Investment asset classes suitable for the passive long-term investor: I am going to make some assumptions here, and not get into too much detail, but these are the asset classes I think are suitable for passive long-term investment: 1) Domestic Stocks - self-explanatory. They are liquid, exchange traded, and have a high long-term return albeit at some risk. I would break this down into large and small cap stocks, to provide diversification. Small caps tend to return more but have more risk (generally they do worse in bear markets). 2) Domestic Government Treasuries. Again, self-explanatory. Low-risk, low-return. They tend to do well in some situations - such as deflation, market panics, and recessions - where stocks typically get hammered. Thus they provide a valuable hedge against crisis situations. Also, in more normal times they provide predictable income and add stability to a portfolio. 3) Real estate. Fairly low correlation to stocks and bonds. Returns tend to be higher than bonds but lower than stocks, over the long-run. Nowadays ETFs allow one to invest in real-estate investment trusts (REITS) which broadly track the returns of national real estate markets. Real estate provides some income returns (due to rental income) and some equity-like capital appreciation (due to land scarcity, inflation). It thus provides a fairly good, albeit imperfect, long-run inflation hedge. 4) Foreign stocks, including blue chip G7, and emerging markets. Blue chip foreign stocks provide similar returns to domestic stocks, whilst also not being totally correlated. They thus reduce overall volatility whilst not reducing returns - a classic diversification free lunch. Emerging markets are higher risk but over the long-run ought to provide higher returns to compensate. They are even less correlated, another bonus. 5) Commodities. These provide a pretty low real return over the long-run, however they do have the great benefit of having very low, possibly even negative correlation to the stockmarket. In certain circumstances, such as low growth high inflation scenarios, or wars, they do extremely well whilst other assets like stocks, bonds, and/or real estate get hit hard. A small commodity allocation should reduce portfolio risk and provide diversification, whilst not reducing overall returns that much. 6) Treasury inflation protected securities (TIPS). Just like treasuries, except they have a cast-iron inflation hedge so are even lower risk. An essential part of the fixed-income portion of any portfolio. Asset classes that I would not recommend: 1) Corporate bonds. These provide more risk than treasuries, without much extra return. More importantly, in crisis situations they become illiquid and correlated to stocks, so their bear market protection is poor. 2) Junk bonds. Same problems as corporate bonds, but even worse. 3) Actively managed funds. Data shows higher fees, higher taxes, higher transactions costs, more volatility and lower performance for most active funds compared to index-trackers. 4) Unlisted investments such as hedge funds, private equity. I do not think the typical investor has the resources to screen funds/firms, and keep tabs on subsequent performance. They are also illiquid and have high fees. For non-experts/pros, I would steer clear and stick to the much lower risk exchange-traded asset classes. Now, onto the expected long-run returns of these asset classes...
Expected long-run returns of various asset classes: Long-run historical data (e.g. 30 years+) can provide a guide to expected returns from asset classes, based on empirical data. However it is somewhat flawed as the returns are heavily biased by start and end dates. The 1929-1959 returns of US stocks are incredibly different to the 1932-1962 returns. So, we need to temper this by also looking at what return we'd expect from theory. Investment theory states that long-run returns should broadly match risk. Thus if bonds have outperformed stocks several years in a row, that is more likely to be a short-term phenomenon, since stocks have more risk and should outperform in the long run. Stocks - data suggests a long-run return of about 8-12%. Theory suggests they should outperform the other asset classes in the long-run. Treasuries - the long-run return should be the current yield minus inflation over the duration of the bond. TIPS should return the current yield. Over the long-run, bonds have returned about 4-6% in the US and most other advanced economies. Real estate - riskier than bonds but not as volatile as stocks, and possessing economic features of both, real estate should return around 7-8% per annum as a fair estimate. Data seems to bear this out. Commodities - here I would estimate they return inflation plus maybe 1%. Data is hard to get for a broad commodities index. So, now onto risk: Stocks - high risk. Declines of 50% seem to happen every 25-30 years or so, and 75-90% is not unheard of. A 20-30% bear market seems to come along every 6-7 years or so. Small caps and emerging markets are even higher risk. Bonds - low risk. Longer durations are more risky, shorter durations have minimal risk (especially TIPS). Moderate correlation with stocks. Real estate - medium risk. Quite cyclical, with some meaningful bear markets from time to time, but lower risk than the S&P. Commodities - medium/high risk. Now we face the question of how much to allocate to each asset class. We should generally put a big chunk into the higher return asset classes, whilst using the lower-return lower risk assets for diversification and lower but more stable returns. Thus we should have the most in stocks. Real estate and bonds should have healthy weightings. Commodities are fairly high risk and low return, so should have the smallest weight, being there mainly because of their negative correlation which gives some bear market protection.
Portfolio allocation - the role of risk: How much you put in each asset class is going to be dependent on return and risk characteristics, along with correlation factors. Ultimately the main determinant is your personal risk profile. What you should do is ask yourself, in a serious bear market what is the most you are prepared to suffer as a drawdown? Bear in mind that a diversified investment portfolio will, over the long-run, almost always recoup drawdowns - it may take a few years but permanent loss of capital is rare, short of nuclear war or communist revolution. Thus drawdowns are mostly psychological phenomena, rather than a serious threat to the health of diversified portfolios over the long-run. 1929-32 was a bit of an outlier, but a conservative portfolio even then would eventually have recouped most losses, in inflation-adjusted terms, within a reasonable time. Remember that bonds soared during that period, whilst the CPI and real estate collapsed. If you could only tolerate a small drawdown in single figures, then you simply cannot have much in risky assets. If you are a real gunslinger, then you should have a lot in stocks and real estate, and only modest amounts in bonds. I will give some model portfolios, taking these factors into account. You can then estimate how much they would have lost in the recent market turmoil, as well as the 2000-2003 bear (I can't give exact figures as many ETFs did not exist then - plus I don't fancy doing days of work just to get the figures precise). This should give a good indication of real world risk. Risk tolerance should be considered carefully. It is not just dependent on personality, but also other objective factors. Here are the main determinants of what your risk tolerance should be: 1) Personality. Some can sleep through volatility, being confident of long-run returns. Others hate the idea of even a temporary 15% drawdown. Look at your previous response to market drawdowns, and honestly assess how much risk you can accept without being tempted to pull the plug on your investment portfolio. Selling the lows and going 100% cash at a market bottom, then staying there for years, is a DISASTER for long-run returns. So it is really critical to not take more risk than you can sleep with. 2) Age. If you are young, you can take lots of risk. If you retire in 5 years, you should be very conservative. Youth means most of your total income, and thus contributions to investments, lie in the future. Losses now not only can be made up, but you get to buy assets at generation lows, which boost long-term returns. If you are 20-35, you should PRAY for a 75% bear market, so you can buy loads of stocks at single-digit PEs and retire stinking rich. 3) Size of portfolio relative to income. If you earn $50k per year and have a $5 million portfolio, then investment losses are hard to make up. You should take lower risk. If you earn $250k and your investment portfolio is only $50k, then you should be going for the high returns, since drawdowns are not much compared to your earning ability. 4) Job security. If you have a stable job e.g. government employee, trial lawyer, then you can take more risk as you can pretty much guarantee future income, short of serious injury, death, or mental illness (which can be insured against). If you are a self-employed trader, property developer, or entrepreneur, then you already have a very risky profession. The last thing you need is the prospect of losing 30% on your investments during a recession which could crush your day job. If you are retired/unemployed, your risk-taking should be even less. So, a high risk-tolerant investor would be someone under 35, in a steady job, with high income, a small portfolio, and who doesn't mind big market swings. A conservative investor would be someone 50+, in a risky job, with a big portfolio, and a conservative security-focused personality. Each risk preference requires a different portfolio mix. I will therefore suggest a few model portfolios - low risk, balanced, and aggressive.
One additional note on risk. For the long-term investor, drawdowns are not the only risk. A very real long-term risk is that of losing purchasing power. If you stay in t-bills all your life, you may sleep at night but then retire and find you don't have much in the way of a pension/income. Your portfolio may well be many times smaller than someone who invested in a portfolio including higher return assets. Avoid the fallacy of thinking that minimal drawdowns = minimal risk. Over the long-run, you need to strike a healthy balance between short-term risk and purchasing power/retirement risk. I will now list some model portfolios, by asset class allocation. I will follow up with a post describing the breakdowns of exactly which ETFs to consider for each asset class (e.g. for domestic stocks I'd recommend partly S&P, and partly Russell 2000 ETFs). Model portfolios: Conservative portfolio - this is designed to keep drawdowns to a minimum, whilst still providing returns acceptably higher than cash/bonds. STOCKS: 35% Domestic: 20% International: 10% Emerging mkt: 5% REITS: 10% BONDS: 50% Treasuries 25% TIPS 25% COMMODITIES 5% Portfolio summary: RISK: this is a very resilient portfolio. In a 2000-2003 scenario, where stocks fell 50%, this portfolio would lose only about 15% on the stock side (once dividends are included). The 50% bond position would have returned about 3.5% per annum in coupons, as well as a capital gain (10-20% from 2000-2003 depending on maturity). Real estate did well and commodities respectably during the bear. Your drawdown would have been mild, and by early 2003 at the lows you would actually be net profitable since the 2000 S&P top. Even in the 1929-32 period, this portfolio would have lost around 25-30% maximum. Foreign stocks went down far less than US stocks (about 50% rather than 90%), real estate got hit but not as bad as stocks, ditto commodities, and bonds soared. How would it feel to be 100% invested at the top in 1929, the worst possible time to invest in US history, and by the absolute lows in 1932 you are only down 25% in nominal terms? Given that the general price level fell about 25% during this period, you would have actually NOT LOST MONEY in inflation-adjusted terms, despite being 100% long investments during the most horrendous economic and financial market collapse in US history. The worst period for this portfolio would probably have been the 1970s - but the real estate and commodity portions would have provided at least some relief. TIPS were not invented then, but they would also hedge against future inflation, along with your real estate and commodities allocation, meaning that 40% of your portfolio is a good inflation hedge, along with a further 15% in foreign stocks to provide protection against a falling dollar. Overall, that is a very robust portfolio - if you are the ultra-conservative type, this should fit the bill. RETURNS: On the return side, obviously this isn't going to score big. In more normal conditions, returns will lag a more balanced portfolio. Long-term returns can be estimated at about 10% for the stock side (giving 3.5% per annum total return), about 5% for bonds (giving 2.5%), 7.5% for real estate (giving 0.75%) and say 3% for commodities (0.15%), for a total annual return of just under 6% per annum. Still, that is much better than typical t-bill rates over the long-run. You ought to double your money every 12 years. FURTHER COMMENTS: Another great thing about this conservative portfolio is that you have your capital intact at bear market lows. Imagine having $200k in 2000 or 1929, at the peak, and by the end you still have $200k whilst everyone else has been decimated. You would have the ability to buy stocks at once in a generation lows. You could raise your allocation to 50% stocks or more, relying on the bearish sentiment and low valuations to keep your risk down. This is the ultimate portfolio for someone who loves being there with the cash and staying power to buy when there is blood on the streets. And in more normal years you are still racking up 6% per annum, a respectable return to boost your trading profits or job income. Even the worst bear markets should not really cause you much drawdown on a 3 year view.
I personally like the couch-potato porfolio for long-term investors who don't want to take too much heat on their investments. Couch Potato Porftolio
That's a great portfolio analysis and breakdown. If an investor is going to that route the Vanguard Family of Mutual Funds is probably where they should be looking for investment vehicles.
Great thread so far, haven't had the chance to read the whole thing yet. I did notice you quoting some long held investment beliefs, that aren't entirely true. Particulary the myth that small caps stocks out-perform large cap stocks. http://www.vanguard.com/bogle_site/sp20020626.html Basically small caps are riskier and don't provide a better return. If you take the performance of small caps v. large caps since 1945, the performance is basically the same. I thought this article was a real eye opener and makes me want to look into other "commonly held beleifs" about investing. 5yr
The performance of small, mid and large cap stocks will vary according to where you are in the business cycle.
Balanced portfolio: STOCKS: 45% Domestic: 25% World: 15% Emerging: 5% REITS: 20% BONDS: 30% Treasuries 15% TIPS 15% COMMODITIES: 5% Portfolio summary: this is designed to provide a good blend between risk and returns. Stocks and REITS make sure that almost 2/3 of the portfolio is in fairly high return assets, whilst there is enough in bonds to provide ballast in a crisis. RISK: In 2000-2003 the stocks would have contributed a loss of about 20%, bonds would have given a gain of about 10%. I don't have REIT ETF data for 2000-2002 but the underlying real estate did well, so I would assume flat prices plus typical REIT yields of say 7%, leading to about a 4% contribution. Thus the total 3 year drawdown would have been about 6%, compared to over 45% for the S&P. During the 2007-08 bear, losses would have been contained to single digits, with REITS and stocks getting hammered (foreign stocks less so than S&P, due to the weak dollar), but bonds and commodities doing very well. The 1929-32 period would have resulted in about a 33% loss on stocks, I would guess REITS in a similar situation would fall say 75% for a 15% loss. Bonds would probably gain 15-30% including coupons, for a 5-10% return. Total loss from peak to trough about 35-40% - nasty, but survivable. In real-terms that loss would have amounted to a mere 15-20%. During the 1970s period, the 20% REIT allocation would have been a very nice inflation hedge, along with 15% in TIPS and 5% commodities, plus 20% in foreign stocks for a nice boost as the dollar collapsed. RETURNS: long-run returns would be expected as follows. Stocks 10% = a 4.5% contribution. Bonds 5% = 1.5% contribution. REITS 7.5% = 1.5%. Commodities 3% = 0.15%. TOTAL = 7.65%. This is way ahead of cash, and a healthy 1.75% ahead of the conservative portfolio. You would double in 9 and a half years roughly. FURTHER COMMENTS: this is still a pretty solid portfolio, with good defensive qualities in either a disinflationary recession, currency devaluation, or inflationary period. It survived the bubble with minimal damage on a 3 year view, and even the Great Depression would only have caused a 15-20% loss in real terms. That is excellent risk control - normal 20-30% S&P bear markets should be a breeze, probably causing a peak to trough drawdown of no more than 10%. Returns are quite nice at 7.5%. A long-run return of 7.5%, with typical drawdowns of 10% or less, is a very healthy risk/reward balance. Pretty much the same risk as bonds, which would yield 5% given my assumptions - that's basically a free extra 2.5% per annum with almost no significant risk increase. For most investors, this portfolio provides a nice way to sleep at night, whilst also racking up respectable gains for the long term. Its downside resilience also gives good flexibility for investing at cheap valuations after bear markets.