The problem with a 3 fund portfolio

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dad2000
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Re: The problem with a 3 fund portfolio

Post by dad2000 » Sat Oct 12, 2013 5:04 pm

Perhaps this analogy is a bit too narrow, but I'll give it a shot because some of us are quantitative and may have counted cards in the past.

There are many blackjack counting systems. Some are very simple for a human to execute, with a very small decision table, and get you most of the theoretical advantage you can get from counting. There is also a perfect system, which makes the best probabilistic decision given any sequence at the table, and can only be perfectly executed by a computer. And there are several in between. The more complex the system, the more mistakes a human will make, and the more likely your error rate will exceed the incremental advantage given by the system.

None of these systems guarantee that you'll win on any given night. I've played thousands of hands at the tables and played various systems. In the end, I found that I won more with a simple system, without having to work nearly as hard. At least until I got barred :-(

In the end, a simple allocation to the broad asset classes are good enough to squeeze out most of the gain. I've had to slice and dice a little because of the ERs in my 401k, but my rebalancing efforts have basically been to steer my new contributions to bonds. It's quite easy, and I'm tracking as well as most of the lazy portfolios.

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JamesSFO
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Re: The problem with a 3 fund portfolio

Post by JamesSFO » Sat Oct 12, 2013 5:17 pm

tpm871 wrote:I agree with the OP, although I'd say that slice & dice isn't for everyone. If you don't want to spend a bit more time, don't have the risk tolerance to rebalance when it feels uncomfortable, and/or selling to rebalance puts you at a tax disadvantage (e.g., not much room in tax deferred space, not much capital losses to offset gains, high tax bracket) then the three fund approach may be better for you.
Your points seem to be ones for a more active style of portfolio setup/investing (not non-index, but just more active choices and discipline of portfolio maintenance) not an answer to the 3-fund portfolio having a problem or being too simple as raised by the OP.

I agree, there is POTENTIAL to over perform if you spend the time setting your regional weights manually, I'm not convinced that is a reason that the 3-fund portfolio is bad or problematic... Further, why not split up your US holdings by large/mid/small cap? Etc.

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ruralavalon
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Re: The problem with a 3 fund portfolio

Post by ruralavalon » Sat Oct 12, 2013 5:24 pm

dad2000 wrote:Perhaps this analogy is a bit too narrow, but I'll give it a shot . . .

. . . The more complex the system, the more mistakes a human will make, and the more likely your error rate will exceed the incremental advantage given by the system.

. . . . . In the end, I found that I won more with a simple system, without having to work nearly as hard.
. . . . .
Actually, a very good analogy. The questions become: (1) Is the extra anticipated reward worth the guaranteed extra effort?; and (2) Might the simpler less error-prone system do better than the theoreticlly better but more error-inducing system?

Or maybe the best question to ask yourself: Did you in fact sell (treasury) bonds to buy stocks in late 2008 early 2009? The theory of the thing does not matter, if you are too paralyzed to execute.
"Everything should be as simple as it is, but not simpler." - Albert Einstein | Wiki article link:Getting Started

hq38sq43
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Re: The problem with a 3 fund portfolio

Post by hq38sq43 » Sat Oct 12, 2013 6:27 pm

A small plea against people (or he, she, or they) that. . . Things and places are thats. People are whos. Hence, he, she, or they, who--not that.
Harry at Bradenton

dcbrew
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Re:3 fund portfolio

Post by dcbrew » Sat Oct 12, 2013 7:20 pm

As a new participant I need to express my disappointment in market knowledge here!!

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LadyGeek
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Re: Re:3 fund portfolio

Post by LadyGeek » Sat Oct 12, 2013 7:39 pm

dcbrew wrote:As a new participant I need to express my disappointment in market knowledge here!!
Welcome! Don't worry about missing any points here, it's more of a "what-if" discussion. (If I'm wrong, someone please correct me.)

Here's what you need: Three-fund portfolio

Or, this: Getting Started

If you have any questions, just ask. (Start a new thread if it's on a different topic.)
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tpm871
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Re: The problem with a 3 fund portfolio

Post by tpm871 » Sun Oct 13, 2013 2:44 am

ogd wrote:
tpm871 wrote:4. Market weight isn't a guarantee that it's the best weighting. Just because Europe is X% and Asia is Y% of the world market doesn't mean that's automatically best for you.
What is the best weighing for me, then? I don't really care about either, since I live in the US. Where would I come up with X and Y? Why would I want to ignore the possibility of seismic shifts in the distribution of global wealth, and insist that Europe has to be 20% despite all the indicators that the market is looking at? The 40% fixed income in my portfolio represents my risk tolerance, but what is Y%? My Asia tolerance?


I wasn't suggesting that the goal is to somehow find an optimal X% Europe and Y% Asia. My point is that just because total international has Europe at a market weight of X%, that is not inherently better than some other weighting.

If Europe grows in the world markets relative to Asia, the question that you should ask yourself isn't "should I make adjustments to stay proportional to the world market?" Instead, the question should be, "what system of adjustments may give me the best value in the long run?"

There are no guarantees, and we can't predict the future. But the approach looks to take advantage of there being some degree of temporary fluctuation that is independent among regions. This brings opportunities to buy more of one at lower prices at different times, and to trim back on the other at higher prices at different times. See how Europe and Pacific Rim fluctuate a bit differently here:

http://finance.yahoo.com/q/bc?s=VGK&t=1 ... &q=l&c=Vpl

But before you label this as "market timing", realize that it strictly uses standard rebalancing mechanics (e.g., rebalance bands) to determine when and by how much to make adjustments, as opposed to a person's "gut feeling" on what they think will happen.

tpm871
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Re: The problem with a 3 fund portfolio

Post by tpm871 » Sun Oct 13, 2013 3:17 am

JamesSFO wrote:
tpm871 wrote:I agree with the OP, although I'd say that slice & dice isn't for everyone. If you don't want to spend a bit more time, don't have the risk tolerance to rebalance when it feels uncomfortable, and/or selling to rebalance puts you at a tax disadvantage (e.g., not much room in tax deferred space, not much capital losses to offset gains, high tax bracket) then the three fund approach may be better for you.
Your points seem to be ones for a more active style of portfolio setup/investing (not non-index, but just more active choices and discipline of portfolio maintenance) not an answer to the 3-fund portfolio having a problem or being too simple as raised by the OP.

I agree, there is POTENTIAL to over perform if you spend the time setting your regional weights manually, I'm not convinced that is a reason that the 3-fund portfolio is bad or problematic... Further, why not split up your US holdings by large/mid/small cap? Etc.
Yes, slightly more active. Besides the lower fees that I pointed out, I was also trying to describe how going "less simple" could help you maybe do a little better, which is exactly what the OP suggested.

Yes, I'd also recommend US small cap funds for similar reasons. I use total stock market to represent mostly large caps, and add a separate small cap fund for greater diversification.

By investing in total stock market only, you are investing mostly in large caps. Like I said earlier, just because TSM is the market weight doesn't make it automatically optimal. Adding more small caps allows you to take more (and different) risks, seeking higher returns. Since large and small caps fluctuate a little differently, there's some additional rebalancing opportunities.

But I wasn't trying to say that the three fund approach is bad. It works well, but isn't the only way.

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JoMoney
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Re: The problem with a 3 fund portfolio

Post by JoMoney » Sun Oct 13, 2013 5:26 am

tpm871 wrote: ...By investing in total stock market only, you are investing mostly in large caps. Like I said earlier, just because TSM is the market weight doesn't make it automatically optimal. Adding more small caps allows you to take more (and different) risks, seeking higher returns. Since large and small caps fluctuate a little differently, there's some additional rebalancing opportunities.
TSM will never offer higher returns than the market, but it's the optimal way to ensure you get the markets return. It invests in all cap sizes, dollar for dollar as they are represented in the market. Taking some other method MAY offer a higher return, but at the risk of under-performing. If your goal is to garner more than a share of the markets return, it won't be done by simply holding the market. But, consistently doing better than the whole of all stock investors may prove to be more difficult than what charts of the recent past might make it seem.
John Bogle wrote:First let us put to rest the canard that the remarkable success of traditional marketweighted indexing rests on the notion that markets must be efficient. Even if our stock markets were inefficient, capitalization-weighted indexing would still be -- must be -- an optimal investment strategy. All the stocks in the market must be held by someone. Thus, investors as a whole must earn the market return when that return is measured by a capitalization-weighted total stock market index. We can not live in Garrison Keillor's Lake Wobegon, where all the children are above average. For every investor who outperforms the market, there must be another investor who underperforms. Beating the market, in principle, must be a zero-sum game. http://johncbogle.com/wordpress/wp-cont ... 0op-ed.pdf
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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JamesSFO
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Re: The problem with a 3 fund portfolio

Post by JamesSFO » Sun Oct 13, 2013 9:03 am

tpm871 wrote: Yes, slightly more active. Besides the lower fees that I pointed out, I was also trying to describe how going "less simple" could help you maybe do a little better, which is exactly what the OP suggested.

Yes, I'd also recommend US small cap funds for similar reasons. I use total stock market to represent mostly large caps, and add a separate small cap fund for greater diversification.

By investing in total stock market only, you are investing mostly in large caps. Like I said earlier, just because TSM is the market weight doesn't make it automatically optimal. Adding more small caps allows you to take more (and different) risks, seeking higher returns. Since large and small caps fluctuate a little differently, there's some additional rebalancing opportunities.

But I wasn't trying to say that the three fund approach is bad. It works well, but isn't the only way.
I do not believe any 3-fund portfolio advocate believes it is the only way. I think many advocates believe that for the amount of mental energy invested in managing finances it delivers on a solid promise: you get the market return cost effectively for very little effort spent around investing choices.

The OP was claiming that the 3-fund portfolio was too simple. You propose a variation of slice-and-dice, I agree it has potential to out perform. I'm not understanding the SPECIFIC mechanism that the primary target audience of a 3-fund portfolio would use to select how much additional risk to take (small cap) or how to divide up the countries/regions into funds and get the MARKET return for similarly little effort.

It is a possibility with a slice-and-dice portfolio that you will exceed the market return, but it is by no means guaranteed. For example, if you were overinvested (vs the market weight) in Asia going into the Asian economic crises of the 2000's, you got a lower return. Similarly, TSM is invested in small cap proportionately, and correctly, you note that tilting to small cap means taking more risk. How much more risk should people take?

So again, what's the mechanism to pick the investment bands? If the claim is that the 3-fund portfolio is too simple, but this other approach is Goldilocks style just right, spell out the specific mechanisms for picking weightings that you would give to the random Joe so they could implement your slice-and-dice and achieve MARKET returns.

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LadyGeek
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Re: The problem with a 3 fund portfolio

Post by LadyGeek » Sun Oct 13, 2013 9:17 am

To the new investors, here's additional background: Slice and dice

Note the warning at the top of the article, as this approach takes on additional risk.
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tpm871
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Re: The problem with a 3 fund portfolio

Post by tpm871 » Sun Oct 13, 2013 10:25 am

JamesSFO wrote: I do not believe any 3-fund portfolio advocate believes it is the only way. I think many advocates believe that for the amount of mental energy invested in managing finances it delivers on a solid promise: you get the market return cost effectively for very little effort spent around investing choices.

The OP was claiming that the 3-fund portfolio was too simple. You propose a variation of slice-and-dice, I agree it has potential to out perform. I'm not understanding the SPECIFIC mechanism that the primary target audience of a 3-fund portfolio would use to select how much additional risk to take (small cap) or how to divide up the countries/regions into funds and get the MARKET return for similarly little effort.

It is a possibility with a slice-and-dice portfolio that you will exceed the market return, but it is by no means guaranteed. For example, if you were overinvested (vs the market weight) in Asia going into the Asian economic crises of the 2000's, you got a lower return. Similarly, TSM is invested in small cap proportionately, and correctly, you note that tilting to small cap means taking more risk. How much more risk should people take?

So again, what's the mechanism to pick the investment bands? If the claim is that the 3-fund portfolio is too simple, but this other approach is Goldilocks style just right, spell out the specific mechanisms for picking weightings that you would give to the random Joe so they could implement your slice-and-dice and achieve MARKET returns.
Right. I pretty much agree with everything you say. I'd just clarify:

There's nothing special about a MARKET return, as opposed to the return that you'd get from some other allocation. In some years, the market return would be better than another allocation and vice versa. There is no guarantee of either always being better.

The weightings are a personal decision, based on how much risk you'd be willing to take. More risk tends to yield higher returns in the long run. Less risk may help you sleep better at night. Market returns is result of just one risk profile, not the specific goal of investing.

In choosing an allocation, I look for correlation among asset classes to be different. If two funds have similar long term returns, but lower correlation, that implies that investing in the two funds is a bit safer than investing in just one -- and there's more opportunity to get rebalancing bonuses along the way.

As for how to pick the bands, this article did an analysis:

http://www.tdainstitutional.com/pdf/Opp ... yanani.pdf

But personally, I choose bands sizes that are in proportion to the past volatility of each fund (i.e., more volatile funds have larger bands).

Of course this all is too much complexity for many people. I wouldn't fault people for preferring the three fund approach instead.

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JamesSFO
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Re: The problem with a 3 fund portfolio

Post by JamesSFO » Sun Oct 13, 2013 10:31 am

tpm871 wrote: Of course this all is too much complexity for many people. I wouldn't fault people for preferring the three fund approach instead.
Ditto; I also agree with you especially the part emphasized, if it is too much complexity for most people than the OP's hypothesis about the 3 fund portfolio is likely wrong for that reason.

Texas hold em71
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Re: The problem with a 3 fund portfolio

Post by Texas hold em71 » Sun Oct 13, 2013 10:40 am

JamesSFO wrote:
tpm871 wrote: Of course this all is too much complexity for many people. I wouldn't fault people for preferring the three fund approach instead.
Ditto; I also agree with you especially the part emphasized, if it is too much complexity for most people than the OP's hypothesis about the 3 fund portfolio is likely wrong for that reason.
The more complex your method of investing, the more time you will spend. If you enjoy complexity, then by all means, spend your time. Most people don't. Just as there is an opportunity cost of simplicity- potential lower return, there is an opportunity cost of spending time on complexity - loss of time to spend with your family, etc. One can be quantified, the other cannot, but it is a cost most people recognize exists.

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1210sda
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Re: The problem with a 3 fund portfolio

Post by 1210sda » Sun Oct 13, 2013 12:17 pm

IF...the three fund portfolio lies on the efficient frontier (as John Norstad has shown), then getting additional return by slicing and dicing can only be gained by taking on more risk.

If you want more return and are willing to take on additional risk to do so, why not just increase the equity allocation of your Three Fund portfolio. This way you could get greater return and still have the simplicity of the Three Fund portfolio.

Larry Swedroe states that the benefit of slicing and dicing (i.e. adding size and value components) is to reduce your "fat tail" risk.

So my question (to myself) is: Is the reduction of fat tail risk enough to give up the simplicity of the 3FP.

1210

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ogd
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Re: The problem with a 3 fund portfolio

Post by ogd » Sun Oct 13, 2013 1:01 pm

tpm871 wrote:I wasn't suggesting that the goal is to somehow find an optimal X% Europe and Y% Asia. My point is that just because total international has Europe at a market weight of X%, that is not inherently better than some other weighting.

If Europe grows in the world markets relative to Asia, the question that you should ask yourself isn't "should I make adjustments to stay proportional to the world market?" Instead, the question should be, "what system of adjustments may give me the best value in the long run?"
The market weighing means I don't have to make any adjustments at all. I am letting the market decide (with much more information than I have) how big their relative sizes should be going forward. Among the information that the market has is that Europe is slightly cheaper today on several counts, for example. I would be second guessing if I decided on my own that the market is not paying enough attention to price, of all things.
tpm871 wrote:But before you label this as "market timing", realize that it strictly uses standard rebalancing mechanics (e.g., rebalance bands) to determine when and by how much to make adjustments, as opposed to a person's "gut feeling" on what they think will happen.
I wasn't labeling it market timing, I was saying it might be a case of cargo cult investing, at least when it comes to Europe vs Asia. In my mind, there has to be a story behind the rebalancing. When I rebalance to 40% fixed income, I am doing this to control the risk in my portfolio. I can also (much less readily) accept that the performance of value vs growth and small vs large tends to mean-revert with a premium on one side, because of all the literature on the subject.

But what does rebalancing Europe to 20% mean? Suppose it's the weight of a few years ago -- what's my reason to expect that Europe comes back to that proportion, as opposed to permanently losing competitiveness? It's not even a clear risk tradeoff, like small-value -- I literally can't tell whether Europe is more risky than Asia going forward. If I wanted to assert risk, like another poster said, it's much simpler to adjust the fixed income proportion anyway.

At best, this is a primitive form of technical analysis, not that I think sophisticated technical analysis is any more worth of the considerably larger amount of paper that it's printed on. I look at two graphs of A and B, I see a gap opening and I decide that B is now a better buy and should be piled into. But who's to say that the gap is not going to be permanent? And the bigger point: it can't be possibly be that simple. Just because we use a rebalancing technique that works in other contexts, it does not mean that what we're doing is on solid ground.

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