Asset Allocation for Muppets with a 401(k)

A few people have recently asked me to write a post on asset allocation.   I decided to focus the post on the situation facing so-called “muppets” since they have greatest need for the advice.  A term like “muppet” which can be used in a derogatory way can be argued to be a badge of honor for some people.  In other words, the sooner you “get to acceptance” if you are indeed a muppet the better.  Warren Buffett writes: “By periodically investing in an index fund…the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”

The usual caveats apply: the following post is not intended to be investment advice. Consult you investment adviser, everyone is unique….

I recently saw an article on asset allocation written by Vanguard, a firm I admire for its low fees and non-profit status. You can find Vanguard’s  17 page article here which I hope you read *after* this post: https://advisors.vanguard.com/iwe/pdf/ICRPC.pdf?cbdForceDomain=false

The paper makes clear that Vanguard has strayed significantly in some areas from John Bogle’s principles. While the Vanguard paper is valuable, it is flawed as will be discussed below.   Why has Vanguard strayed?  My view is that a quest for higher “assets under management” (AUM) has made Vanguard forget the adverse consequences of the dysfunctions of muppets described by behavioral economists that John Bogle knows well.  Rather than protect muppets against their human behavioral failures such as the inevitable chasing of performance, Vanguard now advocates practices supported at best by theory and not practice such as active management.

In the paper Vanguard tries to make the case for active investing in theory while ignoring the fact that in practice muppets are muppets and will do things like chase performance and trade too much.  Rather than give advice that protects muppets from themselves, Vanguard chases AUM which no doubt  increases the salary and bonus of managers. This is “incentive cause” bias at work at Vanguard unfortunately.  Vanguard is still my favorite asset manager, it is just that their advice on a topic like active management of funds is misguided.  I also sympathize with John Bogle’s beef with Vanguard on ETFs since ETFs are cheaper only in theory for muppets since ETFs encourage chasing performance.

Muppets should invest through low-cost index funds. Full stop.  Warren Buffet’s partner Charlie Munger puts it simply: “Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund. I think that works better than relying on your stock broker.“   Why is a no-load low fee fund important?  John Bogle is similarly direct in answering that question: “In investing, you get what you don’t pay for.  Costs matter.” “The case for indexing isn’t based on the efficient market hypothesis. It’s based on the simple arithmetic of the cost matters hypothesis. In many areas of the market, there will be a loser for every winner so, on average, investors will get the return of that market less fees.”

To be useful to muppets, an asset allocation program must be simple and that 17 page Vanguard paper is anything but simple. So let’s try to make it simple: David Swensen writes that investors have three tools to generate investment returns: “asset allocation, market timing and security selection.  Asset allocation [is the] decision regarding the proportion of assets that an investor choses to places in particular classes of assets.”  Of these three tools, Swensen believes asset allocation is by far the most important.

Swensen summarizes what I have said so far here:

“Asset allocation is the tool that you use to determine the risk and return characteristics of your portfolio. It’s overwhelmingly important in terms of the results you achieve. In fact, studies show that asset allocation is responsible for more than 100 percent of the positive returns generated by investors.”

Vanguard agrees with Swensen arguing the right supporting number is 88% instead of more than 100%.

Part of the asset allocation process is choosing the categories you will invest in. For muppets, stocks, bonds, money market funds and for some people real estate usually in the form of investment trusts (REITs) are the right asset categories.  Muppets should avoid commodity and currency investments. It is useful to point out that when it comes to investing, more than 90% of people are muppets and should be buying low-cost index funds within the stock and bond categories.

Life inevitably presents a human with risk (outcome known, probabilities known), uncertainty (outcomes known, probabilities unknown) and ignorance (outcomes unknown, probabilities therefore not computable).  You can’t live and avoid these things. Unfortunately, it is human nature to be overoptimistic about the downsides of these three aspects of life.  So you need to be careful, particularly if you are a muppet. A careful muppet tends to be a happy muppet.

There are several different types of risk that must be considered in the asset allocation process. In allocating assets one must understand what risk is: risk is the chance that you will suffer harm or a loss of capital.  Despite Vanguard and what some others may say, risk is NOT equal to volatility.  How the price of a security may vary with time is volatility, which is precisely equal to volatility. That something like volatility is an aspect of risk does not make it equivalent to risk.

It is critical to understand that “return risk” written about in the Vanguard paper is not the only objective in an asset allocation process since other forms of risk must be managed as part of any investment plan. A very important goal for a muppet is saving for retirement.  One goal in saving for retirement to avoid eating cold soup from a can in a single-wide unheated trailer.  In short, you don’t want to be financially destitute.  Another goal is to have enough wealth to be comfortable.  You should have at least two minimum “numbers” in mind:  (1) the minimum level needed to live a hard scrabble life and (2) the level you desire to be comfortable.

Another type of risk is running out of cash at some point in your life.  I have seen situations in my life where people have paper wealth but no cash and I have seen no wealth and no cash. In the paper Vanguard recommends that investors keep from three to 33 months in living expenses in cash. That is a very big range in terms of a recommendation but at least three months expenses in cash seems a minimum and six months even wiser.

Achieving a basic level of financial security is essential. What is a basic level of financial security?  Here’s an extreme analogy. A billionaire once said “If you have a billion dollars, the first thing you should do is buy $100 million in US Treasuries since if you never sell them no matter what happens, you will live well.” For a muppet, the figure is not $100 million, but you get the point. There is an amount that you will want to have saved as a minimum like $1 million on top of social security.  Warren Buffett has put this point in another format using an analogy from the board game Monopoly: the older you get the more you want to avoid financially “returning to go” and having to start over again. In addition for Return Risk there is Return to Go risk. Stated positively, having what is called “f-bomb you money” is a valuable thing indeed. If you are willing to live simply, “f-bomb you money” need not even be that much money.

As part of your asset allocation process you must decide what types of assets you will own as investments and you must decide what your proportionate allocation should be in each category.  John Bogle, who is in his 80s, has a relatively simple formula for asset allocation:

“A good place to start is a bond percentage that equals your age.  Although I don’t slavishly adhere to that rule…”  “My personal, non-retirement accounts are about 80 percent bonds and 20 percent stocks, reflecting my old rule of thumb that your bond allocation should roughly equal your age.    My retirement accounts are more like a 50-50 split between stocks and bonds, because of a longer time horizon and because yields on bonds are extremely unattractive right now. Bonds in my retirement accounts are about 30 percent Treasuries and 70 percent investment-grade corporates.”

In doing this math it’s important to take social security into account, which Bogle argues is like a bond. Bogle said once:

“… let’s say you’ve been lucky enough to accumulate, let’s say $300,000 in your personal investment account, and the capitalized value of your social security at a certain age is also going to be $300,000.  It’s a great investment, I have to admit, as long as it’s great, it’s going to be great if that isn’t too oxymoronic for you. But so you know, it’s basically a bond position with an inflation hedge. So you’re at 50/50 if your $300,000 of your own money is entirely in equities.”

A huge advantage of this ”bonds equal to your age” rule of thumb for a muppet is simplicity. You don’t need to read 17 page papers or meet with an advisor.  You can in its simplest form invest your age in bonds and have the rest in stocks.  Or you can invest your age in bonds minus some percentage to reflect your volatility tolerance or the fact that you are relatively wealthy. Your age in bonds minus 10 or 20% would be one example of a modified rule of thumb.  If you look at so-called “target date” or” life cycle” fund that is really all they are doing.  Of course, the fund promoters are all doing this in different ways within  that percentage sometimes with allocations to things other more exotic asset classes.  People too often talk about target date funds like they represent a generic strategy.  They aren’t.  My own view is simple: why pay a target date fund manager a significant amount of money in fees just to have them invest your age minus 10-20% in bonds and the rest in stocks and speculate in other categories like any active manager?  As John Bogle has said many time and in many different ways, that costs matter *a lot* with regard to investment performance.  It is relatively easy to put together your own do it yourself target date fund by copying other target date funds and skill the fees.  It takes a little work to do it yourself, but with some target date fund charging more than 1%, that is a lot of money saved that can compound for you. The caveats here for a muppet is clear: are you willing to do the work? Will you follow through?  A *low fee* target date fund like Vanguard’s may be worthwhile for a muppet who would rather be playing golf or watching a movie.

Others have their own suggestions about the proper allocation between stocks and bonds. Some talk about 60% stocks and 40% bonds as if age doesn’t really matter.  Many assets managers have calculators which they suggest be used in calculating the right assets allocation. When I use the Vanguard asset allocation calculator it suggest that I put 100% of my assets in stocks, which is, well, wrong given my desire to avoid return to go risk.   Another form of asset allocation is Nassim Taleb’s “barbell” approach which is beyond the scope of this post and arguably a topic not suitable for muppets.  As the very least a muppet should take away from Taleb’s  works that negative Black Swans are significantly more prevalent than you may imagine and your allocation to “safer” assets classes should be significantly greater than you think.  The reciprocal of this is the concept of optionality, but this is a post containing advice for muppets and I’m going to resist discussing that topic since muppets are muppets. Taleb also points of that you should observe what people actually do which is often not what they say. For example, Harry Markowitz once described how he allocated assets as follows: “My intention was to minimize future regret. So I split my contributions 50-50 between bond and equities.”  That is a far cry from what he argues in his academic papers.  Another Nobel prize winner has revealed  that he keeps a huge amount of money in money market accounts and acknowledges that it contradicts his own work.

The Bogelheads group illustrates a few so-called lazy portfolios at this link: http://www.bogleheads.org/wiki/Lazy_Portfolios Reading the material at this Bogleheads link is contorting as well as instructive since it reveals that “experts” may disagree and that the process is an art more than it is a science. I suspect that one of these portfolios will appeal to each muppet in a unique way.   In general, I like a “no more than 10% allocations to REITS in some of these Lazy Portfolios, but again, muppets need the asset allocation process to be simple.

As I said previously, there is the question of how you invest inside an allocation.  Should you devote 30-40% of you equities to foreign stocks as Vanguard recommends in the paper?  For most muppets their liabilities are in US dollars so 30-40% seems too high for me. Twenty percent might be better if a muppet wants an allocation to foreign stocks. But again, if muppets need to make this decision about foreign stocks allocation of top of the basic allocation, do they face that complexity and just freeze up and make bad decisions. Is it better just to keep them in domestic equities only so as to keep it simple? That’s a hard decision, but if the muppet can deal with the complexity and won’t tune out, allocating 20% of the stock category to foreign equities can be a good thing.

And what should the allocations be within the bond category? Most muppets should keep it simple and buy a broad diversified bond fund with low fees like Vanguard’s Total Bond Market Index. If you want to do it yourself or want a different mix, how much should you have in treasuries, corporate and municipal bonds? Again, simple is wise.  Make it too hard and a muppet will tune out of the asset application process, turn on the TV and make no decision.  The Lazy Portfolio attributed to Swensen in the previous link keeps it simple with half of the bonds in Treasury Inflation Protected Securities (TIPS) and half in US Treasuries.

When a financial advisor tells you need to engage in “tactical asset allocation,” hold tightly to your wallet and run away like the wind. “Tactical asset allocation” is an oxymoron. That advisor is almost surely trying to get you to buy and sell securities which will probably generate fees for him or her which is about the other two categories: market timing and security selection. Tactical assets allocation is really a justification for market timing and stock selection which generates fees and expenses.

You will also get people who take a number regarding the amounts going into each asset category which is subjectively determined and make argument based on the work of an academic or two that you should often be rebalancing your portfolio based on some precise formula.  You will hear about math and things like “the efficient frontier.”  Assume that this talk is bullshit, because it is.  Despite what some people may say there is no precise formula when it comes to this process.  People who say you need to hire them to do complex calculations are trying to invent ways to separate you from some of your money by charging fees and expenses.

David Swensen writes:

 “Rebalancing to long-term policy targets plays a central role in the portfolio management process.”

Rebalancing works for muppets because it counteracts your tendencies to chase performance which lowers your financial returns. In other words, the rebalancing process works because you are human and not rational, not some efficient markets-based explanation.  You and I know that markets are not always efficient.  Academics assume the contrary since it makes their math pretty, but that assumption is bullshit.

Rebalancing around a number which is not precise in the first place does not need to be precisely done.  I personally don’t rebalance other than doing so with new money until I am more than 5-10% off my targets. Vanguard gives the same advice in its 17 page paper that funds should be:

“…rebalanced only if the targeted percentage of equities or bonds has deviated by a meaningful amount, for example, by more than 5 percentage points…”

I rebalance as I go along with new money coming in. My purpose in doing so is to avoid taxes, fees and expenses. Vanguard gives the same advice:

“It’s preferable to rebalance every time cash enters or leaves the portfolio. These cash flows can include any dividend, interest, or capital gains distributions generated by the assets.”

There is a tradeoff between taxes, fees and expenses and benefitting from mean reversion are at work here and I personally err if at all on the side of avoiding taxes, fees and expenses.

Be careful out there.

9 thoughts on “Asset Allocation for Muppets with a 401(k)

  1. Great post Tren and I would do just US stocks & bonds but with time permitting make a few changes.

    If you are 30 year old muppet and looking to retire in 35 years, it’s a very long time and the world will really change. The new risk that exists today that did not exist when Bogle, Swensen and Buffett were developing their theories is US economy getting stuck at 0% interest rates. 0% interest rates are very different from the economic theory that has worked especially well during Greenspan age.

    Munger on 5/3/2013 – Before japan went into a 20 year period of stagnation pretty much every intelligent economist in the world would have said it is impossible that what has happened in Japan has happened. Ofcourse it wasn’t impossible, it did happen and that’s made people worry that other places could get to be like japan. We always have that, remember the dutch disease, Holland got into economic trouble because they found so much oil and gas and they call that the dutch disease. Just suck the life out of the rest of the economy because they were doing so well in oil and gas. Now we have the Japanese disease. Ofcourse it can come to other countries but nobody knows exactly how much or when and they didn’t predict it in Japan either.
    Becky – Do you think we look like Japan 20 years ago?
    Munger – We don’t know because we haven’t had their conditions but Japan has scared the rest of the world.
    Becky – We are watching what Japan’s central bank is doing.
    Munger – We are behaving a lot like Japan. It didn’t work that well over there.
    http://video.cnbc.com/gallery/?video=3000166059&play=1 (starting at about 1 min)

    Munger is saying that what happened in Japan could happen in the US where it becomes difficult to move from 0%.

    Rather than predict weather US will have 70-80% drop in real estate and stock market over a 20 year period; it would be better to hedge that risk in a retirement portfolio and be immune to predicting inflation/deflation in the US.

    I would increase my exposure to strong emerging markets with Vanguard style low fees country funds (replicating the s&p 500 of that country). Make that about 30% of the portfolio and not have more than 5% in any one country ETF as a % of the entire portfolio.

    India, Vietnam, China, South Korea, Mexico would be countries to consider.

    The basic premise is that the % of world GDP coming from these countries will increase over the next 35 years and if they are on the path to capitalism then the wealth will be created in the public stock market.

    Do not jump in to allocate 30% in one year but move 5% of the portfolio every year to ignore timing the market.

    The reason for a 30% exposure to emerging markets is to remove the risk of low growth from 0% interest rates over an extended period and if there is better way to do it then use that mechanism.

    This approach to diversification is also something that aligns with Ray Dalio’s view of having uncorrelated return streams.

    Ray Dalio – If you have 15 or more good, uncorrelated return streams — the math of that is such that if you go from 1 to 2 uncorrelated return streams. That you will reduce your risk by about 80% at about 15.
    http://articles.businessinsider.com/2011-09-19/wall_street/30174718_1_beta-portfolio-balance-sheet#ixzz2TDQVX1Ux

  2. Thanks Tren – I always enjoy your posts. If you are ever struggling for blog post ideas an “asset allocation for non-muppets” would be a very interesting read.

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  5. Great post… what do you think of services like WealthFront (https://www.wealthfront.com/) and FutureAdvisor (https://www.futureadvisor.com/) which propose to run an asset allocation portfolio for muppets in a more systematic way, without ever having to worry about rebalancing (the software does everything for you). They generally allocate to 5-7 assets (ETFs), and they calibrate your portfolio according to the way you answer various questions in order to assess you investment horizon and risk tolerance. I agree risk != volatility, however running a large paper loss could cause someone to pull the plug on their investment at just the wrong time, so the two are not entirely disconnected.

  6. Nice post. However, I do have to take issue with your (and Bogle’s view) on ETFs. Although they can be abused (what can’t?), they really are a wonderful way for many to invest. They are more tax efficient than the vast majority of passive mutual fund. Basically they can be viewed as a tax-managed fund just by their construction. Also, there is usually a fee involved with purchasing a mutual fund from another family in say an IRA for instance. If your money is at Fidelity it will cost you money to purchase a Vanguard mutual fund when you can buy the exact same fund in ETF form sans fee.

    Lastly, to really simplify things for “muppets” I think it would actually be much wiser to invest in target-type funds IF they are inexpensive. Now the re-balancing is just done for you by the pros. My favorites are the Vanguard LifeStrategy funds. For instance, Vanguard LifeStrategy Moderate Growth Fund (VSMGX) costs 16 basis points and keeps a 60 (equity)/40 (bond) balance with equities balanced across US and International. The family has funds that go from 80/20 to 20/80 depending on your stage in life and appetite for risk. Set it and forget it.

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