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Saturday, May 13, 2006

Book Review: The Four Pillars of Investing

Wlliam Bernstein is the author behind The Efficient Frontier, the website discussing asset allocation and the theory and tools behind it. Bernstein wrote two books on investing, his first being The Intelligent Asset Allocator, a technical discussion of Asset allocation. This is the book, he says, for liberal arts major. (I did get a Bachelor of Arts in Computer Science, so this book is for me!)

Being a big fan of asset allocation, Bernstein writes:
since you cannot successfully time the market or select individaul 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

This is generally good advice, and his chapters on indexing, market timing, bubbles, and history are really good, and very much worth reading. His actual sample portfolios, however, are excessively complicated. For instance, for a taxable account, he suggests a bond portfolio that looks like this:
  • 25% Treasury Ladder
  • 25% Vanguard Short-Team Corporate Bond
  • 25% Vanguard Limited Term Tax-Exempt
  • 25% Vanguard California Intermediate-Term Tax-Exempt
I can understand not wanting to dump everything into California municipalities, with their risky histories, but it is doubtful that this portfolio with its attendant extra costs and extra manipulation needed would do so much better than one consisting entirely of a Treasury Ladder and the California Tax-Exempt fund as to be worth the extra effort. If you don't trust the California funds, a 75% weighting in the Treasury Ladder would be a better bet. Bernstein also neglects the delicious I-bonds, which have good tax properties and are worthy of an allocation.

For his tax-sheltered example, he goes for something even more complex for the equity portion:
  • 20% Vanguard 500 Index
  • 25% Vanguard Value Index
  • 5% Vanguard Small Cap Index
  • 15% Vanguard Small Cap Value Index
  • 10% Vanguard REIT Index
  • 3% Vanguard Precious Metals
  • 5% Vanguard European Stock Index
  • 5% Vanguard Pacific Stock Index
  • 5% Vanguard Emerging Stock Markets Index
  • 7% Vanguard International Value
There are several problems with this:
  1. Rebalancing between all these portfolio is a chore, and I doubt if most individual investors would enjoy having this many options
  2. Meeting the minimums alone would require a fairly substantial tax-sheltered portfolio
  3. Most 401(k) plans won't give you a good enough selection of Vanguard funds to enable you to cover such diversification.
  4. By having so many small accounts, you ignore the benefit of being able to qualify for Vanguard's Admiral shares, which have a significant reduction in expenses. Such reduction in expenses might cause your ultimate return to be higher than a complex portfolio, also partly because you are more likely to be able to rebalance such a portfolio on a regular basis.
Bernstein also doesn't understand the SEPP 72(t) exception, which is a very useful tool for early retirees, so don't expect help from him on such matters.

Ultimately, there's a lot of value in keeping your portfolio simple and easy to follow. When you see something that seems really complicated and hard to manage, run away and go for something simpler. I doubt if Bernstein's hypothetical tax-sheltered account would do much worse with:
  • 65% Vanguard Total Stock Market Index
  • 10% Vanguard REIT Index
  • 3% Vanguard Precious Metals
  • 22% Vanguard Total International Index
A simpler portfolio with lower costs and much less to go wrong.

[Addendum: The reason Bernstein recommends holding the components of the Total International Index is that you get the foreign dividend tax credit, which reduces your overall costs. This is a big enough deal that it's worth considering. I still think there's value in simplicity, however.]


Trinity said...

Nice analysis.

Regards to Sunnyvale:)

md said...

Good discussion. I think Bernstein's portfolios are meant for people with more than $1M to manage. For someone with $100K to put $3K into Precious Metals seems pointless.

Piaw Na said...

I disagree. A small percentage in precious metals can pay of. Zimbabwe's inflation rate is a 100%, for instance, and you bet that owning precious metals there right now is way better than bonds and stocks. A little bit of insurance will go a long way.

Now you might think that when you get 1000% inflation, you've got other things to worry about, and you'd be right, but if you do survive you want to have some assets left...

md said...

that owning precious metals there right now is way better than bonds and stocks

Apparently owning a roll of toilet paper there can be a really good thing at the moment.

I'm completely in the dark about precious metals; please explain. You can't eat them, and I think if I went down to the Stop & Shop with a Krugerand I'd just get weird stares (or mugged). You have to guard them, so they actually cost money to keep. And if you own them in your Vanguard account (I imagine there are no Vanguard accounts in Zimbabwe), why not just invest in international funds instead or the health sector or some such thing instead?

I'm largely ignorant of the way the monetary system works so maybe this is part of my problem with precious metals. I never understood why the gold in Fort Knox mattered, but then I don't understand why we're paying to make pennies, either.

Piaw Na said...

Precious metals are basically a commodity (i.e., they can't be printed out of paper, like government fiat metal). In a hyper inflationary envirnoment, such commodities will hold their value and be more useful than stocks or non-inflation-indexed bonds.

You could instead of holding precious metals, hold other high value items --- for instance, in the past, certain Latin American countries had rapid inflation, and one solution rich people had in those countries was to buy lots of imported cars and park them in their driveways and trade them for goods and services instead of using money.

Note that most precious metals funds don't just hold the metal --- many of them hold stocks of mining companies as well.

Lake Oxbow said...


Two questions:

1) Have you ever shared your personal asset allocation? I've bought your book and also read most (I believe) of the relevant posts on your blog, but never come across it. I was recently re-reading Bernstein myself and realized that none of his sample portfolio starting points really map onto my situation ... my situation is a bit like yours (engineer/math-literate, windfall relatively young, aiming to maintain and protect wealth from erosion more than crazy growth at risk).

2) Finally, you say interesting stuff on bonds ... I think, again, because you have a slightly different view to them than the average investor given your basis (I'm guessing limited ability to tax shelter, care more about protection against inflation than growth, etc). Have you ever done an overall primer on them and the different classes? Or perhaps you have a suggestion for a good place to start; whether a book or online? Again, I've done a lot of searching (courtesy of your ex-employer!) and most of the online stuff is really polemic.

Hope you can help + thanks for all the awesome stuff you write about here. You;ve convinced me to say no to the .75% financial advisor and I'm going to go it alone from here :)

Piaw Na said...

I don't remember if I've ever published my exact allocation, which is a crazy mix mostly because of legacy: i.e., if I had my portfolio to build all over again I wouldn't do it this way.

As for bonds: there's only one book worth reading: Unconventional Success. He breaks down why the other bond classes (corporate bonds, etc) aren't worth considering.