Bernstein 4

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Bernstein 4

Post by JWR1945 »

Refer to Chapter 4 of our currently featured book The Four Pillars of Investing by William Bernstein.

Once again, I found myself at odds with William Bernstein and much more closely aligned with John Bogle. This time, it was right off the bat where William Bernstein's four bullets summarizing lessons from the first three chapters greatly distort reality.

William Bernstein summarizes his position in italics on page 108:
In other words, since you cannot successfully time the market or select individual stocks, asset allocation should be the major focus of your investment strategy, because it is the only factor affecting your investment risk and return that you can control.
I direct your attention to the table on page 109 that lists the returns of four asset classes for the years 1998, 1999 and 2000. Remember what you have been taught about the merits of diversification and asset allocation. When one zigs, another is likely to zag, reducing overall volatility. Now skip ahead to page 123 and read what William Bernstein has to say about REITS.
Their [REITs] historical returns, as well as their expected future returns, are probably comparable to the market's. And, as we saw a few pages ago, they can do quite well when everything else has gone down the tubes. Unfortunately, the same table showed that the opposite is also true: they can do poorly when the rest of the market is going great guns - .Again, it comes down to tracking error: how much does it bother you when an asset grossly underperforms the rest of the market? Because of the high volatility and tracking error of REITs, the maximum exposure you should allow for this asset class is 15% of your stock component.
It is time to go back to basics. Learn what Gummy found out about the mathematical foundation underneath asset allocation theory. Asset allocation works when different assets with comparable returns [and comparable levels of volatility] have little correlation or negative correlation. In that case, there can even be a true rebalancing bonus. If the assets have different returns, the overall return will generally lie between the best and worst individual performers. The rebalancing bonus in this case is only in reference to the overall (proportionate) level without rebalancing. The overall return is not higher than that of the best individual performing asset.

The behavior of REITs (except for higher volatility) is the ideal behavior for adding an asset.

I take this as a point of departure to look at what John Bogle has suggested to well (enough) off investors for their taxable accounts: buy 15 to 20 carefully selected individual stocks to make your own index fund. [This is because of taxes. See pages 292 and 293 of Common Sense on Mutual Funds.] The reward is well worth the added risk.

Now let me introduce another of John Bogle's major themes: always take a good look at costs. Any kind of rebalancing has a cost. If you own individual securities instead, you can add to positions during accumulation or sell from positions during distribution in a tax efficient manner. You buy more of the undervalued stocks or you sell more of the overvalued stocks. For maintaining an asset allocation, it is a matter of grouping stocks among several asset classes.

By buying individual stocks (to make up your own index fund or group of funds), you can maintain an asset allocation at no additional cost. Even better, if you pay attention to prices, you can time the rebalancing process to your advantage. For example, you might choose to rebalance at an opportune time once every one to three years and/or whenever a particular asset class has grown more than 5% to 10% out of balance. The degree of timing is minimal. The key is depending upon the degree of imbalance among asset classes. I have included a loosely defined requirement linked to the calendar to assure that rebalancing actually does take place.

Even if you buy individual stocks to match the S&P500 (or another capitalization weighted index), there will be times to rebalance just to keep your allocations consistent with that of the index. Your individual stocks are substituting for industry classes within the index. Individual stocks may do better or may do worse than their industry classes when compared to the index.

Have fun.

John R.
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