think that this volatility will be caused by the EM holding.  Time will tell.

[moda0306]

LT Corporate bonds or Copper may be volatile, but there is a fundamental reason that they don't fit into the portfolio.  EM may have good overall returns (So do other assets not in the PP)  but that doesn't necessarily mean that it's going to give you the right volatility at the right time.  If the stock portion of the portfolio is supposed to capture prosperity (because the other assets tend to rise during some adverse macro-economic periods), then to try to diversify that portion into sectors that could do well during our currency collapsing or poorly in times of great American prosperity is like throwing copper into your gold portion, or TIPS into your cash.

Gold: Capture inflation through an almost pure monetary metal, so that during economic collapse its industrial value collapsing isn't a risk

LT Treasuries: Capture deflation with the most reliable borrower of the dollar in the world.

Stocks: Capture prosperity by betting on companies in your home-country (even though they do business abroad).

I'm not saying EM won't continue to do well.  Copper, oil, TIPS, corporate bonds, junk bonds, and gold stocks could all do extremely well also.  But they don't really belong in the PP.

[AdamA]

Ditto, Moda.

I'd add:

This issue of the total US market vs the S&P vs EM vs Pacific Rim vs Value vs Growth, etc is something everyone struggles with a bit when they first start thinking about the PP. 

This is b/c mainstream portfolio theory really focuses on this type of diversification, so no one wants to miss out on potential Value or Small Cap premiums, or when the Pacific Rim finally takes off again, or whatever may (or may not) happen in the future.  Basically, we all want to reach for a little more yield. 

My advice:  instead of reaching for yield, reach for safety and low costs.  Think about things like the safest way to hold gold, keeping as much of your cash is US Treasuries as possible, maintaining a low cost, tax efficient account (which gets tougher and tougher the more you slice and dice). 

EM's and SCV's will cycle like anything else.  Everyone knows about the potential "bonus" you get from owning these, and you know what happens when everyone knows something...

Same for copper and other commodities, and even real estate.  These are all recently (last decade or two) popular "investments" so it's hard to ignore them (and probably exactly why you should). 

Adam