100% stock portfolio for young people... why bother diversifying at all?

[Broken Arrow]

Wow. Active thread. And a very thought-provoking question indeed.

I'm no expert on this subject, but the way this simpleton understood it is that, when you're just starting out, you can "afford" to take more risk, and if it pans out, it can obviously mean a huge difference in your nest egg down the road.

You really can't get a good return out of bonds, but I'm pretty sure you guys knew that. Hence the recommendation to avoid it. Of course, being too aggressive is unwise also. Hence the need to diversify, even if it means watering down your returns. Again, nothing new here.

As for bonds itself... well, I believe the issue surrounded retirement funds, which means the short-term investment argument doesn't apply. Even if it's for short-term passive income, you will get hit with capital gains... which I think is fine so long as that's not the only investment you have. Otherwise, taxes are a killer and will eat away your returns, and at the same time, miss out on the growth potential of your current asset. So, the only advantage I see for them is a limited hedge against the market as well as a means to protect your principal....

Which wouldn't make sense to me if you're someone who is young, perhaps not the next Warren Buffet, and may not have a lot stashed away yet.

I acknowledge that much of this is debatable as well, so I'm not firmly entrenched in any camps of thought on this one yet. I am seriously contemplating bonds as well, as a means to further diversify my portfolio... and plan on doing just that by the time I hit 40.

Ultimately, to delay bonds is to take great faith in the historical run as well as the future growth potential of the stock market. In that respect, I also agree that it's up to individual preference and risk tolerance.

[jIM_Ohio]

adding 20% bonds to a 100% equities portfolio has been shown to reduce returns by around .5%-1.5% per year. Closer to a half percent most periods, but 1.5% over some 5-10 year spans.

If someone is 20 years from retirement, those .5% really add up over time.

In a short time period (5 years) the .5% makes little difference.
The longer the time period, the bigger the difference

$10,000 compoundend annually at 10% for 10 years
1 10000 10% $11,000
2 $11,000 10% $12,100
3 $12,100 10% $13,310
4 $13,310 10% $14,641
5 $14,641 10% $16,105
6 $16,105 10% $17,716
7 $17,716 10% $19,487
8 $19,487 10% $21,436
9 $21,436 10% $23,579
10 $23,579 10% $25,937

$25,937

$10,000 compounded annually at 9.5% for 10 years
1 10000 9.5% $10,950
2 $10,950 9.5% $11,990
3 $11,990 9.5% $13,129
4 $13,129 9.5% $14,377
5 $14,377 9.5% $15,742
6 $15,742 9.5% $17,238
7 $17,238 9.5% $18,876
8 $18,876 9.5% $20,669
9 $20,669 9.5% $22,632
10 $22,632 9.5% $24,782

$24782

difference $1155, which is 4.4% of larger portfolio.

Not a huge difference, but the longer the time, the more that 4.4% increases to something signficant

(15 years the difference is 6.6%-$2759)

Obviously the 9.5% return would reduce volatility. When accumulating volatility is not the important measurement. When spending (drawing down), volatility IS the important measurement.

[Scanner]

Sweeps,

You made a very assumptive statement:

Small-cap stocks beat large-cap stocks over the long term.

Says who?

The Pundits?

The Pundits also told me back in the 90's that Domestic should be the core part of your portfolio with only a smidgen of International (10% was the going recommendation)

I didn't listen to the Pundits and went with a 50/50 split. Thank God I did because I hold 100% more in my Janus Overseas than I do in my T. Rowe Price Blue Chip.

I agree with JimOhio that asset allocation is an art. I don't like too many chips out on the table but you can't have only chip on either. It depends how good of a manager you are.

[Scanner]

I love these discussions too as I feel the amateur investors we all are. . .we tend to see things and ask good questions sometimes.

My "Dogs of the Sectors" post was kind of in jest. . .but I think there's something to it.

Rather than shooting for what the Pundits say. . .I like to think a bit contrarian to the Pundits and maybe a bit futuristic when making my decisions.

I like to look for 10-20 year trends.

Will big co.'s rule?

Will small co.'s rule?

Will commodities gain in importance?

Is America positioned well or is Europe or Japan or Korea?

How much more will the financial sector take a beating?

How much more will real estate (residential) take a beating?

I don't believe in timing but I do beleive this with my heart (let me bold it)

You can't buy at the bottom but you can buy on the way down.

I think you answer these questions and you find your "investment philosophy."

And the fun thing about it is we are all different.

If you really in your heart of hearts beleive that big businesses will totally collapse and lose all competitive edge in the next 10-20 years and we will witness the total annilihation of Coke, Exxon, and Walmart, then by all means be an "owner" in that.

[sweeps]

Sweeps,

You made a very assumptive statement:
Small-cap stocks beat large-cap stocks over the long term.


Says who?

The Pundits?

Says history. I don't have links to the studies for you, but supposedly small caps beat large caps over time (by 2 percentage points I believe it was).

But regardless, that was just an example and not my point. My point was there is an inconsistency with the advice most people give to young people. They're told, don't diversify, go 100% stocks!!! That they have time to make up for volatility. But then they're told to diversify within stocks? Why? Why not go for the best performing subclass in stocks?

That, sir, is the question I pose.

[Broken Arrow]

Sweeps, I respect you greatly, but to "go with the best performing subclass" is to assume that we can know the future performance of any particular fund (or is that cap or sector?)

I mean, unless we're psychic, we really can't do that. Sure, we can look at the historical performance data of any particular fund, see how it compares with others, how long it's been running, how much turnover, expenses, yadda yadda. While that's important and helps to some degree, it's still no guarantee of future performance.

Given that we can't predict future performance, that's why most people do the next best thing, which is to diversify in order to mitigate that risk.

But as I mentioned earlier, there is also an assumption that stocks do indeed out-perform most bonds in the long run. Perhaps you disagree, but that's why if one has a large horizon, it would be worth it much more to go with the one that makes more money and still provides stability, and that would be large caps over bonds.

I should probably add that stocks and bonds are inherently different animals. While a bond fund may behave like stocks, in the end, they are still debt instruments. Until maturity and one buys a new bond, the rates are fairly set. (Yes I am aware that there are exceptions. ) Large caps, on the other hand, has the potential to continue to grow. For long term investing, growth is the name of the game. So, to me, and with a high risk tolerance, I see large caps as the "better mouse trap" in balancing out the much more aggressive but risky funds.

I feel kind of funny explaining all this, because I know you know all this. Like grasshopper trying to explain the nature of the pebble to the master that which holds said pebble. So, please pardon me if I seem like I am insulting your intelligence. Please don't make me walk over rice paper and pick up scorching vats of burning coal.

[sweeps]

You can't have it both ways. You can't use past performance to say stocks outperform all other asset classes, and then tell me I can't use past performance to say "X" stock subclass (whether it be large caps, small caps, value stocks, growth stocks, int'l stocks, emerging markets, whatever) outperform all other stock subclasses.

Scanner brought up Dogs of the Dow. If that strategy works out to win over a diversified basket of stock investments -- over the long term -- wouldn't it make sense to advise that strategy?

C'mon folks, let's open up our thinking a little bit. We give newbies the same advice over and over and over, but is there sound logic behind it?

[Broken Arrow]

I'm not against the idea that I could be wrong at all, and I'm open to Thinking Different. Honest.

However, I don't think there's a logical disconnect between saying that stocks, in general, have done better than bonds. I just don't know which stock (funds) are going to be the studs and which ones are the duds.

To be fair, I don't place too much value in looking at past performances, even though they're always listed. Rather, I'm looking more along the lines of where each fund is invested, and match it up with other funds that fill in its gaps in order to get a good overall spread going. For example, my funds had way too much US stocks, and that's the real reason why I went overboard with international. It's not because they're performing great right now (although I'm not complaining ). I don't know how long that'll keep up. Instead, I'm making it play catch up with the rest of my portfolio. Once it hits a desired percentage (which is actually more like 20%), I plan to rebalance and level it out.

To be even more fair, I also agree that there is an inherent danger in simply thinking that diversification is the way to go. I posted a link to Warren Buffet's thoughts on diversification a little while back, and he has stated that he personally doesn't diversify. As Mr. B puts it, diversification is for people who are unable to read into the fundamentals of businesses and are within "their circle of competence". I believe that as we grow in our investing savvy, the need to diversify will continue to shrink, and perhaps that is part of your objection.... because your skill level is different than that of a beginner. For a beginner (which I would include myself), it's good to start out diversified. Then, as their skill level increases, they can start expanding into less and less diversified areas of investing for better returns. And where we all expand to depends on each individual, as they will have to find that out for themselves. For example, some may prefer focusing on a home business, some prefer to be slum lords, while others may prefer stock picking.

However, I'm also of the opinion that we need to get our stable core investments going first before we take on these riskier ventures (although I also acknowledge that It Depends on your individual situation).

This is a very thought-provoking thread indeed....

[jIM_Ohio]

Sweeps,

You made a very assumptive statement:



Says who?

The Pundits?

The Pundits also told me back in the 90's that Domestic should be the core part of your portfolio with only a smidgen of International (10% was the going recommendation)

I didn't listen to the Pundits and went with a 50/50 split. Thank God I did because I hold 100% more in my Janus Overseas than I do in my T. Rowe Price Blue Chip.

I agree with JimOhio that asset allocation is an art. I don't like too many chips out on the table but you can't have only chip on either. It depends how good of a manager you are.

There is a reason pundits only suggest small percentages in international. My 25% position in the 90's would be considered highly aggressive. Now many will say I am underweight.

The reason for international outperformance right now is
a) the weak dollar
b) the weak dollar
c) GDP of the world is increasing moderately
d) the weak dollar

once the US does any of the following
a) raises interest rates
b) stops deficit spending
c) stops printing "more" money (some is good, more is bad)
d) gets out of sub prime debacle

the dollar will rebound and the 20%+ returns we are seeing from International will go back to 5% or so, and domestic funds will look much much more attractive.

This is weakest the dollar has been in history. It is a bubble which will burst (all bubbles do burst sooner or later). The weak dollar inflates returns of overseas investments. The weak dollar is among the reasons for high gas prices as well.

The key to assett allocation is to profit from the times we have now (weak dollar). Predicting this 7 years ago (or even 5 years ago) was not something I read anywhere... so having a position in international made sense from an asset allocation standpoint so the 20% international returns we have now mix in with the 8% returns I am getting everywhere else in my portfolio to give me close to an 10% overall return right now.

[jIM_Ohio]

I love these discussions too as I feel the amateur investors we all are. . .we tend to see things and ask good questions sometimes.

My "Dogs of the Sectors" post was kind of in jest. . .but I think there's something to it.

Rather than shooting for what the Pundits say. . .I like to think a bit contrarian to the Pundits and maybe a bit futuristic when making my decisions.

I like to look for 10-20 year trends.

Will big co.'s rule?

Will small co.'s rule?

Will commodities gain in importance?

Is America positioned well or is Europe or Japan or Korea?

How much more will the financial sector take a beating?

How much more will real estate (residential) take a beating?

I don't believe in timing but I do beleive this with my heart (let me bold it)

You can't buy at the bottom but you can buy on the way down.

I think you answer these questions and you find your "investment philosophy."

And the fun thing about it is we are all different.

If you really in your heart of hearts beleive that big businesses will totally collapse and lose all competitive edge in the next 10-20 years and we will witness the total annilihation of Coke, Exxon, and Walmart, then by all means be an "owner" in that.

This reason, and this reason alone, is why I buy managed funds. The way my core fund works is it buys these value stocks when the time is right.

Examples- in 2000-2002 Microsoft got pummelled. I had yet to pay a dividend. PRFDX opened a small position in MSFT (PRFDX is a value fund which invests 2/3 of assets in dividend paying companies). MSFT started a dividend shortly after. The fund also bought ORCL, at same time and that stock, to best of my knowledge, does not pay a dividend yet.

3 years earlier the stock which did this was PG.

As long as manager is right more often than he is wrong, this will profit over long term. 1 year performance in a given year will lag an index here or there, but in long run I am quite happy with manager performance at a cost of .69% ER.

[Scanner]

You can't have it both ways. You can't use past performance to say stocks outperform all other asset classes, and then tell me I can't use past performance to say "X" stock subclass (whether it be large caps, small caps, value stocks, growth stocks, int'l stocks, emerging markets, whatever) outperform all other stock subclasses.

Scanner brought up Dogs of the Dow. If that strategy works out to win over a diversified basket of stock investments -- over the long term -- wouldn't it make sense to advise that strategy?

C'mon folks, let's open up our thinking a little bit. We give newbies the same advice over and over and over, but is there sound logic behind it?

Sweeps,

Like I said, it's about your investment philosophy and forwarding it.

You hit a salient point - what Wall Street financial advisors do is look at history.

Well, why?

What will history tell us?

History/schmistory, I say to the Wall Street Chuckleheads.

It tells us what happened. . . not what is going to happen.

I used my Domestic vs. International as an example. The psychology of the times in the 80's and 90's was

"America rules. We're da bomb. Core investment should be Domestic. We can do no wrong. Golly gee, Gomer. . .past history supports this."

Meanwhile all around you, the seeds of globalization were being planted.

Now, what you are doing is trying to sell this:

"America is best place to start a small business in the whole world. All great upstarts will be here and they will totally trump and outcompete any large businesses in the next 10-20 years."

And you are trying to sell this at a time when you have Big Oil Mr. President in office.

That's a hard sell to me, especially being a tiny business owner (I am hardly ready to go public and be a small cap, LOL).

America isnt' too kind to small businesses. For one, we are taxed pretty hard. Two, yup. . .you guessed it healthcare. I, for one, beleive there are many Bill Gates sitting in big companies in a cubicle who would love to go out and upstart the next Microsoft but don't for fear of losing benefits and healthcare for their family. Our current healthcare system does not encourage entrepreneurship; it encourages working "for da' man."

Now. . .if you have a rebuttal to this. . .of why I should let all of my chips ride on Small Caps. . .I'm all ears.

I just can't buy "Well. . .past history indicates small caps are da' bomb."

[jIM_Ohio]

Says history. I don't have links to the studies for you, but supposedly small caps beat large caps over time (by 2 percentage points I believe it was).

But regardless, that was just an example and not my point. My point was there is an inconsistency with the advice most people give to young people. They're told, don't diversify, go 100% stocks!!! That they have time to make up for volatility. But then they're told to diversify within stocks? Why? Why not go for the best performing subclass in stocks?

That, sir, is the question I pose.

don't diversify and go 100% stocks are not opposites of one another (read my blog).

If the 100% equity portfolio has been chopped up into pieces (large cap, mid cap, small cap, international large cap, international small cap, emerging markets) plus maybe REITs (are those stocks?-I think yes), then I would venture to say that portfolio is more diversified than one which is 50% S&P 500 and 50% bonds. Probably also more diversified than 33% S&P 500, 33% International index, 33% bonds.

More diversified, with higher returns, and lower long term risk (risk as measured by variability of returns amongst asset classes held over 20+ years).

[Scanner]

JimOhio,

I agree with you on international - as you know, I've had ants in my pants over what I am concluding is an overexposure right now in International (33%).

I'd like to get out (or more likely- reduce it to 15%) and into something that's taken a beating, like residential REIT or the financials (they won't take a beating forever, since the sub-prime debacle seems contained). Something on the way down.

REIT returns can be quite blah. . .7% was the norm in the 90's. . .but that's okay because I would have taken "a profit" on my International. I can't expect to find the next hot sector but right now, these are the sectors on the slide.

[jIM_Ohio]

JimOhio,

I agree with you on international - as you know, I've had ants in my pants over what I am concluding is an overexposure right now in International (33%).

I'd like to get out (or more likely- reduce it to 15%) and into something that's taken a beating, like residential REIT or the financials (they won't take a beating forever, since the sub-prime debacle seems contained). Something on the way down.

REIT returns can be quite blah. . .7% was the norm in the 90's. . .but that's okay because I would have taken "a profit" on my International. I can't expect to find the next hot sector but right now, these are the sectors on the slide.

I think financials is a good play. I might suggest a tech fund, maybe a global tech fund, a financials fund and REIT. 5% in each (assuming position in each is at least 5-10k).

My portfolio isn't big enough (yet) to slice and dice that thin with 5% positions.

[Scanner]

JimOhio,

My portfolio isn't huge but you know me. . .I don't care to have more than 4 chips on the table at this point of my investment career. I'll probably make one play and that's it.

I should probably call Janus and move some of my money off the table and into a bondfund while I get the transfer finalized to Schwab.