The Core Four

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.

Postby Rick Ferri » Mon Dec 31, 2007 10:38 am

why not stay with market risk - why then the 10% REITs? Why not simply stay with Taylor's 3 musketeers: Total US/Intl/Bond Index?


Sure, that would work. If you were going to do the "Thrifty Three" portfolio, then Taylor's portfolio is a great choice.

The reason I included REITs in the Core Four is:

1) REITs are a bona fide separate asset class than stocks and bonds. They have different underlying assets, different tax structure, different risks, and ll that is evident in historically low to varying correlations with bond and common stocks.

2) Commercial real estate represents about 15% of our economy, but only 2% of the stock market. So it is disproportionally underrepresented in a market index (made worse in 2007 by the privatization of the largest REIT - Equity Office Properties).

BTW, if you want to slim a portfolio down to TWO funds, here is a Dynamic Duo portfolio to consider:

Vanguard Total Stock Market Index Fund (VTSMX – fee 0.19%)
Vanguard Total Bond Market Index Fund (VBMFX – fee 0.20%)

In review, we have put forth three simple portfolios:

The CORE FOUR

Vanguard Total Stock Market Index Fund (VTSMX – fee 0.19%)
Vanguard FTSE All-World ex-US Index Fund (VFWIX – fee 0.40%)*
Vanguard REIT Index Fund Investor Shares (VGSIX – fee 0.21%)
Vanguard Total Bond Market Index Fund (VBMFX – fee 0.20%)

Taylor's THRIFTY THREE

Vanguard Total Stock Market Index Fund (VTSMX – fee 0.19%)
Vanguard FTSE All-World ex-US Index Fund (VFWIX – fee 0.40%)*
Vanguard Total Bond Market Index Fund (VBMFX – fee 0.20%)

The DYNAMIC DUO

Vanguard Total Stock Market Index Fund (VTSMX – fee 0.19%)
Vanguard Total Bond Market Index Fund (VBMFX – fee 0.20%)

*There is a separate conversation going on comparing the Vanguard FTSE All-World ex-US Index Fund to the Total International Portfolio. The two funds are highly correlated, but there are differences in fees, taxes, and slight differences in composition.

Rick Ferri

BTW, one could probably write an on-line book about these portfolios, i.e. compare and contrast, benefits and drawbacks, fees, taxes, etc. I'm taking a break from book writing in 2008. Anyone motivated enough to write a book on this concept with all sales revenue and licencing fees going to charity? Mel, Taylor, Mike? How about a Diehards sequel?
Last edited by Rick Ferri on Mon Dec 31, 2007 10:39 am, edited 1 time in total.
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Re: The Core Four

Postby Valuethinker » Mon Dec 31, 2007 10:38 am

sgr000 wrote:
Rick Ferri wrote:Going into 2008, remember Von Clausewitz' epigram, "The greatest enemy of a good plan is the dream of a perfect plan."

When alluding to von Clausewitz, it's good to remember the countervailing opinion from the Graf von Moltke: "No battle plan survives contact with the enemy."


Thank you. I have been misquoting that as Clausewitz, perhaps no surprise that it was Von Moltke.

If you look at the German WWI plan (Von Moltke's) vs. the German WWII plan, the WWII plan succeeded totally, and the WWI plan failed.

Besides historical factors like the invention of the tank and the dive bomber, and the incompetence of the French WWII High Command, one key factor was chance.

Hitler's original invasion plan for France in 1940 was a repeat of the Von Moltke one which had failed in 1914. However a light plane carrying 2 officers crashed, and the French captured the plan.

Hurriedly, the German High Command adopted a radical plan by ?Von Schlieffen? which involved a surprise attack through dense woods (the Ardennes, later the famous site of the Battle of the Bulge), and driving straight to the Channel, cutting the Allied forces in two. It succeeded brilliantly.

The lesson for investing perhaps is that there's nothing like a good plan, but the key success factor may be an adaptability in the face of radically changed conditions.
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Postby Index Fan » Mon Dec 31, 2007 10:41 am

Excellent post, Rick!

My 2 cents...I'd include the Vanguard TIPS Fund into the mix and make it a "core five" for a bit more diversification.
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Postby Rick Ferri » Mon Dec 31, 2007 10:46 am

The lesson for investing perhaps is that there's nothing like a good plan, but the key success factor may be an adaptability in the face of radically changed conditions.


Yes, however the changed condition should be long-term changes in your life goals rather than short-term changes in market conditions. For example, as a person approaches retirement they may change their allocation from asset accumulation to one that fits their retirement distribution needs.

Another change is the addition of new asset classes through the low-cost securitization of assets. For example, REITS were not available in a Vanguard index fund until 1996. That might prompt re-engineering in a portfolio.

Rick Ferri
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Postby jar2574 » Mon Dec 31, 2007 10:47 am

Small Hi:

Is your portfolio entirely made up of small value stocks? You seem quite confident that they are the bee's knees.

I think Taylor was just making the point that SV is popular now because it has been doing well. When SV does poorly, it will be less popular.

Rick:

Thanks for this thread. I don't understand REIT, even after reading a few threads on the subject. Seems like a way to invest in real estate to me, and I thought that real estate had a worse track record than equities.

So I'll stick to 1/3 US TSM, 1/3 Intl, and 1/3 US TBM. Won't be tempted to chase performance with that allocation. :)
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Postby Michael Weiss » Mon Dec 31, 2007 10:56 am

Rick Ferri wrote:The reason I included REITs in the Core Four is:

1) REITs are a bona fide separate asset class than stocks and bonds. They have different underlying assets, different tax structure, different risks, and ll that is evident in historically low to varying correlations with bond and common stocks.

2) Commercial real estate represents about 15% of our economy, but only 2% of the stock market. So it is disproportionally underrepresented in a market index (made worse in 2007 by the privatization of the largest REIT - Equity Office Properties).


Rick,

Your basis is reasonable if your goal is primarily to reduce overall volatility. IMO, however, using REITs over SCV because they have somewhat lower correlation to stocks and bonds is not the best way to look at portfolio construction. At the end of the day, a slightly lower standard deviation has minimal on the value of your portfolio.

MW
Last edited by Michael Weiss on Mon Dec 31, 2007 11:05 am, edited 1 time in total.
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Postby Rick Ferri » Mon Dec 31, 2007 11:01 am

using REITs over SCV because they have somewhat lower correlation to stocks and bonds is not the best way to look at portfolio construction


We have been discussing this in earlier posts. I am looking for 'beta' in these core portfolios, i.e. market risk and equity risk premiums. Once market risk is covered, investors can extend their risks to value, size, strategy, etc. as they wish. BTW, strategy risk is using actively managed funds in a portfolio.

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Postby Rick Ferri » Mon Dec 31, 2007 11:05 am

I don't understand REIT, even after reading a few threads on the subject. Seems like a way to invest in real estate to me, and I thought that real estate had a worse track record than equities.


Jar,

If you are not comfortable with an asset class, then do not include it in your portfolio. In your case, I recommend Taylor's THRIFTY THREE portfolio as the center of your investment strategy:

Vanguard Total Stock Market Index Fund (VTSMX)
Vanguard FTSE All-World ex-US Index Fund (VFWIX)
Vanguard Total Bond Market Index Fund (VBMFX)

Rick Ferri
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Postby zigkelton » Mon Dec 31, 2007 11:13 am

Nice and simple -- which is great!
Two questions, though:

1) If one is now in the early part of the "decumulation" phase, would there be key questions or concepts that one should think about to modify these portfolios?

2) With the above context, would TIPS be a substitute for TBM in one's Tax-deferred account?
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To summarize

Postby GIS Guy » Mon Dec 31, 2007 11:16 am

These conversations get a bit complicated. When I read the first post my mind is clear, but by the time I get to the end of the thread my mind is foggy and I ask myself what did I learn? Maybe we can summarize this conversation at some point to make a short and concise statement?

Rick Ferri said:
"Extending the portfolio may earn you a slightly higher return, or lower the risk, or both. However, nothing is guaranteed."

I see 2 paths one can take then, correct me if I am wrong please:

1) Invest in each asset class (i.e., a "core portfolio" or "keep it simple method")

or

2) Extend and/or tincker with this "core porfolio" to try and get a higher return and/or lower risk, hopefully

GIS
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Postby jar2574 » Mon Dec 31, 2007 11:39 am

Rick Ferri wrote:
I don't understand REIT, even after reading a few threads on the subject. Seems like a way to invest in real estate to me, and I thought that real estate had a worse track record than equities.


Jar,

If you are not comfortable with an asset class, then do not include it in your portfolio. In your case, I recommend Taylor's THRIFTY THREE portfolio as the center of your investment strategy:

Vanguard Total Stock Market Index Fund (VTSMX)
Vanguard FTSE All-World ex-US Index Fund (VFWIX)
Vanguard Total Bond Market Index Fund (VBMFX)

Rick Ferri


Thanks.
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The Fab Four

Postby pkcrafter » Mon Dec 31, 2007 11:43 am

Rick, thanks for the great post.

Rick wrote:
IMO, a portfolio of market risks is where many investors should end. I agree that value and size risks are not too difficult to comprehend for experienced investors, but three-factor investing is an advanced strategy. Unfortunately, for less experienced or disciplined investors, when value and small stocks are out of favor, good intentions typically go by the way-side and emotions take over. And we all know what happens when emotions rule investment decisions! As such, many investors would be better off not doing a three-factor portfolio.

Again, I have no issue with experienced and disciplined investors doing a three-factor portfolio. But I cannot recommend that everyone do it. To assume that everyone is sophisticated is just not reality. And it takes a deep understanding of the strategy to stick with it during long periods of under-performance.


In my option, this is unshakable advice for all the right reasons. For those questioning Rick's Fab Four portfolio, please keep in mind that Rick is an expert with lots of experience dealing with investors. He knows what he's taking about and we are every fortunate that he is willing to share his expertise with us.

The point is that while some individual investors may be advanced enough and happier with a 3 factor model, it isn't going to be the best recommendation for the vast majority of average investors for the very reasons Rick has mentioned. And for those wishing to tweak, Rick does mention extension funds. But for the majority of new investors seeking suggestions on this forum who want something easy to understand and easy to stay with, Rick's advice is absolutely on target. There is power in the simple portfolio and it will do the job.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
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Re: To summarize

Postby SurgPath » Mon Dec 31, 2007 12:05 pm

GIS Guy wrote:These conversations get a bit complicated. When I read the first post my mind is clear, but by the time I get to the end of the thread my mind is foggy and I ask myself what did I learn? Maybe we can summarize this conversation at some point to make a short and concise statement?

Rick Ferri said:
"Extending the portfolio may earn you a slightly higher return, or lower the risk, or both. However, nothing is guaranteed."

I see 2 paths one can take then, correct me if I am wrong please:

1) Invest in each asset class (i.e., a "core portfolio" or "keep it simple method")

or

2) Extend and/or tincker with this "core porfolio" to try and get a higher return and/or lower risk, hopefully

GIS


Wow! You read my mind. I agree, I'm a little foggy as well.
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Postby SmallHi » Mon Dec 31, 2007 12:08 pm

Jar,

Small Hi:

Is your portfolio entirely made up of small value stocks? You seem quite confident that they are the bee's knees.

I think Taylor was just making the point that SV is popular now because it has been doing well. When SV does poorly, it will be less popular.


Actually, what Taylor said was that the popularity (read: justification) for a small value tilt was based on recency and the last few years of outstanding returns.

My point was, the justification for tilting away from the market is actually based on over 8 decades of market research, a rational distribution of risk/return, and the prevailing asset pricing model in use today.

Not everyone will or even should tilt away from the market. I am fine with that. I think everyone, however, should at least consider it. Better to have reviewed the data and theories and decide against it than to say "its too complicated or complex", or, "i am intentially limiting my investment portfolio to X holdings". If you can figure out Int'l Investing and REIT investing, you can probably understand multifactor investing.
As my data showed, the tracking error from Int'l and REIT investing is probably greater than tilting within the dimensions of our domestic market, and the expected payoffs are much less.

As Michael has pointed out and I mentioned as well...all investment strategies will become unpopular when they "underperform". That is a lousy reason for excluding them from an investment portfolio.

If you embrace the theory/model that drives the expected equity risk premium (and thus an expected outperformance of US, Int'l, and EM Market portfolios), there is no reason to believe the same risk/return behaviors will not also generate positive excess returns to size and value dimensions globally.

I have no particular insight as to the future premiums for small and value dimensions of the market any more than I do for the overall equity risk premium -- so my personal portfolio is highly diversified. As is is usually beneficial with most predicitions, I default to the naive forecast. Moderate equity, size, value, term and credit risks will probably be sufficient for future planning purposes. If one or more is way off (beta, for example), I would be much more comfortable not concentrating my entire portfolio in that risk...

What prompted any comment from me in the first place is the assumption that US REITS are a CORE element of a diversified portfolio, yet size and value tilts are secondary (at best). There is credible research indicating that Int'l investing may be unnecessary if you target BETA exclusively (Sinquefield 1995), and only for those considering size or value dimensions of the Int'l markets are the higher investment costs justified.

As for my multifactor confidence, well...size and Value dimensions have brilliant explainatory powers in the context of a diversified portfoliio, and we have 80+ years of exchange traded data on their behavior through booms and busts (and info in over a dozen different countries over shorter periods). Size and Value dimensions can also be accessed in a more tax efficient manner, leaving valuable tax-deferred space for ST taxable fixed income. And, asset class or not, REITS contain industry specific risks (see 2007) that mirror most other sectors.

If one were to develop a REIT tracking variable (NARIET minus TSM), we would find that the premiums, persistence, and diversification benefits relative to a TSM portfolio are actually less than size or value tilts...yet the volatility of its premium is higher than the ERP, size, or value risks.

Furthermore, a REIT allocation introduces a portfolio to the sensitivity of the value premium (REIT minus TSM and Value minus Growth have an annual correlation of almost +0.7%, and poor periods for Value minus Growth tend to coincide with very poor relative periods for REITS). A logical question is whether or not you would prefer to take this "risk" in a 100 securitiy portfolio with industry specific risks, or a several thousand LV/MV/SV portfolio spanning over a dozen sectors?

Bottom line, there are as many reasons to develop a multifactor portfolio as their are a CAPM allocation. Completely ignoring this is the issue I have. Relegating certain factors in the FF5F Model to primary and secondary is not how I have interpreted the FF research. Adding REITs is not the diversification antidote some would have you believe. I understand that only using asset classes that Vanguard offers presents a bias for some, but its not a sufficient metric for building a long term portfolio for those of even modest net worths...

SH
Last edited by SmallHi on Mon Dec 31, 2007 12:23 pm, edited 4 times in total.
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Postby stratton » Mon Dec 31, 2007 12:14 pm

SmallHi wrote:If one were to develop a REIT tracking variable (NARIET minus TSM), we would find that the premiums, persistence, and diversification benefits relative to a TSM portfolio are actually less than size or value tilts...yet the volatility of its premium is higher than the ERP, size, or value risks.

Just for grins and giggles I'll point out REITs are generally mid and small value.

Paul
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Postby Valuethinker » Mon Dec 31, 2007 12:23 pm

stratton wrote:
SmallHi wrote:If one were to develop a REIT tracking variable (NARIET minus TSM), we would find that the premiums, persistence, and diversification benefits relative to a TSM portfolio are actually less than size or value tilts...yet the volatility of its premium is higher than the ERP, size, or value risks.

Just for grins and giggles I'll point out REITs are generally mid and small value.

Paul


As Larry points out, in the case of Small and Value you are trading off risks you can take, against the market as a whole which may not wish to take those risks (illiquidity and financial risk).

I'm not sure this is the case in REITs.

Real estate is an asset that gives you some inflation protection (good), some diversification against equities (good) but less in recent years, and long run lower returns than equities. As a fairly long term investor (say 20 years) I can trade low liquidity and financial risk with the market by buying small value.

I'm not sure what box REITs fit on that schema.
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The bottom line

Postby Taylor Larimore » Mon Dec 31, 2007 12:29 pm

Hi SmallHi:

"To the extent that your post helps investors realize that SV doesn't always outperform the S&P 500, it is helpful. Beyond that, its a questionable comment...

I know its one of your favorite charts, might you consider adding the following (*)s the next time you use it so first time investors can see the whole story?"


The biggest improvement to both our posts would be adding:

"Past performance is no guarantee of future performance."

Happy New Year!
Taylor
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Postby jacqueeagonsr » Mon Dec 31, 2007 12:31 pm

Great post, Rick. From The Smartest Investment Book You'll Ever Read by Solin and The Coming Generational Storm by Kotlikoff and Burns I devised this following asset allocation plan that fits my risk tolerance.

VBTLX - Total Bonds 36%
VTSAX - Total Stocks 36%
VGPMX - Prec. Metals 4%
VGSIX - REIT 4%
VGTSX - Total International 20%

It's similar. Your comments will make me research and reconsider the international fund. In todays environment I probably would not include the Precious Metals fund. But, I got into it years ago when gold was around $300/oz. So, I keep it because I've been able to drag a lot of money out each time I've rebalanced. As time goes by and it falls out of favor (and that time may be very near), I plan to replace it with the Health Care fund (or ETF, if it's closed).

Regards,
J.

p.s. - that's my REAL portfolio - not a 'what if'. (added via edit)
Where ever you go, there you are!
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One more point

Postby pkcrafter » Mon Dec 31, 2007 1:33 pm

One more point. It turns out that the more you research the academic literature, the studies, the conclusions of experts—that is the more you know—the more you realize that the learned knowledge isn't necessary to create a very efficient portfolio. You cannot create a perfect portfolio, but you can create a very nice one with little effort. At some point, adding more tweaking provides diminishing degrees of improvement. On many levels, simplicity is very hard to beat for the average investor.

Sure, some people will prefer complicated portfolios and there is certainly nothing wrong with this, but this approach should never be the default advice for new investors or average investors. The downside possibilities with portfolios that don't come close to tracking the market far outweigh the upside for all but the most knowledge and experienced investors.

Happy New Year,

Paul
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"The Dream of a Perfect Plan"

Postby Taylor Larimore » Mon Dec 31, 2007 1:42 pm

Hi Bogleheads:

Rick Ferri has offered us a very simple, diversified, low cost portfolio which he calls the "Four Core." Rick's portfolio reminds me of a speech Mr. Bogle made at the Boston 'Money Matters Conference' in 1999. He called it, "The Dream of a Perfect Plan." Below are excerpts from that speech:

"I warn you that complexity--which I call 'witchcraft,' may seem to offer a perfect plan, but it rarely delivers on the dream it promises."

"Among those 145 equity mutual funds that have in fact survived the past three decades, only 15 have outpaced the stock market as a whole. That is, the fund investor had only about one chance out of ten to surpass the market's return."

"There is an obvious—and optimal—way to closely approach this 100% target: Simply own the market."

"The greatest enemy of a good plan is the dream of a perfect plan."

"You deserve a 'fair shake' and I will be speaking out until you get it."


To read the entire speech by one of the most experienced and knowledgeable investment authorities in the world, use the link below:

http://www.vanguard.com/bogle_site/lib/sp19991016.html

Happy New Year!
Taylor
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Thanks

Postby GIS Guy » Mon Dec 31, 2007 1:54 pm

Thank you Rick and Taylor,

You have taken the complexity out of it and summed it up nicely. There is excellent information in this thread for both the advanced and novice (like myself) investor. It reinforces why someone with my experience should keep it simple, and that I likely won't miss out on much by doing so.

Happy New Year to you too!

GIS
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the "WONDERFUL ONE"

Postby BigD53 » Mon Dec 31, 2007 4:58 pm

Great discussion.

After I retire, I want complete simplicity and hands-off investing. I also desire to have the pros at Vanguard rebalance my funds for me.

In my tax deferred accounts, I will choose the "Wonderful One" fund:
Target Retirement.
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Postby Captain_WI » Tue Jan 01, 2008 10:12 am

Thank You Taylor

I have been reading along on this site for a year and have to say I can get very intimidated at times by the complex info given at times. I started watching this site for a simplistic and cost effective way of investing my money and these plans give that.

Thanks from someone who likes to keep it simple!!!
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Re: The Core Four

Postby hudson » Tue Jan 01, 2008 10:35 am

[quote="Rick Ferri"].

The “Core Four” are:

Vanguard Total Stock Market Index Fund Investor Shares (VTSMX – fee 0.19%)
Vanguard FTSE All-World ex-US Index Fund (VFWIX – fee 0.40%)
Vanguard REIT Index Fund Investor Shares (VGSIX – fee 0.21%)
Vanguard Total Bond Market Index Fund Investor Shares (VBMFX – fee 0.20%)

Rick Ferri[/quote]

The Core Fore is a very useful post for me. I would alter it to fit me as follows...all Vanguard:

Stocks: 55%
Total Stock Market, VTSMX 20%
FTSE International, VFWIX 20%
REIT, VGSIX 5%
Small Cap Index, NAESX 10%
Bonds: 45%
Short Term Treasuries, VFISX 22.5%
Inflation Protected Bonds, VIPSX 22.5%

Maybe this is the Ferri-Swedroe-Larrimore-Diehard solution?
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Rick

Postby CountryBoy » Tue Jan 01, 2008 12:36 pm

Rick, with so many of us raising so many questions, it is easy to have some questions be ignored or forgotten about. Specifically, toward the beginning of this thread I asked but never heard back re:

Rick, I bought your ETF Book and am continuing to study it. I am wondering if it could be more efficient for some people to buy some of the Core funds in ETFs.

For example if one knows that they are a DH and are going to put money in 'for the long haul' and not trade ETFs then couldn't it be more efficient to buy say VTSMX in the ETF equivalent?


By way of followup on this,
1-On page 62 your table demonstrates the ER savings for buying VTSMX not as a mutual fund but rather as an ETF with VTI and
2-On page 64, you discuss tax savings

So aren't costs related to ER and taxes relevant and would it not be better to buy ETFs rather than mutual funds? Or am I misreading your book?

Many thanks,
CountryBoy
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Postby Rick Ferri » Tue Jan 01, 2008 2:47 pm

CountryBoy,

Should you buy Vanguard open-end funds or Vanguard ETFs?

The answer is, it depends on costs, custody, and convenience. As a reminder, either way you are buying the same fund. VTSMX and VTI are just different share classes of the Vanguard US Total Market Fund.

Costs are a three-fold equation:

1. Expense ratio: Both the open-end and etf have management fees and administrative expenses. For example, the Vanguard Total Stock Market Index Fund investor shares VTSMX = 0.19%, VTSAX = 0.09 (Admiral shares), and VTI = 0.07% (ETF).

2. Commissions: If you buy Investor shares or Admiral shares directly through Vanguard there is no commission. However, your will pay a commission if you buy Investor shares, Admiral share or the ETF through a brokerage firm such as Fidelity, Schwab or Ameritrade. The fee for buying an open-end mutual fund is higher than buying ETF shares.

3. Trading Spread: Only applies to ETF shares that trade on an exchange. The spread is the difference between what you pay and the true NAV of the fund at the time you bought it. This can be a few pennies per share to about 25 cents depending on when you buy and the liquidity of what you are buying.

Custody is twofold (where you hold your account):

1. Direct with Vanguard: You have an account with Vanguard directly and invest in their open-end funds. There are no commissions to do this. However, you are limited to trading open-end shares once per day at the end of the day NAV.

2. Indirect with a brokerage firm: VBS, Fidelity, Schwab, Merrill et all. You will pay a commission to buy open-end funds and ETFs. Commission costs vary considerably between firms and are different for mutual funds and ETFs. Open-end funds still trade once per day at the end of the day NAV, but you can buy ETF shares anytime during the day at whatever the market price is.

If convenience is a factor:

1. You want one account with only Vanguard funds and no other investments, then open a Vanguard account and buy open-end funds.

2. You want one account with Vanguard funds and other investments, i.e. other mutual funds, stocks, bonds, ETFs, etc., then you should custody at a discount brokerage firm that gives you access to all of those investments.
So, here is how this all shakes out, IMO:

1. If you plan to buy only Vanguard funds - go directly to Vanguard. This is the least expensive option for Admiral Share class investors. For Investor Share class investors, this is still the lowest cost option if you are buying multiple funds in a diversified portfolio and if you are dollar-cost averaging.

2. If you plan to buy other investments in addition to Vanguard funds and want the convenience of one custodian - choose a low cost custodian and buy Vanguard ETFs. Don’t buy Vanguard open-end funds through a broker when ETF shares available because the commission cost is higher. That would provide the convenience you are looking for without adding to cost.

3. If you don’t care about having multiple accounts or the inconvenience trading in different places, then go with Vanguard directly for the Vanguard funds and open a low-cost custodian account for all the other stuff. See #1.

4. If you are buying only a couple of Investor Shares class one-time, then going with Vanguard directly or buying ETFs is like slitting hairs. Going through a low-cost broker and buying ETFs is probably the lowest cost option in the short-term, however direct Vanguard clients can convert Investor class shares to Admiral Shares Class when they have reached a certain level.

As we used to say in the Marine Corp, it is as clear as mud.

Rick Ferri

BTW, our clients custody at Schwab Institutional and we buy Vanguard ETFs when they are available for a fund. Vanguard no longer supports investment management companies to custody directly. We have negotiated very low commissions through Schwab, and we trade blocks of ETFs over an institutional level platform to keep spreads very low.
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Postby Robert T » Tue Jan 01, 2008 3:24 pm

.
Rick,

FF research shows that CAPM explains 70% of diversified portfolio's return. CAPM is based on a function of beta, or market risk. The three factor model explains 95% of a diversified portfolio's return, with beta being the dominant of the three factors!.

Any way you slice the data, it comes back to the basic fact that market risk (beta) is the dominant factor driving portfolio returns. And I believe Fama and French would agree.

This general message seems consistent with the presentation inthis Fama Jr. article (see page 12). I have always wondered about these findings (and their interpretation) and think it is important to distinguish the impact of market risk (beta) on:
    (i) the variability of portfolio returns,
    (ii) the level of portfolio returns, and
    (iii) cumulative portfolio size.
1. On the variability of returns

The numbers above and in the Fama Jr paper reflect the R^2 derived from the respective single factor and three factor regressions and reflect the variation of portfolio returns explained by the variation in the single or three factors. So the numbers relate to variability of returns (not the level of returns) as I understand it. In addition, Fama Jr, in the above linked article, adds a conditioning statement (underlined below).

    The single factor model explains about 70% of returns for a cross-section of equity portfolios of various sizes and styles. The farther you get from the market the less it explains.” Pg. 13 (my underline).

    The three factor model explains upward of 95% of returns for a cross-section of equity portfolios of various sizes and styles. Unlike the single factor model, it continues explaining returns the farther a portfolio gets from the market”. Pg. 13. (my underline)
The table below presents results of testing the above findings. ‘Beta’ (or the single factor model) explains between 100% and 43% of the variability of returns across the five return series examined below. The results seem consistent with the Fama Jr finding that “the farther you get from the market the less it explains”. The implication is that the more a portfolio is tilted to value the less return variability ‘beta’ explains and the more the size and value tilt explain.

Code: Select all
Single and Three Factor Regressions R^2’s using monthly data from July 1995 to April 2007.

                                       R^2                R^2           
                                  Single Factor       Three Factor
                                      Model              Model

MSCI US Broad Market Index             1.00               1.00
MSCI Prime Market Value Index          0.71               0.94
S&P/Citigroup 600 Value                0.63               0.91
DFA Small Value                        0.60               0.95 
S&P/Citigroup 600 Pure Value           0.43               0.84


2. On the level of returns

If we assume the expected annual return of the market = 7%, the value premium = 4%, and the size premium = 2%. Then for the market return to account for 70% of the expected return of a portfolio, the portfolio would need about a 0.4 size loading and 0.6 value loading by my estimate (1*7+0.4*2+0.6*4=10.2). This is quite a significant size and value tilt. This is probably more significant than the tilts of most 'slice and dice' investors, and if this is the case then ‘beta’ would account for an even higher share of the level of annual return.

3. On cumulative portfolio size

While market risk (‘beta’) is the dominant factor driving the variability of returns and the level of returns on an annual basis, this may not be true for cumulative portfolio size over time. The 30% of expected return not accounted for by ‘beta’ in the above example is not insignificant. If we assume a market return of 7%, and that this accounts for 70% of the 10% return of a value and small cap tilted portfolio, in takes 25 years for the growth of $1 in the value and small cap tilted portfolio to be double that of the market portfolio. So beyond 25 years, the market (‘beta’) only portfolio accounts for less than 50% of the cumulative portfolio size of the market, and value and size tilted portfolio. While the above example ignores costs – the cumulative portfolio size difference with costs IMO will still be significant.

Just my interpretation.

Robert
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Robert --

Postby SmallHi » Tue Jan 01, 2008 4:34 pm

I look at it slightly different (when I claim that "in some periods, your size/value tilt is as or more important than your equity/fixed decision"). Lets consider the 1964-2006 period (the inception of 1YR Notes):

Code: Select all
STRATEGY          ANN RET          ST DEV

1YR T-Notes         6.7%           3.3
US TSM             10.7%          16.9
US Vector          14.5%          20.2
US SV              16.7%          26.2

P1                 10.7%          16.9
P2                 10.7%           9.2

(P1) = 100% US TSM
(P2) = 45% US Vector; 55% 1YR T-Notes


This period covers over 40 years, and we find that every dollar taken away from 1YR T-Notes and invested in TSM is less profitable than every dollar taken away from TSM and shifted to SV. To me, more profitable = more important.

Now, clearly, except for Swedroe, I don't know anyone who has a 100% SV portfolio. US Vector*, on the other hand, is probably a reasonable (if not somewhat agressive) allocation for someone who has considerable multifactor intensions.

When we observe the returns to 1YR T-Notes compared to (P1) and (P2), we can see it takes 100% market risk to achieve the same results (a 4% return premium) as a 45% Vector, 55% 1YR T-Note portfolio.

A simple way of looking at this would to interpret an investors size/value decisions to be approximately 2X as important as their equity/fixed decision (given that it takes approximately double the market exposure to achieve the returns of a balanced small/value tilted mix).

Just my take. And, obviously, not every period will look like this.

SH

*there is nothing special about Vector, I could have just as easily used a TSM/SV allocation to approximate the theoretical risks and returns
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Postby SmallHi » Tue Jan 01, 2008 4:46 pm

Robert, cont'd...

The implication is that the more a portfolio is tilted to value the less return variability ‘beta’ explains and the more the size and value tilt explain.


Not only that, but also the more tilted a portfolio is, the more foregiving a CAPM regression is. DFA US SV has a +0.40%/month alpha under a CAPM regression, and -0.08%/month under the FF3F. (both are statistically insignificant).

Also, there are some investors/advisors who do or have advocated a tilt similar to what you looked for above (0.4/0.6)...see this newsletter from over 10 years ago: http://www.equiuspartners.com/pdf/asset ... t97ac2.pdf

SH
Last edited by SmallHi on Tue Jan 01, 2008 6:53 pm, edited 1 time in total.
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Re: Rick --

Postby Eric » Tue Jan 01, 2008 4:59 pm

SmallHi wrote:If you want to give yourself the greatest likelyhood of capturing the premiums, you probably need to establish a permanent tilt and (as Fama says...) "ride it to the beach".


This quote might inadvertently lead readers to think that Fama Sr. advocates value-tilting. He doesn't, at least not as a general proposition.
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Great Discussion - Thanks Rick

Postby newlifeca » Tue Jan 01, 2008 5:15 pm

Rick, thanks for taking time to not only post, but interact with the variety of responses it generates. I learn a lot.
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Postby Rick Ferri » Tue Jan 01, 2008 5:27 pm

All of these points about the FF 3-factor model are fine. But lets not misinterpret the implications of the reseach. The FIRST factor and the most prevalent factor in the FF model is BETA. If you run 10,000 random portfolios of 100 stocks each, BETA will explain 70% of the return of those portfolios on average.

Fama and French say, and have always said, design a portfolio starting with market risk first (beta), then add size and value risks based on your personal preference, or add none at all.

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Postby SmallHi » Tue Jan 01, 2008 6:19 pm

Eric,

This quote might inadvertently lead readers to think that Fama Sr. advocates value-tilting. He doesn't, at least not as a general proposition.


Do you have any evidence to support your claim?

Rick,

Fama and French say, and have always said, design a portfolio starting with market risk first (beta), then add size and value risks based on your personal preference, or add none at all.


I don't want to argue semantics, but...

As far as I know, Fama and French advocate first determing your overall level of size and value exposure across the global equity markets (or your tilt away from a market neutral portfolio), and then determine how much of this TOTAL risk you can handle. Beyond that level, hold short term high quality fixed income to complete your portfolio.

That is not the same as building a TSM mix, determing your equity/fixed ration, and then deciding whether or not to tilt.

Regardless of the order (which came first, the chicken or the egg :D ), the potential magnitude of the decisions (tilting plus equity/fixed) justfiy those decisions garnering equal attention. Ultimately, not everyone will tilt away from the market, nor will every investor choose a market allocation whatsoever (an all value investor, for example), or choose any fixed income...but each decision should be given an equal and prominent role in the portfolio formation process. (IMO)

SH
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Postby Eric » Tue Jan 01, 2008 7:28 pm

SmallHi wrote:Eric,

This quote might inadvertently lead readers to think that Fama Sr. advocates value-tilting. He doesn't, at least not as a general proposition.


Do you have any evidence to support your claim?


I'm not sure the burden of proof should be on me, when you first suggested that Fama supports your view. (By "your view," I don't just mean that there's a value premium, but also that investors generally should respond to that premium by value-tilting their portfolios. Fama supports the former but not the latter.)

But anyway, here's a speech by Bogle quoting Fama. Key passage (underlining added by me):

John C. Bogle wrote:In any event, place me squarely in the camp of the contrarians who don't accept the inherent superiority of value strategies over growth strategies. I've been excoriated for my views, but I'm comforted by this reported exchange between Dr. Fama and a participant at a recent investment conference: "What do you say to otherwise intelligent people like Jack Bogle who examine this same data and conclude that there is no size or value premium?" His response: "How far are they from the slide? If I get far enough away, I don't see it either . . . Whether you decide to tilt towards value depends on whether you are willing to bear the associated risk . . . The market portfolio is always efficient . . . For most people, the market portfolio is the most sensible decision."
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Postby Eric » Tue Jan 01, 2008 7:43 pm

SmallHi,

Let's approach this another way. You like to point out that the premium for value over growth is similar to the premium for stocks over bonds. OK, let's run with that.

The capitalization-weighted total market is about 60% stocks and 40% bonds. Now, as you point out, there's a stock premium (with associated risk). Taking that premium into account, should investors generally tilt their portfolios more toward stocks? Maybe go 80/20 instead of 60/40? For some investors that's certainly appropriate, but I assume you agree that's not appropriate for investors generally.

(Then again, maybe you don't agree. Some very well-regarded researchers -- Siegel comes to mind -- do seem to argue for tilting more toward stocks. But that's a controversial position.)
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Postby Michael Weiss » Tue Jan 01, 2008 10:04 pm

Eric wrote:
SmallHi wrote:Eric,

This quote might inadvertently lead readers to think that Fama Sr. advocates value-tilting. He doesn't, at least not as a general proposition.


Do you have any evidence to support your claim?


I'm not sure the burden of proof should be on me, when you first suggested that Fama supports your view. (By "your view," I don't just mean that there's a value premium, but also that investors generally should respond to that premium by value-tilting their portfolios. Fama supports the former but not the latter.)

But anyway, here's a speech by Bogle quoting Fama. Key passage (underlining added by me):

John C. Bogle wrote:In any event, place me squarely in the camp of the contrarians who don't accept the inherent superiority of value strategies over growth strategies. I've been excoriated for my views, but I'm comforted by this reported exchange between Dr. Fama and a participant at a recent investment conference: "What do you say to otherwise intelligent people like Jack Bogle who examine this same data and conclude that there is no size or value premium?" His response: "How far are they from the slide? If I get far enough away, I don't see it either . . . Whether you decide to tilt towards value depends on whether you are willing to bear the associated risk . . . The market portfolio is always efficient . . . For most people, the market portfolio is the most sensible decision."


I am somewhat perplexed as to why you would provide this quote. First, the quote makes little sense. Fama states that a value premium is obvious but also says that the market portfolio is the most sensible option for most investors.

I guess that the quote implies that the average investor is not sufficiently educated regarding investments to pursue a value tilt. I am not sure what is so complicated about value investing and the premium and why this type of strategy is so much more complicated than a Core strategy. Not only does the data support the value premium, but there are common sense behavioral reasons for the premium.

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Postby Eric » Tue Jan 01, 2008 10:29 pm

Michael Weiss wrote:First, the quote makes little sense. Fama states that a value premium is obvious but also says that the market portfolio is the most sensible option for most investors.


Vary the quote slightly, by substituting "stock" for "value" so that we're referring to the return premium that stocks offer over bonds. Here's the revised quote: "X states that a stock premium is obvious but also says that the market portfolio [i.e., the market ratio of stocks and bonds] is the most sensible option for most investors." Would you say that this revised quote "makes little sense"?

Michael Weiss wrote:I guess that the quote implies that the average investor is not sufficiently educated regarding investments to pursue a value tilt. . . . there are common sense behavioral reasons for the premium.


Fama Sr. has said very clearly (e.g., here) that he does not agree with the "behavorial" story. Now, Fama could be wrong -- my point was just that posters shouldn't say he supports this position, because he doesn't. (Interestingly, the article I linked above indicates that Fama's partner, French, does think there's some mispricing. But Fama says explicitly that he disagrees.)
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Postby SmallHi » Tue Jan 01, 2008 10:59 pm

Eric,

my point was just that posters shouldn't say he supports this position, because he doesn't


I never said "Fama says everyone (or anyone) should tilt". I say they should consider it based on his and French's research. Fama does say, if you do tilt, you should be willing to "ride it to the beach".

There is no inconsistency here whatsoever. Never once did I say "everyone should tilt because Eugene Fama thinks so". That is very clearly the point you are trying to make (and I am not sure why, or how you got that from my comments).

When Fama was asked if "everyone should tilt heavily towards small and value stocks", he said "no, this is a risk story the way we tell it, so there is no optimal portfolio...in every asset pricing model, the market is an efficient portfolio, and investors can decide to tilt away from it based on their specific tastes, but they needn't do it....you can also decide to go the other way, say no, I like the growth side of it as long as they have a diversified portfolio, I can't argue with that either. Theres a whole multidimensional continuim here of efficient portfolios that anyone can decide to buy that I cannot quarrell with. And I have no recommendations, because its all a matter of taste. If you eat apples and I like oranges, I cannot argue with that. There is no perfect portfolio, instead a continuim of them...an infinite number of them."

In the same interview, he expresses his continued belief in his variable maturity approach to fixed income investing, and that TIPS have not replaced the benefit to shorter term nominal fixed income (and specifically his One Year Fixed Portfolio).

Also...when discussing the spectrum of investment decisions:
"what does matter is asset allocation, the choice of stock v bond, and within stocks, are you gonna tilt towards value or small, and also how much to allocate to international...there are just a handful of important decisions."

SH
Last edited by SmallHi on Tue Jan 01, 2008 11:26 pm, edited 2 times in total.
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Rick

Postby CountryBoy » Tue Jan 01, 2008 11:06 pm

Rick thank you for your answer and starting a new thread on the topic.

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Wellington or Core 4?

Postby tomc » Tue Jan 01, 2008 11:12 pm

As described earlier, an example of a 60% stock and 40% bond portfolio with the Core 4 is:

36% VTSMX
18% VFWIX
06% VGSIX
40% VBMFX

Do you think the "Core 4" held in this allocation would be better than holding Wellington in my Roth IRA which is my current only holding?
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4-funds, Wellington or Target Retirement?

Postby Taylor Larimore » Tue Jan 01, 2008 11:38 pm

Hi Tom:
"Do you think the "Core 4" held in this allocation would be better than holding Wellington in my Roth IRA which is my current only holding?"


The "Core 4" and Wellington are both very good choices. In my view, an appropriate Target Retirement Fund could be even better in your situation (everything in one Roth IRA). You can read about the Target Funds here:

https://personal.vanguard.com/us/content/Funds/FundsVanguardFundsTargetOverviewJSP.jsp

Best wishes.
Taylor
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Postby Eric » Tue Jan 01, 2008 11:59 pm

SmallHi wrote:Never once did I say "everyone should tilt because Eugene Fama thinks so". That is very clearly the point you are trying to make (and I am not sure why, or how you got that from my comments).


I did not mean to offend you. You originally quoted Fama as saying "ride it [i.e., the value premium] to the beach." That quote could be read as "go for it." The point I was trying to make was that Fama is not saying "go for it." I appreciate your providing additional context in your most recent post and explaining that you do not ascribe that view to Fama.

I do note that you asked if I had "any evidence to support [my] claim" that Fama does not advocate value tilting. I interpreted that to mean that you disagreed with my claim, which influenced my interpretation of your original post. (In fact, if you read the sequence carefully you will see that at first, I just said that others might misinterpret your quote. It was only after you asked me for evidence to back up my position that I assumed you actually took the opposing view.) I now understand that I was mistaken.

Edit: Could you provide a link to the article you mention in your most recent post? It sounds interesting and I would like to read it. Thank you.
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Postby ken250 » Wed Jan 02, 2008 12:41 am

Of course tilting toward Value and Small is a risk story, how else could an advisor "transfer the liability" for recommending something other than the "market". (I wonder if FINRA is looking into 50% vs 25% Int'l stock allocations? Commodities?)

After 5 years of posting about "FF's" data-biasing in one of their "landmark papers" that was supposed to prove the VP was a risk story, there's still not been a response. :(

Anybody interested in the VP needs to supplement their "FF" perspective, you really should be examing the VP from numerous perspective.....if you don't you're fooling yourself.
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Postby ken250 » Wed Jan 02, 2008 1:20 am

re REITs...

I took a bath this year to the tune of 16.5%.........and I love it!

I'm seeing future REIT purchases as being relatively cheap, and all those additional shares will generate additional income when I retire.

The diversification benefits are a plus for all investors in REITs, but one might not want to be investing in them for growth.

I'm currently at 10% directly invested in VGSIX, slightly higher if my other funds have REIT exposure. By the time I retire I may be as high as 20% in REITs.
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Postby Milo » Wed Jan 02, 2008 5:04 am

Currently all of my mutual funds are actively managed funds in a taxable account. I'm in the process of converting to Taylor's Thrifty Three:

50% Total Stock Market
25% FTSE All-World Ex-US
25% Total Bond Market

Would it be better if I just took the plunge and converted all at once or spread it out over the next six months to a year?

Happy New Year to all!!!

Milo
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Postby zigkelton » Wed Jan 02, 2008 8:55 am

Milo wrote:Would it be better if I just took the plunge and converted all at once or spread it out over the next six months to a year?

There are some references in other threads I can not find just now, but basically, over the last several decades the entry price has been better 66% of the time when investing an amount all at once in a Stock fund, while investing over time has resulted in a better price about 34% of the time. (I do not remember ever seeing or analyzing the same choice for a Bond fund.)

The 34% of the time that it was better to invest over time (vs. all at once) was during prolonged Bear markets.

Of course, another consideration will be how to handle taxes given your current funds are in taxable accounts .

Good luck! :D
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Postby Michael Weiss » Wed Jan 02, 2008 9:32 am

Eric wrote:
[Fama Sr. has said very clearly (e.g., here) that he does not agree with the "behavorial" story. Now, Fama could be wrong -- my point was just that posters shouldn't say he supports this position, because he doesn't. (Interestingly, the article I linked above indicates that Fama's partner, French, does think there's some mispricing. But Fama says explicitly that he disagrees.)


This comment below is more closely related to one of your previous comments.

As far as advocating value tilting is concerned, we are dealing with semantics. It is obvious that Fama is a proponent of value and small investing. He along with his partner French helped build and sit on the board of DFA, which was partly founded to take advantage of the small value premium. Whether Fama actually suggests that individual investors employ a value tilt is irrelevant, as his work is research oriented and is not geared towards the individual investor.

MW
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Postby Xia » Wed Jan 02, 2008 9:36 am

Hi Rick,
Would I be correct in concluding from this discussion that your 'Core Four' would be appropriate for a taxable account?

I apologize for asking such a stupid question, or if it was already addressed previously, but I’m a greenhorn and am not yet savvy enough to recognize tax efficient funds on my own. However, I’m in my mid-40’s, recently retired (against my will) and ~93.5% of my investments are in taxable. So I am very concerned about costs and tax efficiency and am looking for a good basic allocation to start with (and perhaps stay with for the long term) while I learn more.

Thank you,
Xia
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Postby Rick Ferri » Wed Jan 02, 2008 10:02 am

Xia,

If you are in the high tax bracket, REITs and the Total Bond Market Index Fund are not tax savvy investments in a taxable account. They would go into a non-taxable account if you have one.

If you have only taxable money to invest, then I would recommend Taylor's Thrifty Three portfolio as your core and substitute the Vanguard Intermediate-Term Tax-Exempt Fund Admiral Shares (VWIUX - fee 0.08%) for the Total Bond Market Index Fund.

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Postby Eric » Wed Jan 02, 2008 10:22 am

Michael Weiss wrote:It is obvious that Fama is a proponent of value and small investing. He along with his partner French helped build and sit on the board of DFA, which was partly founded to take advantage of the small value premium.


I do think there's a tension in Fama's position -- he has said that he does not advocate value tilting (generally), yet he is also associated with DFA. But I don't think the tension is as great as you suggest. Certainly, Fama would agree that value-tilting is appropriate for some investors, and if DFA wants to exploit that market niche, why shouldn't he help?

Michael Weiss wrote:Whether Fama actually suggests that individual investors employ a value tilt is irrelevant, as his work is research oriented and is not geared towards the individual investor.


Actually, we're not far apart here. I wouldn't go so far as to say that Fama's opinion is "irrelevant," but investors are certainly free to draw different conclusions than he does from his underlying research. Still, it's interesting that the person who knows Fama's research best -- Fama himself -- doesn't advocate value-tilting, at least not as a general proposition.
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