Stick With Your Grandfather's Portfolio

A recent blog post on ABC's website by Certified Financial Planner Byron Studdard set forth the dangers of "investing like your grandfather." I believe it demonstrates why investing like your grandfather (in Studdard's example) is precisely what investors ought to be doing.

An Incorrect Assessment of Bonds

Studdard correctly notes the low-interest-rate environment in bonds and cautions investors against blindly allocating a portion of their portfolios to them, based on traditional notions of age and time horizons. He believes bond allocations "could be a recipe for disaster as interest rates rise." His analysis misses some critical issues.

Because interest in bonds is usually taxed at ordinary income rates, and appreciation on stocks is typically taxed at capital gains rates, stocks are a more tax-efficient way to take risk than bonds.

According to my colleagues Larry Swedroe and Jared Kizer, historical data indicate investors seeking higher expected returns would be better served by increasing their allocation to stocks and limiting their bond holdings to government or other high-quality bonds.

From a risk management perspective, investors might consider increasing their stock allocation to small and value stocks, rather than taking increased risk with bonds. These asset classes have a higher expected return, over the long term.

Studdard misses the primary reason for holding bonds: to reduce risk and dampen volatility, not to increase returns.

An Erroneous Attack on Diversification

Studdard is opposed to broad diversification. Instead, he counsels investors "... to focus on sectors and industries that are trending up." According to him, "These can be pinpointed by watching to see when money is starting to flow into them; increasing demand for a sector."

He references no data to support this strategy. Is simply an influx of money into a sector a reliable and consistent indicator that the sector is "trending up?" Presumably, even if this were true, the market would immediately adjust to this information once it became known, thereby making it impossible to exploit this perceived inefficiency.

Studdard also says that real estate, along with U.S. stocks and bonds "tanked" in 2008. This is simply not true. The Barclays Aggregate Bond Index was up 5.2 percent in 2008. Investors who invested in high-quality fixed income did even better. Five-year Treasuries were up 13.1 percent in 2008.

The alternative to broad asset class diversification using low-management-fee index funds is presumably buying individual stocks or actively managed mutual funds. However, the odds of a portfolio of actively managed funds outperforming a comparable portfolio of index funds over a 10-year period is miniscule.

Another Flawed Attack on Index Funds

Studdard saves his heavy ammunition for an attack on index funds. He dismisses the data indicating most actively managed funds underperform over longer periods of time by stating that "these studies refer to investment returns, not investor returns." He references no data indicating active investors achieve higher actual returns than index investors.

Studdard appears to be recommending a form of market timing: He suggests getting out of the market when your losses reach a predetermined percentage. How would you know when to get back in? Studdard makes no recommendations. Studies demonstrate that 80 percent of market timers fail over any reasonable period of time. That seems more akin to gambling (with even worse odds) than investing.

Finally, Studdard delivers what he thinks is the coup de grace to evidence-based investing: He says it is "easily disputed by anyone who tried buy and hold through the tech crash of 2000 or the financial crisis of 2008-09." Here Studdard makes the common mistake of not defining what he means by "buy and hold." Proponents of evidence-based investing do not advocate blindly "buying and holding" a portfolio. Instead, they advise their clients to re-balance their portfolios frequently to ensure their risk tolerance remains suitable; to harvest tax losses in taxable accounts; and to revisit their ability, willingness and need to take risk on a regular basis. Any of these factors could involve making changes to an index portfolio.

No investment strategy involving risk assures investors they won't lose money. Investors who cannot tolerate short-term losses should have no exposure to stocks.

If your grandfather was wise enough to determine a suitable asset allocation and invest in a globally diversified portfolio of low-management-fee index funds, you should follow his example and be grateful you inherited his wisdom.

Dan Solin is the director of investor advocacy for The BAM ALLIANCE and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.