The prudent way to increase expected returns

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larryswedroe
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The prudent way to increase expected returns

Post by larryswedroe » Thu Mar 14, 2013 8:48 am

http://www.cbsnews.com/8301-505123_162- ... d-returns/

Low interest rates are "forcing" investors to take on more risk to achieve their goals. What's the best way to prudently accomplish that objective today?

Hope this of interest
Larry

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MickeyBoy
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Re: The prudent way to increase expected returns

Post by MickeyBoy » Thu Mar 14, 2013 10:26 am

Thanks, Larry, for the great tips on what to do and not to do in this really tough investing climate. What would we all do without your columns and books? I for one would be in a worse place. Just a note of true appreciation from a fellow Missourian.

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Re: The prudent way to increase expected returns

Post by pauliec84 » Thu Mar 14, 2013 10:47 am

Larry.

Nice article.

Two questions:

1) Why did you use the European Market and not EAFE Market in your chart of valuation ratios? It raises an unnecessary question mark.

2) How high would you go with international weighting. I am at 50%, but even that is underweight market portfolio. So if you were going to truly tilt towards international you would really need something on the order of 70%.

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midareff
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Re: The prudent way to increase expected returns

Post by midareff » Thu Mar 14, 2013 11:03 am

Very interesting and helpful article Larry. I have a 4% of portfolio position in commodities (PCRIX) I intend to replace in early April and was considering VYM, the High Dividend Yielding ETF. Looks like from a dividend production perspective, which is what I am looking for (retired) I may have to rethink that since they are roughly equal (VYM and International), and instead expand my 10% of portfolio position in VG Total International (which is about 25% Emerging) and International Small.

Food to chew on.
Last edited by midareff on Thu Mar 14, 2013 11:23 am, edited 1 time in total.

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grayfox
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Re: The prudent way to increase expected returns

Post by grayfox » Thu Mar 14, 2013 11:21 am

Image
from http://www.businessinsider.com/jim-onei ... ain-2013-3

U.S. stocks earnings yield 4.24%
International looks like about 7% ?
Europe looks like about 9% ?

It looks like it might be a good time to tilt towards foreign stocks.
The foreign stocks have higher expected returns probably because they are perceived as being riskier.

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midareff
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Re: The prudent way to increase expected returns

Post by midareff » Thu Mar 14, 2013 11:40 am

That looks rather convincing Greyfox. ... coupled with the higher dividend return than domestic, potentially higher overall returns and asset class simplification it makes a good argument.

assumer
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Re: The prudent way to increase expected returns

Post by assumer » Thu Mar 14, 2013 12:00 pm

Very interesting; I always enjoy reading your articles!

Unsure if you're able to edit your posted article, but I think there was a minor typo: "shift some of the allocation from domestic stocks to international stocks". Don't mean to be a jerk, just constructive :D

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Re: The prudent way to increase expected returns

Post by larryswedroe » Thu Mar 14, 2013 12:23 pm

Assumer,

Glad you found it helpful.

Greyfox
Thanks for posting. Wonder if there is a site that keeps it updated?

midareff
Personally see no reason to own a high dividend fund. That's just a poor man's value strategy, with lower historical and expected returns. Don't make the mistake of managing portfolio based on cash flow--instead use a total return approach. What you should prefer is low P/B or Low P/E, not high dividend. Finally the commodities fund does provide you with a hedge against the risks of unexpected inflation. So keep that in mind. With that fund you can take a bit more duration risk on the bond side. Sell that, and I would consider shortening the bond duration some. At least be aware of that. That's one of the advantages of owning CCF that is often missed because people make mistake of thinking in isolation. So far we've never had a year of negative CCF and negative bond returns (doesn't mean it cannot happen of course).

Paulie
I just happen to choose the Europe fund (European news is so bad that investors seem to be avoiding it, recency and stage one thinking problems) but also showed the total international
I personally prefer 50%, bit higher US weighting than global market cap but that is to compensate for bit higher trading and fund costs. Personally think should be at least 40%. But the right answer is the % you can stick with when international is underperforming.

I hope that is helpful

Best wishes
Larry

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Re: The prudent way to increase expected returns

Post by assumer » Thu Mar 14, 2013 12:30 pm

Question. You said,
The latter increases your exposure to global systematic risks, while the former doesn't.
Wouldn't this be reflected in the standard deviation? Doesn't the fact that the 50/50 domestic, international result has a higher EV and lower std. reflect that it somewhat is a free lunch, due to the higher sharpe ratio? At least for the past 40 years.

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Re: The prudent way to increase expected returns

Post by The Wizard » Thu Mar 14, 2013 12:38 pm

International stocks tend to be more VOLATILE than domestic stocks, from what I've seen. I'm pretty sure I'm right about this even though I don't have a reference right at hand to prove it.
So I'm afraid that some (non-boglehead) folks that read this Moneywatch article will toss a chunk of cash into international and later jump out when it has a correction. So there should be a CAVEAT for the Nervous Nellies out there...
Attempted new signature...

assumer
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Re: The prudent way to increase expected returns

Post by assumer » Thu Mar 14, 2013 12:44 pm

The Wizard wrote:International stocks tend to be more VOLATILE than domestic stocks, from what I've seen. I'm pretty sure I'm right about this even though I don't have a reference right at hand to prove it.
Volatile, defined as a higher variance (standard deviation)? Larry put that data in the article for some indices, if that's what you're referring to.

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Re: The prudent way to increase expected returns

Post by The Wizard » Thu Mar 14, 2013 12:59 pm

assumer wrote:
The Wizard wrote:International stocks tend to be more VOLATILE than domestic stocks, from what I've seen. I'm pretty sure I'm right about this even though I don't have a reference right at hand to prove it.
Volatile, defined as a higher variance (standard deviation)? Larry put that data in the article for some indices, if that's what you're referring to.
Yes he does; I revisited the link and found what you mentioned.
So the point remains: investors need training to manage their stock allocations properly to benefit from a decent percentage in international index funds...
Attempted new signature...

assumer
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Re: The prudent way to increase expected returns

Post by assumer » Thu Mar 14, 2013 1:08 pm

The Wizard wrote:So the point remains: investors need training to manage their stock allocations properly to benefit from a decent percentage in international index funds...
I agree. Now one thing I would be very interested in would be data (EV and standard deviation) for different domestic / international splits. Larry showed the usefulness of a 50/50 split (higher EV, lower std.) and some solid data about how that changes with different %'s would be useful.

For lack of better data, I've stuck with the domestic / international split that vanguard uses in their target retirement funds (I think it's 27% international) but perhaps a higher international percentage may yield some better performance.

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midareff
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Re: The prudent way to increase expected returns

Post by midareff » Thu Mar 14, 2013 1:56 pm

Thanks for the input Larry.

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Re: The prudent way to increase expected returns

Post by larryswedroe » Thu Mar 14, 2013 1:58 pm

few thoughts

First, international funds will in ISOLATION likely have higher SD due to addition of currency volatility. Now you can hedge that risk (some funds do) but that increases the correlation of returns, reducing the diversification benefit!!

Second, there are several studies on international percentage as optimal. I've cited them in my books. But they all are looking backwards of course. They tend to show something like benefits increase dramatically when you start from low level and even moving above 20%. Then still add value when moving up towards 40% or more. But I would not put too much weight on that. To me the logical starting point is global market cap weighting. Then tilt more or less from there based on issues like your exposure to risks and how much TE you can take. I address all these issues in The Only Guide You'll Ever Need for the Right Financial Plan

Hope that helps
Larry

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Re: The prudent way to increase expected returns

Post by goldendad » Thu Mar 14, 2013 2:10 pm

For the last 2 years I have been using about 20% of my bond allocation capital to sell covered calls on very conservative low p/e large cap stocks. My goal was to earn 8% per year selling just out of the money 6 month calls. So far I have been earning around 10 - 12% per year without a lot of time involved. I only use stocks I am willing to hold for the long term.

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Re: The prudent way to increase expected returns

Post by rmelvey » Thu Mar 14, 2013 2:15 pm

goldendad wrote:For the last 2 years I have been using about 20% of my bond allocation capital to sell covered calls on very conservative low p/e large cap stocks. My goal was to earn 8% per year selling just out of the money 6 month calls. So far I have been earning around 10 - 12% per year without a lot of time involved. I only use stocks I am willing to hold for the long term.
LOL do you sell a newsletter too? I am not sure what this has to do with increasing expected returns through international investing...

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Re: The prudent way to increase expected returns

Post by larryswedroe » Thu Mar 14, 2013 2:23 pm

goldendad

You might want to see my section on covered calls in The Only Guide You'll Ever Need for the Right Financial Plan

One problem I have with them is that using them cuts off the wrong tail (right one), while only reducing the risk of the left tail only by the amount of the premium. If want to improve efficiency IMO superior way to achieve that objective is to simply tilt more to SV and lower equity allocation. That way you cut the left tail and historically by a lot more than you cut the right tail

Best wishes
Larry

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Re: The prudent way to increase expected returns

Post by letsgobobby » Thu Mar 14, 2013 2:29 pm

Due to the recent outperformance of US stocks, the CAPE data from grayfox, and my general desire to be more tilted to small/value than I was in the international space, I rebalanced today out of VTI into VSS in a Roth IRA. From 37.5 to now 40% international, and I suppose this is probably 'deviating from my IPS' but I can live with it, moving opposite the direction recency bias would normally cause.

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grap0013
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Re: The prudent way to increase expected returns

Post by grap0013 » Thu Mar 14, 2013 3:01 pm

^

I like that move bobby. I think you might as well go to 50% international and then you can thank me in 10 years on here for those 50 extra basis points annualized. :wink:
There are no guarantees, only probabilities.

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Re: The prudent way to increase expected returns

Post by Levett » Thu Mar 14, 2013 3:31 pm

This strikes me as a central assumption of the piece:

"If you need to generate more expected return and currently have a low allocation to international stocks, increasing your allocation to the stocks of both international developed markets and emerging markets will provide you not only with more diversification of economic and political risks, but also with a higher expected return for your portfolio."

I take it, therefore (I mean this in a friendly way), that if one doesn't "need to generate more expected return," then it makes perfect sense to carry on with your present plan.

Lev

Note: I introduced the underlining to the above quote.

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Re: The prudent way to increase expected returns

Post by letsgobobby » Thu Mar 14, 2013 4:08 pm

grap0013 wrote:^

I like that move bobby. I think you might as well go to 50% international and then you can thank me in 10 years on here for those 50 extra basis points annualized. :wink:
I am strongly considering exactly this move. I accomplished 1/5 of it today. Can I also come back and blame you if the expected return doesn't materialize?

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Re: The prudent way to increase expected returns

Post by grap0013 » Thu Mar 14, 2013 4:13 pm

letsgobobby wrote:
grap0013 wrote:^

I like that move bobby. I think you might as well go to 50% international and then you can thank me in 10 years on here for those 50 extra basis points annualized. :wink:
I am strongly considering exactly this move. I accomplished 1/5 of it today. Can I also come back and blame you if the expected return doesn't materialize?
Sure you can. I will then proceed to tell you to just give it a couple more years... :sharebeer
There are no guarantees, only probabilities.

larryswedroe
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Re: The prudent way to increase expected returns

Post by larryswedroe » Thu Mar 14, 2013 5:23 pm

Lev
I would think of it another way, if you don't need more return than why not lower your equity allocation and also make the change, that would cut your tail risk while keeping the expected return the same!!!
Larry

allocator
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Re: The prudent way to increase expected returns

Post by allocator » Mon Mar 18, 2013 12:03 am

Larry,

First, I am utterly indebted and very grateful to you for improving the financial life of my family.

Conceptually, I'm with you with respect to increasing the riskiness of the equity portion of a portfolio (in the hope of achieving higher expected returns in that portion of the portfolio), while increasing bond exposure and, thereby, cutting "tail risk." The appeal of such an approach is obvious, especially as one nears retirement targets.
Lev
I would think of it another way, if you don't need more return than why not lower your equity allocation and also make the change, that would cut your tail risk while keeping the expected return the same!!!
Larry


What is less clear to me is how an investor - without a background in finance or statistics - can gauge how much to dial back equity exposure for a given level of additional risk - for example, adding a given % of Emerging Markets or Small Value stocks to pure beta exposure (i.e., "tilting"). Is there a "back of the envelope" (or napkin, a la Carl Richards) method for doing this kind of calculation?


Thanks!

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Re: The prudent way to increase expected returns

Post by ofcmetz » Mon Mar 18, 2013 8:15 am

Thanks for the input Larry. I enjoyed your article as well as the ensuing conversation about it. I've been at 30% international for some time, and while I plan on staying there I definitely understand the arguments for increasing the international allocation.
Never underestimate the power of the force of low cost index funds.

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Re: The prudent way to increase expected returns

Post by larryswedroe » Mon Mar 18, 2013 8:58 am

Allocator
You of course have to make assumptions about expected returns, but you need to do that anyway to determine your AA in first place.

So consider the example of expected returns of say 7% for stocks and 2% for bonds. And now assume 50/50, your expected return is 4.5%. But say your stocks are not TSM but SV. And let's assume given your choice of an SV you think it will outperform TSM by 3%. That means the equity portion will have an expected return of 10%. So to get to the same 4.5% return you just solve the equation for what percentage equities you need to hold.


Hope that helps

Larry

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Re: The prudent way to increase expected returns

Post by allocator » Mon Mar 18, 2013 9:18 am

Great - thanks, Larry.

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Re: The prudent way to increase expected returns

Post by allocator » Mon Mar 18, 2013 2:00 pm

Larry,

Thank you again for your response to my question. As I began to work on my calculations, it occurred to me that expected returns for various asset classes would be based on Fama/French research using their criteria for large, small and value. As the instruments available to most investors on this board (e.g., for small US value: VBR, IJS, RZV) differ from one another with respect to construction, and they certainly differ from DFA funds, how might our "back of the envelope" calculations change based on the fund/ETF we choose? I know we are getting into factor-load territory here, but my question really is, how important is a precise factor-load measurement in making asset allocation decisions? Are these "apples to apples" comparisons?

Again, many, many thanks.

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Re: The prudent way to increase expected returns

Post by yukon50 » Sat May 25, 2013 4:35 am

pauliec84 wrote:Larry.

Nice article.

Two questions:

1) Why did you use the European Market and not EAFE Market in your chart of valuation ratios? It raises an unnecessary question mark.

2) How high would you go with international weighting. I am at 50%, but even that is underweight market portfolio. So if you were going to truly tilt towards international you would really need something on the order of 70%.

I wonder this too. If one wants to tilt, would it need to be around 70%?

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Re: The prudent way to increase expected returns

Post by larryswedroe » Sat May 25, 2013 9:24 am

yukon
I used Europe only because investors seem to want to avoid it now --recency--same result with EAFE,
I personally recommend 50% international,
Should have some home country bias due to bit higher costs and less tax efficiency overseas
Larry

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Re: The prudent way to increase expected returns

Post by ge1 » Sat May 25, 2013 12:39 pm

Thanks Larry for your continued great contributions to this forum.

I'm curious what sort of earnings number is being used to calculate the US P/E ratio? I believe trailing reported earnings for the S&P are around 90, which would give me a P/e ratio of approx 18 and not 13?

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