One Total Market Index Fund vs Three Different Cap Index Fund

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
Amy2017
Posts: 38
Joined: Wed Oct 11, 2017 12:02 pm

One Total Market Index Fund vs Three Different Cap Index Fund

Post by Amy2017 » Thu Oct 19, 2017 11:50 pm

Hi,

I see one Total Market index fund recommended a lot here. In the past I have always invested in three different US stock index funds (large cap 30%, mid cap 20%, and small-cap 20%) plus 20% Total International Index fund and 10% Total Bond Index fund. The money (around 1 million) is in either 401K or Roth IRA accounts. Then I rebalance them once a year usually at the beginning of the year. I like the idea of the simplicity of one Total Market index fund, but somehow I am not totally convinced it is better than holding three US Stock index funds separately.

I am a real estate investor and usually don't spend much time on analyzing stocks or markets. My logic for separating them is that it forces me to sell high buy low during the yearly rebalancing. If I only had Total Market index fund in my portfolio, there was only buying, no selling. Then I read the article below and it seems supporting my reasoning. I am definitely not an experienced stock investor. So maybe some of the smart people here could point out what is wrong with my logic?

https://www.financial-planning.com/news ... ndex-funds

Thanks.

avalpert
Posts: 6197
Joined: Sat Mar 22, 2008 4:58 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by avalpert » Fri Oct 20, 2017 12:00 am

You have a decent tilt to the small risk factor - you should have higher expected returns and higher risk with that portfolio. Whether that additional risk is appropriate for your needs I couldn't tell you.

The notion that rebalancing leads to 'buying low and selling high' is mostly mythology - for the most part when you rebalance your stock heavy portfolio you are selling high and buying high.

lack_ey
Posts: 5715
Joined: Wed Nov 19, 2014 11:55 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by lack_ey » Fri Oct 20, 2017 12:08 am

There's two potential effects:

1. long-term (average) overweighting of smaller stocks relative to the larger stocks
2. rebalancing bonus from buying low and selling high—rebalancing back to fixed percentages results in dynamic overweighting and underweighting relative to market cap weights, with overweight when an asset is lower and underweight when it is higher

First of all, #2 doesn't generally add any returns unless there's some mean reversion of relative returns. Or actually, it's kind of complicated as large cap vs. small cap weights change from more than just relative performance (and furthermore, dividends are part of returns, but it's price action that moves the relative weightings) because new issuance / buybacks / mergers / acquisitions / etc. can change weightings too. Anyway, the point is that this effect is not really that strong, and you're not so much reliably profiting from some kind of buy low, sell high scheme. The question to ask yourself is how strongly you think that you gain from rebalancing back to a fixed percentage (away from the market weights) and why. There are plenty of previous threads about this and some discussions.

As for #1, historically small caps have had somewhat higher returns in many markets, though burstily (doesn't show up every decade or in a lot of periods examined). That's with higher risk and volatility. The past 18 years were relatively strong for small caps and mid caps compared to large caps (remember in 1999 the largest tech stocks were just about to fall back to earth). Run the analysis over some other period and you won't see as much. You can find many mentions of the Fama-French three-factor model, the so-called size effect (or small minus big), and so on. This is well known and discussed.

The author for whatever reason decomposes the total market into 70% S&P 500, 20% Vanguard's mid-cap index fund (which has actually changed over time in which index it follows), and 10% Vanguard's small-cap index fund. That actually overweights the latter two. Currently the S&P 500 is closer to 80% of the total market, though that figure has varied over time. Anyway, that discrepancy is definitely showing up in the analysis.

Also keep in mind the expense ratios have changed over the last 18 years.

Amy2017
Posts: 38
Joined: Wed Oct 11, 2017 12:02 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by Amy2017 » Fri Oct 20, 2017 7:35 am

avalpert wrote:
Fri Oct 20, 2017 12:00 am
The notion that rebalancing leads to 'buying low and selling high' is mostly mythology - for the most part when you rebalance your stock heavy portfolio you are selling high and buying high.
In my case it is actually buying less high and buying more low or at least that is my intention since I don't usually sell. But I am not sure why it is considered a mythology. That was the main motivation that got me into asset allocation several years ago. I know there may be some theories and discussions about this topic. But frankly many of them are over my head. Or only time could tell whether this approach makes sense or not? My husband and I are in our late forty early fifty. I don't see we need the money in our retirement accounts in the near future until maybe RMD kicks in. So I do have time.

Thanks.

avalpert
Posts: 6197
Joined: Sat Mar 22, 2008 4:58 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by avalpert » Fri Oct 20, 2017 8:38 am

Amy2017 wrote:
Fri Oct 20, 2017 7:35 am
avalpert wrote:
Fri Oct 20, 2017 12:00 am
The notion that rebalancing leads to 'buying low and selling high' is mostly mythology - for the most part when you rebalance your stock heavy portfolio you are selling high and buying high.
In my case it is actually buying less high and buying more low or at least that is my intention since I don't usually sell. But I am not sure why it is considered a mythology. That was the main motivation that got me into asset allocation several years ago.
The reason it is mythology is because the equity asset classes are highly correlated and tend to be going up/down at the same time - so what throws your asset allocation out of whack is that one class is going up more/less than the others. So you aren't buying one that is down and selling one that is up you are selling one that is up and buying one that is up by a bit less.

Amy2017
Posts: 38
Joined: Wed Oct 11, 2017 12:02 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by Amy2017 » Fri Oct 20, 2017 9:22 am

But if you look at the data provided by the above article, it seems we did have some years in the past that one cap's return was positive, but the other cap was negative, or one cap performed much better than the other cap. Even buying more of less up one and buying less of up more ones sounds logic to me. If I rebalance every year, it should have a dollar average effect on a yearly basis. Does it? Or in the end dollar average does not really matter? If that is the case, could someone point to an article confirming this one way or the other? I tried to google online, but could not find definite answers.

Thanks.

User avatar
nisiprius
Advisory Board
Posts: 34162
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by nisiprius » Fri Oct 20, 2017 9:43 am

What you're doing is reasonable. You should probably not change it in a hurry if you're happy with it. I'm a "total market" type myself.

"What rebalancing really does for you" is a frequently discussed topic around here. Nobody is ever going to agree. Let me quickly lay out some of the "sides" in the perpetual debate. In each case, I'm putting an asterisk next to the one I personally believe in. But it's always a "might be something to it, then again maybe not, depends on what time period you're looking at, is risk being taken into account, is the person writing an interested party" kind of thing.

1a) Rebalancing actually manufactures extra return, a "rebalancing bonus," out of pure volatility. It is a magic formula that automatically ensures that you buy low, sell high.
1b) There is only a rebalancing bonus if the assets involved show mean reversion, and if the rebalancing interval is comparable to the time period over which there is mean reversion.
1c) *Any "rebalancing bonus" is elusive and unprovable. Rebalance occasionally if your portfolio is so far from your target allocation that you are taking more risk than you mean to.

2a) *A single, cap-weighted, total market index fund is about as good as it gets. Nothing else is provably better and you might as well keep it simple.
2b) You can improve a portfolio by departing from cap-weighting. Some strategies that claim to do this are called "fundamental indexing" and "smart beta." Another set of strategies, sometimes called "slice-and-dice" here in the forum, or "factor-based portfolios," uses a set of multiple index funds, each of which concentrates on a specific factor, to do something called "diversifying across risk factors." These strategies are vital, important, essential, and you are making a terrible, terrible mistake that will ruin the lives of you and your family if you don't adopt them.

Your own portfolio is a simple example of "slice-and-dice." You have chosen to overweight mid-caps and small-caps. Craig Israelsen is very clearly a member of the "slice-and-dice" school. Please note that he is also connected with a portfolio he's developed which he calls the "7Twelve Portfolio" and sells materials on how to invest that way. The last time I checked, there was no way to find out the exact composition of the 7Twelve Portfolio without paying him $195.

I don't much like the article you quoted, and one of the things I particularly dislike is that while he doesn't completely hide "risk," he dances around it. At a first glance, whenever you read about some portfolio with higher return, you should ask "but does it have higher risk-adjusted return?" A second one is, whenever someone shows results over some time period--in this case, 1999 through 2016 inclusive, "does he ever state any reason, any reason whatsoever, for choosing that particular time period?"

Let me take a deep breath before going on with a second posting...
Last edited by nisiprius on Fri Oct 20, 2017 10:26 am, edited 1 time in total.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

User avatar
nisiprius
Advisory Board
Posts: 34162
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by nisiprius » Fri Oct 20, 2017 10:14 am

So, let's use a tool I've gotten very fond of to compare the past behavior of your chosen portfolio and see how it would have been different if you'd used a total market fund instead of your three-way slice and dice. It's a no-cost web tool and whenever I've done any cross-checking it seems reliable. It's called "PortfolioVisualizer" and you can get to it by clicking on the "Source" link below.

I haven't looked at it yet. My "prediction" is that it will turn out that, over whatever is the maximum time period for which PortfolioVisualizer has data, and that the risk-adjusted return will vary less than the overall return. That is, what I expect to see is a bit more return and a bit more risk for your three-way slice. If I'm totally wrong, I'm still going to post the results.

You said "(large cap 30%, mid cap 20%, and small-cap 20%) plus 20% Total International Index fund and 10% Total Bond Index fund)" I'll use the obvious Vanguard index funds for the first three.

So, Portfolio 1, blue, is like yours with the three-way slice-and-dice, to overweight smaller-cap stocks ("load on the size factor," the cognoscenti say).
VLACX Vanguard Large Cap Index Investor 30.00%
VIMSX Vanguard Mid Cap Index Investor 20.00%
NAESX Vanguard Small Cap Index Inv 20.00%
VGTSX Vanguard Total Intl Stock Index Inv 20.00%
VBMFX Vanguard Total Bond Market Index Inv 10.00%

Portfolio 2, red, is the same except that we've replaced VLACX, VIMSX, NAESX with 70% VTSMX, Vanguard Total Stock Market index fund (cap-weighted).

The period of time was chosen by PortfolioVisualizer based on all available data for the funds I chose: "Portfolio Analysis Results (Jan 2005 - Sep 2017) The time period was automatically adjusted based on the available data (Feb 2004 - Sep 2017) for the selected asset: Vanguard Large Cap Index Investor (VLACX)."

Oh, the default is "annual rebalancing," and I didn't change it.

Here's a link to the website so you can play with the numbers yourself:
Source

Before reading my (possibly biased!) interpretation, take a few minutes to look at the curves and the numbers. Remember, blue is yours, red is the result of settling for a total market fund. Look at the "standard deviation" and the "Sharpe ratio."

Image

My observations and my own spin. Remember, financial data is wildly variable and people like to make a big deal over differences that might matter if they persisted over the next thirty years--but probably won't.
  • There isn't a heck of a lot of difference. It's not like the differences you would get from making even a small change in stock/bond allocations, for example.
  • Yes, your three-way slice-and-dice would have had a higher return over that particular time period. $26,191 instead of $25,343. An annualized average of 7.84% versus 7.57%. In my opinion... a tiny difference.
  • BUT: the standard deviation, a measure of volatility or fluctuation or one kind of risk, was higher, too, 14.06% versus 13.16%. In my opinion... a tiny difference.
  • Because the standard deviation was higher, the Sharpe ratio, which is one possible measure of risk-adjusted return, was exactly the same (to within roundoff error). So, as measured by the Sharpe ratio, the slightly higher return over that time period wasn't a free lunch. It was just compensation for taking slightly more risk.
I am not giving advice or trying to convince you to do anything. What I'm trying to show here is that contrary to the impression you may have gotten, 1) it wouldn't have made very much difference on way or the other, and 2) it is very easy to be distracted by a higher return and not notice that it is just the result of a taking a bit more risk.

Notice that "not much difference" cuts both ways. It doesn't mean "it doesn't matter much, so switch." It could also means "it doesn't matter much, so stay put."

The Bogleheads investment philosophy includes "the majesty of simplicity." The reason for advocating a cap-weight total market fund is not that it's necessarily better. It's that you really can't tell so you might as well keep it simple and keep costs down. Bogle wrote:
When All Else Fails, Fall Back on Simplicity.

There are an infinite number of strategies worse than this one: Commit, over a period of a few years, half of your assets to a stock index fund and half to a bond index fund. Ignore interim fluctuations in their net asset values. Hold your positions for as long as you live, subject only to infrequent and marginal adjustments as your circumstances change. When there are multiple solutions to a problem, choose the simplest one.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

pkcrafter
Posts: 12114
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by pkcrafter » Fri Oct 20, 2017 11:03 am

Amy, I don't see anything wrong with your portfolio, but what you are really doing is "tilting", not approximating total market.

Your investments in total stock market are 30% large, 20% mid and 20% small, total equaling 70%. If we look at these holdings as 100% we get (rounded)

43% large
28.5% mid
28.5% small

The total market is very close to:

70% large
20% mid
10% small

So, you are somewhat overweight in mid and heavily overweight (almost 3x) in small.

You may discover that small outperforms :happy , and then again you may discover that small underperforms for 5-6-7 years in a row, thus bringing down returns vs total market. :( Lots of investors don't like that and they sell off small, but because it isn't always cooperative is one of the major reasons why there is a small cap premium in the first place.

I'm waiting for Nisiprius' next post on risk. I think he will report that your portfolio has more risk than TSM, therefore the "expected" return should be somewhat higher. My conclusion is it's fine to hold your portfolio as long as you can handle some periods that don't outperform the total market fund.

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.

Amy2017
Posts: 38
Joined: Wed Oct 11, 2017 12:02 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by Amy2017 » Fri Oct 20, 2017 11:37 am

Hi,

Thanks a lot for the analysis. The Portfolio Visualizer is really cool. I must admit that I have never done this kind of analysis before and always put my faith in other people's calculation. :) Since I contribute around $20000 each year to my 401K and Roth IRA, I tweaked the results a little bit. I also added a Portfolio 3 that has 100% Total Market Index Fund, no Bond or International stocks. Below is the link.

https://www.portfoliovisualizer.com/bac ... ion6_3=100

I agree with Nisiprius that based on this chart, portfolio 1 and 2 are not significantly different during the selected time period. However, if I draw this conclusion based solely on this chart, could I also draw the second conclusion that we should buy US stock fund 100%, not holding any bond or international stocks? The return from portfolio 3 seems significantly more than the other 2. If not, please explain why?

I do have high tolerance of risk because I usually don't pay much attention to the market until it is time to rebalance. So if higher risk means higher reward in the long run, I have no problem. But if higher risk means the same reward in the end, then I might as well take the easy road.

Thanks.

avalpert
Posts: 6197
Joined: Sat Mar 22, 2008 4:58 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by avalpert » Fri Oct 20, 2017 12:03 pm

Amy2017 wrote:
Fri Oct 20, 2017 11:37 am
Hi,

Thanks a lot for the analysis. The Portfolio Visualizer is really cool. I must admit that I have never done this kind of analysis before and always put my faith in other people's calculation. :) Since I contribute around $20000 each year to my 401K and Roth IRA, I tweaked the results a little bit. I also added a Portfolio 3 that has 100% Total Market Index Fund, no Bond or International stocks. Below is the link.

https://www.portfoliovisualizer.com/bac ... ion6_3=100

I agree with Nisiprius that based on this chart, portfolio 1 and 2 are not significantly different during the selected time period. However, if I draw this conclusion based solely on this chart, could I also draw the second conclusion that we should buy US stock fund 100%, not holding any bond or international stocks? The return from portfolio 3 seems significantly more than the other 2. If not, please explain why?
You can conclude you should have been 100% in US in that time frame (or to be more precise you could break it down by year/month/day/minute and identify what you should have been all in on in a given moment) - you cannot conclude what you should be in going forward because past recent trends are not predictive of the future.
So if higher risk means higher reward in the long run, I have no problem. But if higher risk means the same reward in the end, then I might as well take the easy road.
Higher risk might mean higher reward in the long run - it might not, if it was certain it wouldn't be a risk.

Amy2017
Posts: 38
Joined: Wed Oct 11, 2017 12:02 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by Amy2017 » Fri Oct 20, 2017 12:27 pm

So in this case, you think the first conclusion is valid, but the second conclusion is invalid even thought all data comes from the same period. Does that sound like a little cherry picking? Sorry I don't mean to offend anyone. I just want to be a more educated investor once a while. I try to convince myself why I should invest certain way instead of the other way. After that, I may not take a deep look of my portfolios for years.

Some of you mentioned that as long as I am happy with my current portfolios, I could just continue. But I feel really embarrassed to say that I am not really sure whether I should be happy or not. Even though I know I make substantial money out of the stocks during the last 20 years, I don't know the exact amount, let alone comparing that number to the popular benchmark such as S & P 500. With the company stock matching, changing brokerage firms, varying contribution limits, keeping track of it has been a losing battle for me. However, I figure if my investing strategy is sound, then this may not matter.

Thanks.
Last edited by Amy2017 on Fri Oct 20, 2017 12:47 pm, edited 1 time in total.

avalpert
Posts: 6197
Joined: Sat Mar 22, 2008 4:58 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by avalpert » Fri Oct 20, 2017 12:33 pm

Amy2017 wrote:
Fri Oct 20, 2017 12:27 pm
So in this case, you think the first conclusion is valid, but the second conclusion is invalid even thought all data comes from the same period. Does that sound like a little cherry picking? Sorry I don't mean to offend anyone. I just want to be a more educated investor once a while. I try to convince myself why I should invest certain way instead of the other way. After that, I may not take a deep look of my portfolios for years.

Thanks.
Your first conclusion was that during that period their was minimal difference between the portfolio - it drew no conclusion about future periods. You cannot draw any conclusions about future returns just by looking at past results - you need a theoretical framework of what underlies expected performance and assumptions about how that ought to play in the future (within whatever confidence interval you are comfortable with).

If your intent is not constantly try to adjust your portfolio you are probably best served with a well diversified broad mix that includes US/International equities as well as the amount of bonds you want to tamper volatility.

User avatar
rustymutt
Posts: 3646
Joined: Sat Mar 07, 2009 12:03 pm
Location: Oklahoma

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by rustymutt » Fri Oct 20, 2017 12:34 pm

You might consider Vanguard's Balanced Fund with a 60/40 equities to bonds ratio. No rebalancing required is a huge benefit, if like to set it, and just forget it, as I do. I don't worry about the markets up's/down's turnarounds, rebounds, or junk in media circles.
Simply follow the academics studies, many with tout huge diversification, and broad indexes, all while keeping cost low.

Good Luck! That's my two bits worth.
Knowledge is knowing that the Tomato is a fruit. Wisdom is knowing better than to put the tomato in a fruit salad.

Amy2017
Posts: 38
Joined: Wed Oct 11, 2017 12:02 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by Amy2017 » Fri Oct 20, 2017 11:27 pm

Thank you so much for all the thoughtful advice. I am still new to this forum and happen to run into an old post on the risk tolerance topic today. If nothing else, this post has convinced me that I should invest in one total market index fund. I thought I have a high risk tolerance, but when reading through this thread, the panic was obvious even for a staying course believer. I remember my portfolio was down close to 50% at that time. Even though I did stay the course, I think it was mainly because I was very busy with my new born baby at the time. I guess when you are sleep deprived, the stock market is really an afterthought. If I am retired and have too much time, I am not sure I will be mentally tough enough to rebalance responsibly when the market crashes.

viewtopic.php?f=10&t=25126&hilit=I+can%27t+believe

User avatar
parsimony
Posts: 3
Joined: Tue Oct 24, 2017 3:26 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by parsimony » Tue Oct 24, 2017 3:53 pm

rustymutt wrote:
Fri Oct 20, 2017 12:34 pm
You might consider Vanguard's Balanced Fund with a 60/40 equities to bonds ratio. No rebalancing required is a huge benefit, if like to set it, and just forget it, as I do. I don't worry about the markets up's/down's turnarounds, rebounds, or junk in media circles.
Simply follow the academics studies, many with tout huge diversification, and broad indexes, all while keeping cost low.

Good Luck! That's my two bits worth.
Are you satisfied with the returns you've gotten from this approach? I am new to Vanguard funds, and this is an approach that I am currently considering. It seems so much more straightforward than even the "lazy" three and four fund portfolios.

Thanks!

User avatar
rustymutt
Posts: 3646
Joined: Sat Mar 07, 2009 12:03 pm
Location: Oklahoma

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by rustymutt » Fri Oct 27, 2017 1:34 pm

I am happy currently. Let's see in about 5 years how it's working out. I'm 8 years into retirement and averaging 8% annually.
And let me remind some of you to spend a little of what you've made. Enjoy it while you can. And now I don't even have to rebalance. Wow! I'm getting really lazy.
Knowledge is knowing that the Tomato is a fruit. Wisdom is knowing better than to put the tomato in a fruit salad.

FactualFran
Posts: 447
Joined: Sat Feb 21, 2015 2:29 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by FactualFran » Fri Oct 27, 2017 3:30 pm

There are likely a number of reasons why a portfolio of three market-size stock index funds have performed differently than a single total stock market index fund. Some other posts have mentioned that 30% large, 20% mid, 20% small differs from the large, mid, and small percentages within the single total stock market fund.

In addition, the total market index fund holds stock that are not in the combination of three funds mentioned. According to recent Vanguard web pages, the Total Stock Market holds 3623 stocks while the 500 Index, Mid-Cap Index, and Small-Cap Index funds combined hold 2285 stocks. The 2285 total counts the same stock multiple times. For example, Lam Research is in both the 500 Index fund and the Mid-Cap Index fund.

Amy2017
Posts: 38
Joined: Wed Oct 11, 2017 12:02 pm

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by Amy2017 » Fri Oct 27, 2017 4:03 pm

That makes sense. Thanks.

User avatar
ruralavalon
Posts: 11694
Joined: Sat Feb 02, 2008 10:29 am
Location: Illinois

Re: One Total Market Index Fund vs Three Different Cap Index Fund

Post by ruralavalon » Fri Oct 27, 2017 4:19 pm

From time to time I get investing ideas that seem like good ideas.

Some general principles I try to use are:

1) don't act right away, think about it for awhile;
2) generally prefer the simple (total market) over the complex;
3) collect actual historical facts, not opinions on the future;
4) small differences don't really matter;
3) don't strive for the most perfect portfolio or plan, I can never find that; and
6) make a decision and move on.

This leads to a lot of inactivity in our investment portfolio.
"Everything should be as simple as it is, but not simpler." - Albert Einstein | Wiki article link:Getting Started

Post Reply