Does the 3 fund portfolio seem somewhat flawed?

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yarnandthread
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Does the 3 fund portfolio seem somewhat flawed?

Post by yarnandthread » Sat Jan 06, 2018 6:02 am

The 3 fund portfolio uses the Total US stock market (ex. VTSAX or VTI) as one of the 3 components. Given that roughly 83% of the VTSAX/VTI is concentrated in the largest 500 companies by market weight, it closely approximates the S&P 500. So even though it TECHNICALLY owns the whole market, it truly is a large cap fund. If the GOAL is to truly own the entire market, wouldn't it make more sense to own:

1/3 Large cap blend index fund
1/3 Mid cap blend index fund
1/3 Small cap blend index fund

This way you truly aren't picking favorites? You would then have a more EQUAL stake in all publicly traded companies in the US stock market versus a de facto Large Cap fund with VTSAX/VTI. And given small caps historical performance edge versus large caps it makes even more sense to use this vs the traditional 3 fund portfolio if you can stomach the likely increased volatility. A simpler portfolio of 50% large blend and 50% small blend would likely have a similar long term performance of the 1/3 Large, 1/3 Mid and 1/3 Small portfolio based on historical data...anyone agree with this?

This same analysis applies to the International component as well.

Nummerkins
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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by Nummerkins » Sat Jan 06, 2018 7:11 am

The point of the portfolio is that it’s well diversified and simple. If you are going to do that you might as well pick different term bonds funds, different international funds, throw in REITs and whatever else, thus ending up with 10+ funds to manage and balance. KISS!

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by oldcomputerguy » Sat Jan 06, 2018 7:19 am

yarnandthread wrote:
Sat Jan 06, 2018 6:02 am
So even though it TECHNICALLY owns the whole market, it truly is a large cap fund.
That's true. That's because, technically, 80% of the market is large-cap.
It’s taken me a lot of years, but I’ve come around to this: If you’re dumb, surround yourself with smart people. And if you’re smart, surround yourself with smart people who disagree with you.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by midareff » Sat Jan 06, 2018 8:01 am

Yeah BUT, the older you get the less it matters.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by nisiprius » Sat Jan 06, 2018 8:12 am

What you've described is not seen as a flaw by people who use the portfolio. And, incidentally, it is an objection to cap-weighted index funds in general, not the use of three of them in the three-fund portfolio.

This has been a standard talking point against cap-weighted index funds for a long time. I think it has no merit. I think it is also obviously motivated by the problem that there isn't much money to be made by offering just another low-cost cap-weighted index fund, and Vanguard (with its huge funds and economies of scale) is likely to get most whatever money can be made. Actively managed funds with >1.00% expense ratios are losing market share. If you're going to try to compete in the "passive" space, you gotta have a gimmick, and the most common gimmick is some kind of departure from cap-weighting.

The rationale for cap-weighting as a measure of a market was first put forward in 1922 by the economic Irving Fisher in a book called The Making of Index Numbers, and it's been pretty much accepted ever since.

The rationale for index funds themselves was put forward by Paul Samuelson and other in the 1970s; it was in the air at the time, Bogle heard of it by way of Samuelson, while Burton Malkiel also mentioned it in the first, 1973 edition of A Random Walk Down Wall Street. There are several rationales, one being the simple fact, evident in the 1970s, that actively managers were consistently failing to match the index.

Of course, you need to decide why you want to own the market and what it means to own the market.

"The market portfolio" is very simple: it is the actual set of all stocks owned by the market. The market doesn't just decide what price to put on Apple stock, or Costco stock, or Lithia Motors (automotive retailer named for the "famous" mineral springs in its home town) stock. By doing so, it also decides on the total number of dollars to put into that stock. An index fund gives you a miniature copy of the market as it actually exists, measured by dollars which seems like an obvious measuring stick. (What would you choose to measure by? Number of shares? Acres of real estate owned by the company?)

The market portfolio is special. It is not just an arbitrary choice. There are theorems in financial economics that says that given a number of assumptions (that may not be true in the real world), the market portfolio is mean-variance optimum, meaning it that it has the highest possible amount of reward for the amount of risk taken (according to one measure of risk that you may not agree with).

People riff on cap-weighting in all sorts of ways. "Smart beta funds," "enhanced index funds," "fundamental index funds," "factor funds," and of course "equal-weighted" funds and ETFs--some of which are not at all equally weighted, by the way--are all mechanical rules that can be called "indexes" that are not cap-weighted.

Let me give you one reason why cap-weighting might seem valid. Let's take the case of a market that's sealed--nobody takes any money in or out of it, all that happens is trading one stock for another, so the total amount of money in the market doesn't change. Suppose there are only two stocks in the market, Apple and Costco, and let's suppose that collectively 2/3rds of the money is in Apple--that is, there are, let's say, $20 trillion in Apple and $10 trillion in Costco.

Suppose a speculator make a huge trade, and buys a inconceivable amount of Apple, such that there is now $25 trillion in Apple. Since we assume everyone in the market stays 100% invested, that means every dollar put into Apple must have been taken away from Costco, so there is only $5 trillion in Costco. In other words, the price of Apple must have risen by 25%, while the price of Costco must have dropped by 50%.

Now, consider your personal portfolio. If you are holding a total of $30,000 and you are equal-weighted, then you started out with $15,000 each in Apple and Costco. After the trade, you now have $15,000 + 25% = $18,750 in Apple and $15,000 - 50% = $7,500 in Costco, for a total of $26,250. You've lost money. The reason is that you took sides on the trade; by electing to equal-weight, in cap-weighted terms you overweighted Costco. You're on Costco's side. It could have gone the other way, of course. If you run through a similar calculation assuming that dollars flow out of Apple and into Costco, you would make money.

The point is: this is a purely speculative trade. Every dollar made by an Apple stock owner simply comes directly out of the pockets of a Costco stock owners, and vice versa. Equal-weighting isn't being neutral. Equal-weighting means taking sides on the side of the smaller stocks. You've taken sides on a zero-sum speculative maneuver. If you're right, you win; if you're wrong, you lose.

Now suppose you had owned a cap-weighted portfolio. You'd have had $20,000 in Apple and $10,000 in Costco. After the trade, since the total market cap of the market didn't change, the value of your portfolio didn't change. You'd now have $25,000 in Apple and $5,000 in Costco. Your total remains $30,000.

Being cap-weighted has canceled out the speculative part of your investment. You are now equally on both sides of every trade.

To put it another way, if you are cap-weighted, you always own $30,000 / $30 trillion = one billionth of the market as a whole.

If we now assume that the market is not a closed system, because of money flowing into it from dividend payments from stocks--or from collective judgement about the potential future dividend payments made possible by earnings. As the owner of one billionth of the market as a whole, you are unaffected by shifts of dollars between market participants. However, you are the beneficiary of increases in the total value of the market as a whole, due to accumulated earnings from the business operations of the stock-issuing companies.

It is cap-weighting that is the neutral position that takes no sides. It is the only weighting that doesn't. Every other weighting involves siding with some subset of stocks. Most of them, including equal weighting, include siding with small-cap stocks.

A sane person could decide to do that, certainly. There are rationales for smart beta, for fundamental indexing, for factor-based investing, and you may agree with them. All of them basically involve a set of assumptions that's different from those that go into "cap-weighting is optimum," and all of them assume an inefficient market and one in which premia are not simply a reward for taking risk. They basically involve an assumption of persistent, predictable valuation errors in the market. The people that promote them--if they are not just looking pragmatically at past results which might be just luck--have interesting explanations of why there might be such errors and why the market is unable to learn from them and correct them.

But a sane person could also decide to own the market, in the same proportions as the market itself owns them.
Last edited by nisiprius on Sat Jan 06, 2018 8:20 am, edited 1 time in total.
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UpperNwGuy
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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by UpperNwGuy » Sat Jan 06, 2018 8:18 am

Good explanation, nisiprius. Thank you!

rvs323
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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by rvs323 » Sat Jan 06, 2018 9:06 am

Nisiprius, time and time and time again, just as I'm starting to waffle on some part of my portfolio decision making process, you post something like this that both educates me and reinforces my decisions. As someone who is more of a lurker than a contributor here, I know you get lots of positive feedback on your contributions.
I just wanted/needed to be one of those offering my thanks.

yarnandthread
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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by yarnandthread » Sat Jan 06, 2018 11:20 am

nisiprius wrote:
Sat Jan 06, 2018 8:12 am
What you've described is not seen as a flaw by people who use the portfolio. And, incidentally, it is an objection to cap-weighted index funds in general, not the use of three of them in the three-fund portfolio.

This has been a standard talking point against cap-weighted index funds for a long time. I think it has no merit. I think it is also obviously motivated by the problem that there isn't much money to be made by offering just another low-cost cap-weighted index fund, and Vanguard (with its huge funds and economies of scale) is likely to get most whatever money can be made. Actively managed funds with >1.00% expense ratios are losing market share. If you're going to try to compete in the "passive" space, you gotta have a gimmick, and the most common gimmick is some kind of departure from cap-weighting.

The rationale for cap-weighting as a measure of a market was first put forward in 1922 by the economic Irving Fisher in a book called The Making of Index Numbers, and it's been pretty much accepted ever since.

The rationale for index funds themselves was put forward by Paul Samuelson and other in the 1970s; it was in the air at the time, Bogle heard of it by way of Samuelson, while Burton Malkiel also mentioned it in the first, 1973 edition of A Random Walk Down Wall Street. There are several rationales, one being the simple fact, evident in the 1970s, that actively managers were consistently failing to match the index.

Of course, you need to decide why you want to own the market and what it means to own the market.

"The market portfolio" is very simple: it is the actual set of all stocks owned by the market. The market doesn't just decide what price to put on Apple stock, or Costco stock, or Lithia Motors (automotive retailer named for the "famous" mineral springs in its home town) stock. By doing so, it also decides on the total number of dollars to put into that stock. An index fund gives you a miniature copy of the market as it actually exists, measured by dollars which seems like an obvious measuring stick. (What would you choose to measure by? Number of shares? Acres of real estate owned by the company?)

The market portfolio is special. It is not just an arbitrary choice. There are theorems in financial economics that says that given a number of assumptions (that may not be true in the real world), the market portfolio is mean-variance optimum, meaning it that it has the highest possible amount of reward for the amount of risk taken (according to one measure of risk that you may not agree with).

People riff on cap-weighting in all sorts of ways. "Smart beta funds," "enhanced index funds," "fundamental index funds," "factor funds," and of course "equal-weighted" funds and ETFs--some of which are not at all equally weighted, by the way--are all mechanical rules that can be called "indexes" that are not cap-weighted.

Let me give you one reason why cap-weighting might seem valid. Let's take the case of a market that's sealed--nobody takes any money in or out of it, all that happens is trading one stock for another, so the total amount of money in the market doesn't change. Suppose there are only two stocks in the market, Apple and Costco, and let's suppose that collectively 2/3rds of the money is in Apple--that is, there are, let's say, $20 trillion in Apple and $10 trillion in Costco.

Suppose a speculator make a huge trade, and buys a inconceivable amount of Apple, such that there is now $25 trillion in Apple. Since we assume everyone in the market stays 100% invested, that means every dollar put into Apple must have been taken away from Costco, so there is only $5 trillion in Costco. In other words, the price of Apple must have risen by 25%, while the price of Costco must have dropped by 50%.

Now, consider your personal portfolio. If you are holding a total of $30,000 and you are equal-weighted, then you started out with $15,000 each in Apple and Costco. After the trade, you now have $15,000 + 25% = $18,750 in Apple and $15,000 - 50% = $7,500 in Costco, for a total of $26,250. You've lost money. The reason is that you took sides on the trade; by electing to equal-weight, in cap-weighted terms you overweighted Costco. You're on Costco's side. It could have gone the other way, of course. If you run through a similar calculation assuming that dollars flow out of Apple and into Costco, you would make money.

The point is: this is a purely speculative trade. Every dollar made by an Apple stock owner simply comes directly out of the pockets of a Costco stock owners, and vice versa. Equal-weighting isn't being neutral. Equal-weighting means taking sides on the side of the smaller stocks. You've taken sides on a zero-sum speculative maneuver. If you're right, you win; if you're wrong, you lose.

Now suppose you had owned a cap-weighted portfolio. You'd have had $20,000 in Apple and $10,000 in Costco. After the trade, since the total market cap of the market didn't change, the value of your portfolio didn't change. You'd now have $25,000 in Apple and $5,000 in Costco. Your total remains $30,000.

Being cap-weighted has canceled out the speculative part of your investment. You are now equally on both sides of every trade.

To put it another way, if you are cap-weighted, you always own $30,000 / $30 trillion = one billionth of the market as a whole.

If we now assume that the market is not a closed system, because of money flowing into it from dividend payments from stocks--or from collective judgement about the potential future dividend payments made possible by earnings. As the owner of one billionth of the market as a whole, you are unaffected by shifts of dollars between market participants. However, you are the beneficiary of increases in the total value of the market as a whole, due to accumulated earnings from the business operations of the stock-issuing companies.

It is cap-weighting that is the neutral position that takes no sides. It is the only weighting that doesn't. Every other weighting involves siding with some subset of stocks. Most of them, including equal weighting, include siding with small-cap stocks.

A sane person could decide to do that, certainly. There are rationales for smart beta, for fundamental indexing, for factor-based investing, and you may agree with them. All of them basically involve a set of assumptions that's different from those that go into "cap-weighting is optimum," and all of them assume an inefficient market and one in which premia are not simply a reward for taking risk. They basically involve an assumption of persistent, predictable valuation errors in the market. The people that promote them--if they are not just looking pragmatically at past results which might be just luck--have interesting explanations of why there might be such errors and why the market is unable to learn from them and correct them.

But a sane person could also decide to own the market, in the same proportions as the market itself owns them.
Nisiprius: thank you for your reply. Like you mentioned, the stock market is not a closed system; it is certainly an open one with many moving parts and lots of new money coming and going. Not so clean and neat as the Apple and Costco scenario. It just seems that putting equal amounts of money on all the participants, based on backtesting using websites such as https://www.portfoliovisualizer.com/backtest-portfolio, decades long historical data and common sense that smaller companies have more room to grow makes more sense. You aren't just betting mostly on the "big boys". There is also the continual ownership one gets as say Amazon started off small (so you owned it in Small Cap Index) and then it gets larger to Mid Sized level and you owned it there and then it finally landed in Large Cap and guess what you then own it in your Large Index.

Any can't a person argue that having equal portions in the small/mid/large sectors really adds more diversity to a portfolio than a market-weighted approach in which you really mainly just own the 500 largest companies in America? You aren't putting the vast majority of your eggs in that one basket. You are admitting that you don't know which cap size will outperform so own them all in equal amounts....

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by dbr » Sat Jan 06, 2018 11:28 am

yarnandthread wrote:
Sat Jan 06, 2018 11:20 am

Any can't a person argue that having equal portions in the small/mid/large sectors really adds more diversity to a portfolio than a market-weighted approach in which you really mainly just own the 500 largest companies in America? You aren't putting the vast majority of your eggs in that one basket. You are admitting that you don't know which cap size will outperform so own them all in equal amounts....
Sure. Read here: https://www.amazon.com/Your-Complete-Gu ... oe+fadctor

It is up to you to decide if you understand the rationale for these sorts of things well enough to let this approach or other ones guide your investment strategy.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by Jack FFR1846 » Sat Jan 06, 2018 11:40 am

If you're trying to cover the entire market, figure out how much a size is missed in VTI. I have not done the math, but it would not surprise me to find that buying the entire market means a million dollars VTI, $1000 mid cap, $1000 small cap and $50 micro cap. Now, you're covered. If micro cap goes nuts and goes up 100 times in a year, it makes zero differenci in your portfolio.
Bogle: Smart Beta is stupid

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by Taylor Larimore » Sat Jan 06, 2018 11:56 am

yarnandthread wrote:
Sat Jan 06, 2018 6:02 am
The 3 fund portfolio uses the Total US stock market (ex. VTSAX or VTI) as one of the 3 components. Given that roughly 83% of the VTSAX/VTI is concentrated in the largest 500 companies by market weight, it closely approximates the S&P 500. So even though it TECHNICALLY owns the whole market, it truly is a large cap fund. If the GOAL is to truly own the entire market, wouldn't it make more sense to own:

1/3 Large cap blend index fund
1/3 Mid cap blend index fund
1/3 Small cap blend index fund

This way you truly aren't picking favorites? You would then have a more EQUAL stake in all publicly traded companies in the US stock market versus a de facto Large Cap fund with VTSAX/VTI. And given small caps historical performance edge versus large caps it makes even more sense to use this vs the traditional 3 fund portfolio if you can stomach the likely increased volatility. A simpler portfolio of 50% large blend and 50% small blend would likely have a similar long term performance of the 1/3 Large, 1/3 Mid and 1/3 Small portfolio based on historical data...anyone agree with this?

This same analysis applies to the International component as well.
yarnandthread:

We have a third Bogleheads' book being released by Amazon on April 23rd (its available for pre-sale now). It's title is "The Bogleheads' Guide to the Three-Fund Portfolio." In it I have listed "20 Benefits of the Three-Fund Portfolio." I think you will find it helpful to answer your question. In the meantime, use this link:

The Three-Fund Portfolio

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by dbr » Sat Jan 06, 2018 12:07 pm

I would also suggest that it is not useful to talk about a portfolio being flawed unless there is some way there is a misconception or an internal contradiction involved. The better process is to consider the properties of portfolios relevant to the purposes of the investor and see if there are advantages or disadvantages one way or the other and then choose the best option.

As Taylor is pointing out, the three fund approach has lots of advantages and few disadvantages for the purposes of most personal investor. If the market cap loading of TSM funds has meaningful disadvantages for the purposes of those who might invest in a certain portfolio, then that can be discussed on the merits, but it has to be actual merits or lack of same.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by Sandtrap » Sat Jan 06, 2018 12:13 pm

nisiprius wrote:
Sat Jan 06, 2018 8:12 am
What you've described is not seen as a flaw by people who use the portfolio. And, incidentally, it is an objection to cap-weighted index funds in general, not the use of three of them in the three-fund portfolio.
. . . . . . .
But a sane person could also decide to own the market, in the same proportions as the market itself owns them.
Thank you, again, "nisiprius" for an education.
I don't think I'm alone in saying, I have no idea how you can compose a well edited professional student "booklet" in response to a query in such a short time, but am grateful for it.
mahalo nui loa
j :D

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by 2pedals » Sat Jan 06, 2018 1:22 pm

nisiprius wrote:
Sat Jan 06, 2018 8:12 am
But a sane person could also decide to own the market, in the same proportions as the market itself owns them.
+1, nisprius thank you, your post was amazing. :beer

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by RRAAYY3 » Sat Jan 06, 2018 1:28 pm

I have no idea why people insist on making something so wonderfully simple more complicated

Buy Us, Buy Int’l, Buy Total Bond when it’s time to hold onto that accumulation - move on with life

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Post by Taylor Larimore » Sat Jan 06, 2018 1:36 pm

RRAAYY3 wrote:
Sat Jan 06, 2018 1:28 pm
I have no idea why people insist on making something so wonderfully simple more complicated.
RRAAYY3:

There is great truth in your observation. Warren Buffet agrees:
"There seems to be some perverse human characteristic that likes to make easy things difficult."
Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: "A Perverse Human Characteristic" -- Warren Buffett

Post by RRAAYY3 » Sat Jan 06, 2018 1:38 pm

Taylor Larimore wrote:
Sat Jan 06, 2018 1:36 pm
RRAAYY3 wrote:
Sat Jan 06, 2018 1:28 pm
I have no idea why people insist on making something so wonderfully simple more complicated.
RRAAYY3:

There is great truth in your observation. Warren Buffet agrees:
"There seems to be some perverse human characteristic that likes to make easy things difficult."
Best wishes.
Taylor
i have friends who think they are cool talking about bitcoin / "stocks" ... i just laugh, explain what I do, how easy it is, what i "own", and how easy it is to manage for myself

i'll let them buy tesla, i'll continue buying the automotive industry

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by sambb » Sat Jan 06, 2018 1:39 pm

3 fund portfolio is flawed for many reasons, but not what the OP states in my opinion,

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by cherijoh » Sat Jan 06, 2018 2:05 pm

yarnandthread wrote:
Sat Jan 06, 2018 11:20 am
nisiprius wrote:
Sat Jan 06, 2018 8:12 am
But a sane person could also decide to own the market, in the same proportions as the market itself owns them.
Nisiprius: thank you for your reply. Like you mentioned, the stock market is not a closed system; it is certainly an open one with many moving parts and lots of new money coming and going. Not so clean and neat as the Apple and Costco scenario. It just seems that putting equal amounts of money on all the participants, based on backtesting using websites such as https://www.portfoliovisualizer.com/backtest-portfolio, decades long historical data and common sense that smaller companies have more room to grow makes more sense. You aren't just betting mostly on the "big boys". There is also the continual ownership one gets as say Amazon started off small (so you owned it in Small Cap Index) and then it gets larger to Mid Sized level and you owned it there and then it finally landed in Large Cap and guess what you then own it in your Large Index.

Any can't a person argue that having equal portions in the small/mid/large sectors really adds more diversity to a portfolio than a market-weighted approach in which you really mainly just own the 500 largest companies in America? You aren't putting the vast majority of your eggs in that one basket. You are admitting that you don't know which cap size will outperform so own them all in equal amounts....
Okay, personally I am suspicious of anything that involves back-testing - Past performance is not a predictor of future performance.

In addition, you are inherently betting on the premise that small cap stocks will grow at a greater rate than large caps will - sometimes this is true but sometimes it is not - which means that you are introducing more volatility into your portfolio performance. You are also showing a bias towards stocks' share prices growing versus shrinking. By not using cap weighting, you would be currently favoring stocks like Sears which traded at $48.57 per share on Nov 15, 2013 and closed on Friday at $3.48/ share. I would argue that with its current financial difficulties it deserves to have a smaller percentage of my investment now than in did 4 years ago - which is exactly what cap weighting does. The same is true for a bunch of other previously favored stocks that have tanked.

If you want to favor smaller cap stocks, you could carve off a portion using slice and dice by purchasing TSM plus a bit of the Small cap index. But your equal weighting is pretty extreme IMO. Let's assume that a total market fund is 80/12/8 for large cap/mid cap/small cap. If you evenly divide your investment into thirds, you would have about 41.7% of the large cap weighting relative to TSM, 278% of the midcap weighting, and 416% of the small cap weighting. The fundamental indexes that Nisi mentioned are even more skewed.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by RRAAYY3 » Sat Jan 06, 2018 2:08 pm

all i see in the future is more and more big companies buying up smaller ones ... i'll continue buying the total US / total INT'L and let those index decide the best companies to own for me

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Post by Taylor Larimore » Sat Jan 06, 2018 2:34 pm

yarnandthread wrote:
Sat Jan 06, 2018 6:02 am
So even though it TECHNICALLY owns the whole market, it truly is a large cap fund.
Bogleheads should feel confident owning the biggest and most successful companies in the world.
The enemy of a good plan is the search for a better plan. -- Jack Bogle
Best wishes
Taylor
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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by nexchap » Sat Jan 06, 2018 4:03 pm

nisiprius wrote:
Sat Jan 06, 2018 8:12 am

A sane person could decide to do that, certainly. There are rationales for smart beta, for fundamental indexing, for factor-based investing, and you may agree with them. All of them basically involve a set of assumptions that's different from those that go into "cap-weighting is optimum," and all of them assume an inefficient market and one in which premia are not simply a reward for taking risk.
Nisiprius -- great write-up, and I follow/agree with everything except the last sentence in the snippet above: I assume an efficient market, and that any added risk assumed by a participant is rewarded by extra return. Isn't that exactly the reason someone would deviate from the overall market cap? If you want less/more risk than the market optimum, you accept less/more reward for tilting away from the market cap towards sectors that are less/more risky. So a tilt towards / away from small cap, or towards/away from stocks, would be perfectly consistent with "cap-weighting is optimum" (for the market average investor's risk appetite), with an efficient market, and with premia being simply a reward for taking risk. Am I missing something in your argument?

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by willthrill81 » Sat Jan 06, 2018 4:28 pm

I find it interesting that there are so many theories about whether market cap-weighting is superior to other forms of indexing and so little discussion of real world results.

To the OP, your outlined strategy of 1/3 each in large cap, mid cap, and small cap returned 11.56% from 1972-2017. Over that same period, the total stock market (market cap-weighted) returned 10.41%. There was only slightly more volatility and drawdown over that period with your portfolio compared to TSM.

If you like it and can stick with it, I see no reason to go for it.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by heyyou » Sat Jan 06, 2018 4:29 pm

Trev H's four fund equity portfolio of Vanguard funds is 4 x 25% of domestic LB & SCV, foreign LV & SB. Those take advantage of VG's somewhat open boundaries between cap sizes and between value exposures, and yes, they are cap weighted within their exposures.
viewtopic.php?f=10&t=38374
obviously motivated by the problem that there isn't much money to be made
Trev H is just another Boglehead, not posting here to boost his business.

When there were no index funds, it was seen by a few that an index fund would be an improvement over the then current offerings. Now we have index funds, and some believe there is room for improvement over holding only total market index funds. Others disagree, saying a 50/50 split of domestic and foreign total market is better than other choices.

If cap-weighted total is superior, why isn't total world used, since it is near 50/50 US and world? Maybe it is not trustworthy since it is newer than total international, which is newer than total domestic, which is newer than the S&P500 index fund that was ridiculed by the status quo at its introduction. It has been said that some new info is accepted at the rate that department chairmen retire at colleges. That could apply here too.

Total world is more simple than two funds if simplicity is paramount. Yes, cap gains are embedded for current retirees, but the question is less about history, and more about what to buy today, for a distant future retirement. That would be inexpensive, broad exposure to what is now known about factors, with Trev H's 4 x 25% being a good example.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by dbr » Sat Jan 06, 2018 4:38 pm

willthrill81 wrote:
Sat Jan 06, 2018 4:28 pm
I find it interesting that there are so many theories about whether market cap-weighting is superior to other forms of indexing and so little discussion of real world results.

To the OP, your outlined strategy of 1/3 each in large cap, mid cap, and small cap returned 11.56% from 1972-2017. Over that same period, the total stock market (market cap-weighted) returned 10.41%. There was only slightly more volatility and drawdown over that period with your portfolio compared to TSM.

If you like it and can stick with it, I see no reason to go for it.
The objection is that there is no rationale for the plan. The boundaries between those three categories in the M* style box are completely arbitrary meaning that 1/3 number actually has no meaning. The rationale for tilting to small caps is based on some actual analysis of what one gets with different factor loadings. What would we think if it turned out that the return premium on size was to load on large rather than small and get worse performance by going 1/3's? It is also a feature of the M* style box that value/blend/growth is an arbitrary even division while in fact the expected return for value should be higher than growth but nobody says TSM is flawed about the distribution across value.

The real objection people have when naively looking at what makes up TSM is that there is indeed a concentration is a few companies rather than a distribution across all the companies whose stock could be owned. But why there is anything wrong with that is a question that is not simple to answer. It certainly isn't obvious and an answer that can be arrived at without study and information.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by yarnandthread » Sat Jan 06, 2018 7:49 pm

willthrill81 wrote:
Sat Jan 06, 2018 4:28 pm
I find it interesting that there are so many theories about whether market cap-weighting is superior to other forms of indexing and so little discussion of real world results.

To the OP, your outlined strategy of 1/3 each in large cap, mid cap, and small cap returned 11.56% from 1972-2017. Over that same period, the total stock market (market cap-weighted) returned 10.41%. There was only slightly more volatility and drawdown over that period with your portfolio compared to TSM.

If you like it and can stick with it, I see no reason to go for it.
willthrill81: which funds did you use for the backtesting in your analysis? 1.15% is nothing to sneeze at over a 45 year period.....look at how many people on bogleheads taut a 1% passive index savings over actively managed funds as a really big deal.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by danpmor » Sat Jan 06, 2018 9:08 pm

nisiprius wrote:
Sat Jan 06, 2018 8:12 am
What you've described is not seen as a flaw by people who use the portfolio. And, incidentally, it is an objection to cap-weighted index funds in general, not the use of three of them in the three-fund portfolio.

This has been a standard talking point against cap-weighted index funds for a long time. I think it has no merit. I think it is also obviously motivated by the problem that there isn't much money to be made by offering just another low-cost cap-weighted index fund, and Vanguard (with its huge funds and economies of scale) is likely to get most whatever money can be made. Actively managed funds with >1.00% expense ratios are losing market share. If you're going to try to compete in the "passive" space, you gotta have a gimmick, and the most common gimmick is some kind of departure from cap-weighting.

The rationale for cap-weighting as a measure of a market was first put forward in 1922 by the economic Irving Fisher in a book called The Making of Index Numbers, and it's been pretty much accepted ever since.

The rationale for index funds themselves was put forward by Paul Samuelson and other in the 1970s; it was in the air at the time, Bogle heard of it by way of Samuelson, while Burton Malkiel also mentioned it in the first, 1973 edition of A Random Walk Down Wall Street. There are several rationales, one being the simple fact, evident in the 1970s, that actively managers were consistently failing to match the index.

Of course, you need to decide why you want to own the market and what it means to own the market.

"The market portfolio" is very simple: it is the actual set of all stocks owned by the market. The market doesn't just decide what price to put on Apple stock, or Costco stock, or Lithia Motors (automotive retailer named for the "famous" mineral springs in its home town) stock. By doing so, it also decides on the total number of dollars to put into that stock. An index fund gives you a miniature copy of the market as it actually exists, measured by dollars which seems like an obvious measuring stick. (What would you choose to measure by? Number of shares? Acres of real estate owned by the company?)

The market portfolio is special. It is not just an arbitrary choice. There are theorems in financial economics that says that given a number of assumptions (that may not be true in the real world), the market portfolio is mean-variance optimum, meaning it that it has the highest possible amount of reward for the amount of risk taken (according to one measure of risk that you may not agree with).

People riff on cap-weighting in all sorts of ways. "Smart beta funds," "enhanced index funds," "fundamental index funds," "factor funds," and of course "equal-weighted" funds and ETFs--some of which are not at all equally weighted, by the way--are all mechanical rules that can be called "indexes" that are not cap-weighted.

Let me give you one reason why cap-weighting might seem valid. Let's take the case of a market that's sealed--nobody takes any money in or out of it, all that happens is trading one stock for another, so the total amount of money in the market doesn't change. Suppose there are only two stocks in the market, Apple and Costco, and let's suppose that collectively 2/3rds of the money is in Apple--that is, there are, let's say, $20 trillion in Apple and $10 trillion in Costco.

Suppose a speculator make a huge trade, and buys a inconceivable amount of Apple, such that there is now $25 trillion in Apple. Since we assume everyone in the market stays 100% invested, that means every dollar put into Apple must have been taken away from Costco, so there is only $5 trillion in Costco. In other words, the price of Apple must have risen by 25%, while the price of Costco must have dropped by 50%.

Now, consider your personal portfolio. If you are holding a total of $30,000 and you are equal-weighted, then you started out with $15,000 each in Apple and Costco. After the trade, you now have $15,000 + 25% = $18,750 in Apple and $15,000 - 50% = $7,500 in Costco, for a total of $26,250. You've lost money. The reason is that you took sides on the trade; by electing to equal-weight, in cap-weighted terms you overweighted Costco. You're on Costco's side. It could have gone the other way, of course. If you run through a similar calculation assuming that dollars flow out of Apple and into Costco, you would make money.

The point is: this is a purely speculative trade. Every dollar made by an Apple stock owner simply comes directly out of the pockets of a Costco stock owners, and vice versa. Equal-weighting isn't being neutral. Equal-weighting means taking sides on the side of the smaller stocks. You've taken sides on a zero-sum speculative maneuver. If you're right, you win; if you're wrong, you lose.

Now suppose you had owned a cap-weighted portfolio. You'd have had $20,000 in Apple and $10,000 in Costco. After the trade, since the total market cap of the market didn't change, the value of your portfolio didn't change. You'd now have $25,000 in Apple and $5,000 in Costco. Your total remains $30,000.

Being cap-weighted has canceled out the speculative part of your investment. You are now equally on both sides of every trade.

To put it another way, if you are cap-weighted, you always own $30,000 / $30 trillion = one billionth of the market as a whole.

If we now assume that the market is not a closed system, because of money flowing into it from dividend payments from stocks--or from collective judgement about the potential future dividend payments made possible by earnings. As the owner of one billionth of the market as a whole, you are unaffected by shifts of dollars between market participants. However, you are the beneficiary of increases in the total value of the market as a whole, due to accumulated earnings from the business operations of the stock-issuing companies.

It is cap-weighting that is the neutral position that takes no sides. It is the only weighting that doesn't. Every other weighting involves siding with some subset of stocks. Most of them, including equal weighting, include siding with small-cap stocks.

A sane person could decide to do that, certainly. There are rationales for smart beta, for fundamental indexing, for factor-based investing, and you may agree with them. All of them basically involve a set of assumptions that's different from those that go into "cap-weighting is optimum," and all of them assume an inefficient market and one in which premia are not simply a reward for taking risk. They basically involve an assumption of persistent, predictable valuation errors in the market. The people that promote them--if they are not just looking pragmatically at past results which might be just luck--have interesting explanations of why there might be such errors and why the market is unable to learn from them and correct them.

But a sane person could also decide to own the market, in the same proportions as the market itself owns them.

Great explanation!!

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by willthrill81 » Sat Jan 06, 2018 9:12 pm

yarnandthread wrote:
Sat Jan 06, 2018 7:49 pm
willthrill81 wrote:
Sat Jan 06, 2018 4:28 pm
I find it interesting that there are so many theories about whether market cap-weighting is superior to other forms of indexing and so little discussion of real world results.

To the OP, your outlined strategy of 1/3 each in large cap, mid cap, and small cap returned 11.56% from 1972-2017. Over that same period, the total stock market (market cap-weighted) returned 10.41%. There was only slightly more volatility and drawdown over that period with your portfolio compared to TSM.

If you like it and can stick with it, I see no reason to go for it.
willthrill81: which funds did you use for the backtesting in your analysis? 1.15% is nothing to sneeze at over a 45 year period.....look at how many people on bogleheads taut a 1% passive index savings over actively managed funds as a really big deal.
I used the asset classes provided in Portfolio Visualizer. You could easily replicate this with indexed Vanguard funds, but keep in mind that most of these did not exist going back beyond the 1990s.

I wouldn't let all of the theoretical arguments get in the way of your strategy. It's perfectly sound to tilt your portfolio toward smaller funds than the S&P 500, and many Bogleheads do.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by BogleMelon » Sat Jan 06, 2018 9:44 pm

I am no expert like all the others who replied here, but here is how I understand why the 3 fund portfolio is not flawed in a simple humble way:
Assume that there were only 3 companies in country xyz!
Company A (Large Cap) that has outstanding total stock in the market of $6,000,000
Company B (Mid Cap) with stocks of $3,000,000
Company C (Small Cap), stocks in the market $1,000,000
So all the money being traded now in the market is $10,000,000
Now you are an investor with a $10 million in cash, and ready invest in that country. You decided that monopoly is the game you will play, and that you will buy the entire market. How could you call buying 1/3 large, 1/3 mid and 1/3 small buying an entire market? You will miss some stocks out there, and other people will buy them, and you would end up with cash on hand. The only way to buy the entire is to weight towards company A even if that will make your portfolio 60% in large cap (as a monopoly tycoon, you must buy the entire $6 million of company A, the entire $3 million of B and so on).
Now let's assume that you only have $1,000 and want to still mirror buying the entire market? same thing, the amount you invest shouldn't make a difference, since the entire market consists of 60% large cap, then the only way that you buy a proportional piece of the entire market is to buy $600 worth of large cap, $300 mid cap, and $100 small.
"One of the funny things about stock market, every time one is buying another is selling, and both think they are astute" - William Feather

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by willthrill81 » Sat Jan 06, 2018 10:12 pm

BogleMelon wrote:
Sat Jan 06, 2018 9:44 pm
I am no expert like all the others who replied here, but here is how I understand why the 3 fund portfolio is not flawed in a simple humble way:
Assume that there were only 3 companies in country xyz!
Company A (Large Cap) that has outstanding total stock in the market of $6,000,000
Company B (Mid Cap) with stocks of $3,000,000
Company C (Small Cap), stocks in the market $1,000,000
So all the money being traded now in the market is $10,000,000
Now you are an investor with a $10 million in cash, and ready invest in that country. You decided that monopoly is the game you will play, and that you will buy the entire market. How could you call buying 1/3 large, 1/3 mid and 1/3 small buying an entire market? You will miss some stocks out there, and other people will buy them, and you would end up with cash on hand. The only way to buy the entire is to weight towards company A even if that will make your portfolio 60% in large cap (as a monopoly tycoon, you must buy the entire $6 million of company A, the entire $3 million of B and so on).
Now let's assume that you only have $1,000 and want to still mirror buying the entire market? same thing, the amount you invest shouldn't make a difference, since the entire market consists of 60% large cap, then the only way that you buy a proportional piece of the entire market is to buy $600 worth of large cap, $300 mid cap, and $100 small.
Why weight them according to their market capitalization? Why not revenue, profits, or some other metric?
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by edge » Sat Jan 06, 2018 10:17 pm

Because the point of the market portfolio is to achieve market returns.
willthrill81 wrote:
Sat Jan 06, 2018 10:12 pm
BogleMelon wrote:
Sat Jan 06, 2018 9:44 pm
I am no expert like all the others who replied here, but here is how I understand why the 3 fund portfolio is not flawed in a simple humble way:
Assume that there were only 3 companies in country xyz!
Company A (Large Cap) that has outstanding total stock in the market of $6,000,000
Company B (Mid Cap) with stocks of $3,000,000
Company C (Small Cap), stocks in the market $1,000,000
So all the money being traded now in the market is $10,000,000
Now you are an investor with a $10 million in cash, and ready invest in that country. You decided that monopoly is the game you will play, and that you will buy the entire market. How could you call buying 1/3 large, 1/3 mid and 1/3 small buying an entire market? You will miss some stocks out there, and other people will buy them, and you would end up with cash on hand. The only way to buy the entire is to weight towards company A even if that will make your portfolio 60% in large cap (as a monopoly tycoon, you must buy the entire $6 million of company A, the entire $3 million of B and so on).
Now let's assume that you only have $1,000 and want to still mirror buying the entire market? same thing, the amount you invest shouldn't make a difference, since the entire market consists of 60% large cap, then the only way that you buy a proportional piece of the entire market is to buy $600 worth of large cap, $300 mid cap, and $100 small.
Why weight them according to their market capitalization? Why not revenue, profits, or some other metric?

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by 1210sda » Sat Jan 06, 2018 10:34 pm

nisiprius wrote:
Sat Jan 06, 2018 8:12 am
The market portfolio is special. It is not just an arbitrary choice. There are theorems in financial economics that says that given a number of assumptions (that may not be true in the real world), the market portfolio is mean-variance optimum, meaning it that it has the highest possible amount of reward for the amount of risk taken (according to one measure of risk that you may not agree with).
Is Vanguard's Total Stock Market Fund (VTSAX) close enough to the market portfolio that the same (mean-variance optimum) could be said of it?

Is VTSAX on the "efficient frontier"??


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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by willthrill81 » Sat Jan 06, 2018 10:53 pm

edge wrote:
Sat Jan 06, 2018 10:17 pm
Because the point of the market portfolio is to achieve market returns.
But "market returns" are determined by how you define the market. I've yet to hear a compelling argument that market capitalization is the best means of defining a market.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by yarnandthread » Sat Jan 06, 2018 10:53 pm

BogleMelon wrote:
Sat Jan 06, 2018 9:44 pm
I am no expert like all the others who replied here, but here is how I understand why the 3 fund portfolio is not flawed in a simple humble way:
Assume that there were only 3 companies in country xyz!
Company A (Large Cap) that has outstanding total stock in the market of $6,000,000
Company B (Mid Cap) with stocks of $3,000,000
Company C (Small Cap), stocks in the market $1,000,000
So all the money being traded now in the market is $10,000,000
Now you are an investor with a $10 million in cash, and ready invest in that country. You decided that monopoly is the game you will play, and that you will buy the entire market. How could you call buying 1/3 large, 1/3 mid and 1/3 small buying an entire market? You will miss some stocks out there, and other people will buy them, and you would end up with cash on hand. The only way to buy the entire is to weight towards company A even if that will make your portfolio 60% in large cap (as a monopoly tycoon, you must buy the entire $6 million of company A, the entire $3 million of B and so on).
Now let's assume that you only have $1,000 and want to still mirror buying the entire market? same thing, the amount you invest shouldn't make a difference, since the entire market consists of 60% large cap, then the only way that you buy a proportional piece of the entire market is to buy $600 worth of large cap, $300 mid cap, and $100 small.
1/3 is your portfolio's stock percentage of each of the different sized cap sectors. You should not really miss out on any stocks out there because you are buying a large cap blend fund, a mid cap blend fund and a small cap blend fund. No one on this planet is rich enough to buy the entirety of the stock market, so yes, buying a total stock fund gets you proportionally in the same position. My original point in this thread is that even though by owning only a total US stock fund you technically own the entire market, the way the fund is based (by being market cap weighted) the fund's performance really mirrors a large cap blend fund pretty closely and it doesn't allow the mid and small caps to move the needle very much. By doing a 1/3 large, 1/3 mid and 1/3 small you are putting equal dollar amounts of your personal money in play in order to not try and choose the winners.....which in a total US stock market fund would be betting on large cap stocks to win out over time.

If one looks at historical performance, there are years when large cap wins, some years when mid cap wins, and some years when small cap outperforms so why not own all 3 in equal amounts as long as a person can tolerate the historically increased volatility that comes with owning smaller cap stock funds.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by edge » Sat Jan 06, 2018 10:57 pm

The market capitalization is what the market thinks the company is worth. Since the market determined the worth of these companies, then the market portfolio would reflect that.

Seems obvious?

The other metrics you mentioned: revenue, profits, or some other metric cannot adequately capture the market value of a company. Profitability may come at the expense of growth. Revenue may have low margins. The current quarter or annual financial results may not reflect future probabilities of lower or higher future returns etc, etc, etc.

Market capitalization captures the aggregate market opinion on the value of the company and its future prospects.
willthrill81 wrote:
Sat Jan 06, 2018 10:53 pm
edge wrote:
Sat Jan 06, 2018 10:17 pm
Because the point of the market portfolio is to achieve market returns.
But "market returns" are determined by how you define the market. I've yet to hear a compelling argument that market capitalization is the best means of defining a market.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by willthrill81 » Sat Jan 06, 2018 11:08 pm

edge wrote:
Sat Jan 06, 2018 10:57 pm
The market capitalization is what the market thinks the company is worth. Since the market determined the worth of these companies, then the market portfolio would reflect that.

Seems obvious?

The other metrics you mentioned: revenue, profits, or some other metric cannot adequately capture the market value of a company. Profitability may come at the expense of growth. Revenue may have low margins. The current quarter or annual financial results may not reflect future probabilities of lower or higher future returns etc, etc, etc.

Market capitalization captures the aggregate market opinion on the value of the company and its future prospects.
willthrill81 wrote:
Sat Jan 06, 2018 10:53 pm
edge wrote:
Sat Jan 06, 2018 10:17 pm
Because the point of the market portfolio is to achieve market returns.
But "market returns" are determined by how you define the market. I've yet to hear a compelling argument that market capitalization is the best means of defining a market.
So basically, you're saying that market cap-weighting an index is a popularity contest. On that point I agree with you. However, that doesn't mean that it's the optimal approach for investors. I've never seen it mentioned here, but the #1 market cap weighted firm in any given market tends to underperform the entire market cap-weighted market by 5%. Yet that is the top holding in a market cap-weighted index.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by nexchap » Sun Jan 07, 2018 12:13 am

willthrill81 wrote:
Sat Jan 06, 2018 11:08 pm
edge wrote:
Sat Jan 06, 2018 10:57 pm
The market capitalization is what the market thinks the company is worth. Since the market determined the worth of these companies, then the market portfolio would reflect that.

Seems obvious?

The other metrics you mentioned: revenue, profits, or some other metric cannot adequately capture the market value of a company. Profitability may come at the expense of growth. Revenue may have low margins. The current quarter or annual financial results may not reflect future probabilities of lower or higher future returns etc, etc, etc.

Market capitalization captures the aggregate market opinion on the value of the company and its future prospects.
willthrill81 wrote:
Sat Jan 06, 2018 10:53 pm
edge wrote:
Sat Jan 06, 2018 10:17 pm
Because the point of the market portfolio is to achieve market returns.
But "market returns" are determined by how you define the market. I've yet to hear a compelling argument that market capitalization is the best means of defining a market.
So basically, you're saying that market cap-weighting an index is a popularity contest. On that point I agree with you. However, that doesn't mean that it's the optimal approach for investors. I've never seen it mentioned here, but the #1 market cap weighted firm in any given market tends to underperform the entire market cap-weighted market by 5%. Yet that is the top holding in a market cap-weighted index.
I don't think "popularity contest" has much meaning here. There's a pool of investors (the market) who get up each day and look for opportunities to a) increase returns for the same risk or b) get the same returns for less risk. If trading asset X for asset Y satisfy either of those goals, then they trade X for Y until the drop in the price of X / gain in the price of Y brings the two back to equilibrium. Is that a "popularity contest"? The market cap of every asset at any point in time reflects the best reward available for the risk that asset presents: if asset X winds up representing 5% of the entire investable universe, its because that just happens to be the price at which buyers and sellers hit equilibrium, not that X is super-popular.

When you deviate from that weighting (let's say you underweight X relative to the market), you're making one of two statements:
1) I believe that the investor equilibrium is wrong, and asset X isn't going to provide the returns the market thinks. More people should be selling X and buying Y, so I'll get ahead of them. Or
2) The market has correctly priced X for the average risk profile of all the investors out there, but my risk profile isn't "average". Maybe I'm 90, and shedding risk. I'll never get enough reward out of X to justify its volatility, so I don't want any of it. Or maybe I'm 20, with a 10 figure trust fund, and willing to go 100% into the riskiest stuff out there to maximize rewards.

Argument 2 is a very sane reason to deviate from market-cap indexing, but I don't think it has anything to do with rejecting "popularity"

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Re: "The enemy of a good plan"

Post by venkman » Sun Jan 07, 2018 1:01 am

Taylor Larimore wrote:
Sat Jan 06, 2018 2:34 pm
Bogleheads should feel confident owning the biggest and most successful companies in the world.
True, but the problem is that EVERYONE should feel confident owning the biggest, most successful companies in the world; and that relatively safety will result in lower expected returns. In the (somewhat paraphrased) words of Larry Swedroe, "The best companies are not the best investments."

That being said, I'll also paraphrase Jack Bogle and say that, while the 3-fund portfolio may not be the best investment strategy, there are an infinite number of strategies that are worse... :happy

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by jalbert » Sun Jan 07, 2018 1:12 am

wouldn't it make more sense to own:

1/3 Large cap blend index fund
1/3 Mid cap blend index fund
1/3 Small cap blend index fund
Yes, if what you want is a small-cap and mid-cap tilt. Many people prefer a market weight index fund, which never needs rebalancing, an advantage in a taxable account. The equal weight portfolio above will need to be rebalanced to maintain equal weight.
Risk is not a guarantor of return.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by randomguy » Sun Jan 07, 2018 1:29 am

yarnandthread wrote:
Sat Jan 06, 2018 6:02 am
The 3 fund portfolio uses the Total US stock market (ex. VTSAX or VTI) as one of the 3 components. Given that roughly 83% of the VTSAX/VTI is concentrated in the largest 500 companies by market weight, it closely approximates the S&P 500. So even though it TECHNICALLY owns the whole market, it truly is a large cap fund. If the GOAL is to truly own the entire market, wouldn't it make more sense to own:

1/3 Large cap blend index fund
1/3 Mid cap blend index fund
1/3 Small cap blend index fund

This way you truly aren't picking favorites? You would then have a more EQUAL stake in all publicly traded companies in the US stock market versus a de facto Large Cap fund with VTSAX/VTI. And given small caps historical performance edge versus large caps it makes even more sense to use this vs the traditional 3 fund portfolio if you can stomach the likely increased volatility. A simpler portfolio of 50% large blend and 50% small blend would likely have a similar long term performance of the 1/3 Large, 1/3 Mid and 1/3 Small portfolio based on historical data...anyone agree with this?

This same analysis applies to the International component as well.
Your still picking favorites. YOu are going to own a ton more apple (3.4% of large cap) than Bank of America (1.2%.) And bank of america is the 10th largest stock. Think how little of the 100 you will own. The mid caps are a bit more concentrated but you will end up with a situation where you might own .04% of the 500 biggest stock and 2% of the 501 biggest stock because one is considered a large cap and the other is considered a midcap. Does that make any sense? You can google the discussions about market cap weighting versus equal weighting to see the pluses and minuses of each approach.

But yeah at a high level a lot of people thing investing with a bias away from large caps makes sense. Other people disagree. I

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by BogleMelon » Sun Jan 07, 2018 10:00 am

willthrill81 wrote:
Sat Jan 06, 2018 10:12 pm
BogleMelon wrote:
Sat Jan 06, 2018 9:44 pm
I am no expert like all the others who replied here, but here is how I understand why the 3 fund portfolio is not flawed in a simple humble way:
Assume that there were only 3 companies in country xyz!
Company A (Large Cap) that has outstanding total stock in the market of $6,000,000
Company B (Mid Cap) with stocks of $3,000,000
Company C (Small Cap), stocks in the market $1,000,000
So all the money being traded now in the market is $10,000,000
Now you are an investor with a $10 million in cash, and ready invest in that country. You decided that monopoly is the game you will play, and that you will buy the entire market. How could you call buying 1/3 large, 1/3 mid and 1/3 small buying an entire market? You will miss some stocks out there, and other people will buy them, and you would end up with cash on hand. The only way to buy the entire is to weight towards company A even if that will make your portfolio 60% in large cap (as a monopoly tycoon, you must buy the entire $6 million of company A, the entire $3 million of B and so on).
Now let's assume that you only have $1,000 and want to still mirror buying the entire market? same thing, the amount you invest shouldn't make a difference, since the entire market consists of 60% large cap, then the only way that you buy a proportional piece of the entire market is to buy $600 worth of large cap, $300 mid cap, and $100 small.
Why weight them according to their market capitalization? Why not revenue, profits, or some other metric?
Because when you buy, you buy the outstanding stocks (AKA market capital), you are not buying the revenue, you are not buying the profits. Buying the entire market = buying the entire stocks of all the companies regardless of their profits.
"One of the funny things about stock market, every time one is buying another is selling, and both think they are astute" - William Feather

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by deltaneutral83 » Sun Jan 07, 2018 10:35 am

Thank you Nisiprius for the analysis.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by willthrill81 » Sun Jan 07, 2018 11:06 am

BogleMelon wrote:
Sun Jan 07, 2018 10:00 am
willthrill81 wrote:
Sat Jan 06, 2018 10:12 pm
BogleMelon wrote:
Sat Jan 06, 2018 9:44 pm
I am no expert like all the others who replied here, but here is how I understand why the 3 fund portfolio is not flawed in a simple humble way:
Assume that there were only 3 companies in country xyz!
Company A (Large Cap) that has outstanding total stock in the market of $6,000,000
Company B (Mid Cap) with stocks of $3,000,000
Company C (Small Cap), stocks in the market $1,000,000
So all the money being traded now in the market is $10,000,000
Now you are an investor with a $10 million in cash, and ready invest in that country. You decided that monopoly is the game you will play, and that you will buy the entire market. How could you call buying 1/3 large, 1/3 mid and 1/3 small buying an entire market? You will miss some stocks out there, and other people will buy them, and you would end up with cash on hand. The only way to buy the entire is to weight towards company A even if that will make your portfolio 60% in large cap (as a monopoly tycoon, you must buy the entire $6 million of company A, the entire $3 million of B and so on).
Now let's assume that you only have $1,000 and want to still mirror buying the entire market? same thing, the amount you invest shouldn't make a difference, since the entire market consists of 60% large cap, then the only way that you buy a proportional piece of the entire market is to buy $600 worth of large cap, $300 mid cap, and $100 small.
Why weight them according to their market capitalization? Why not revenue, profits, or some other metric?
Because when you buy, you buy the outstanding stocks (AKA market capital), you are not buying the revenue, you are not buying the profits. Buying the entire market = buying the entire stocks of all the companies regardless of their profits.
Why would I care about buying "the entire market" as defined by market capitalization if it's likely to lead to sub-optimal returns? I don't really care what I own; I care about returns.

Here's part of the problem with market cap-weighting. If a firm's stock price doubles relative to the rest of the index, then it will comprise twice as much of the index as before, and investors in the index will hold twice as much of that firm as before. But is that firm likely to be twice as good of an investment now as it was before the price doubled? Research indicates a resounding "no," in particular for very large firms. Again, the largest company, as defined by market cap, in a given market has historically underperformed the rest of the market by 5%, yet this will be the largest single holding in a market cap-weighted index. Market cap-weighting is inherently a large cap growth strategy, yet tilts toward small and value have, over the long-term, outperformed large cap growth strategy.

I'm not saying that a market cap-weighted index is nonsensical nor that it cannot serve investors well. But I am saying that I believe that it is likely to lead to lower long-term returns than other means of indexing a market.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by dbr » Sun Jan 07, 2018 11:25 am

willthrill81 wrote:
Sun Jan 07, 2018 11:06 am


Why would I care about buying "the entire market" as defined by market capitalization if it's likely to lead to sub-optimal returns? I don't really care what I own; I care about returns.

Of course. That is why there are so many approaches and tools to designing a portfolio that offers or is hoped to offer results more suitable to the objectives of the investor. How successful that enterprise can be is a discussion that is not resolved by pointing out that the market is "overly concentrated" in Apple and Google.

I would not say one can close that discussion by just asserting the total market. The problem is in characterizing any portfolio that is less optimum than some other choice as "flawed." Even using the term "sub-optimal" is a little perjorative without being specific as to what is being optimized. Usually that is some figure of merit related to both risk and return. If the objective is to get the highest returns possible, one should say so. I don't even like calling that "performance" because that word carries with it suggestions of absolute good when stock returns in general come as a trade off with things most people do not want.

I myself am completely neutral on whether or not anyone in particular "should" prefer the total market.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by nisiprius » Sun Jan 07, 2018 11:29 am

willthrill81 wrote:
Sat Jan 06, 2018 10:12 pm
...Why weight them according to their market capitalization? Why not revenue, profits, or some other metric?...
For the reasons I tried to explain in my post above. Not everyone agrees but there is a clear reason to weight by market cap. It is special. It is not just some arbitrarily chosen weighting.

Cap-weighting also has some other attractive features. It is the only weighting system that does not put you at the mercy of arbitrary category definitions. If you cap-weight the whole stock market, your allocation does not depend on whether REITs are a part of the financial sector or a sector in their own right, and you didn't have to buy or sell stocks when the S&P Dow Jones revised the GICS classification in 2015. If you cap-weight, it doesn't matter whether small-cap utility stocks are included in or screened out of the small-cap value category. If you cap-weight international, you don't need to care why Vanguard says VGTSX is 19.80% emerging markets but Morningstar says it is only 16.57%, and you don't need to do anything if some authority changes its mind about whether South Korea is an emerging or a developed market.

Cap-weighting also minimizes the turnover and transaction costs; compare the Invesco Equally-Weighted S&P 500 A fund, VADAX, with 24% turnover and 0.53% ER, to Vanguard's... heck, Fidelity's cap-weighted Fidelity® 500 Index Premium, FUSVX, 5% turnover and 0.04% expenses.

Now, people can and do make cases, cases that are at least plausible, that departures from cap-weighting can have advantages that outweigh the advantages of cap-weighting. But the advantages of cap-weighting are there, and it is unique. They stem from the bedrock fact that the dollar allocation in the market itself is cap-weighted.
Why would I care about buying "the entire market" as defined by market capitalization if it's likely to lead to sub-optimal returns? I don't really care what I own; I care about returns.
I imagine that ten years ago, Ted Seides of Protege Partners might have said "why would want to own an S&P 500 index fund if it leads to sub-optimal returns, compared to a portfolio of five intelligently-selected hedge funds?" You wouldn't want to own the market if you were sure that some other weighting or choice would give you better returns. Lots of people are sure. That's why only 1/3rd of the market is passively invested.

But you wouldn't want to beg the question by assuming that cap-weighted funds will give suboptimal returns... would you?
Last edited by nisiprius on Sun Jan 07, 2018 11:38 am, edited 2 times in total.
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dbr
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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by dbr » Sun Jan 07, 2018 11:31 am

It is also interesting that factor models such as Fama-French are related to the cap-weighted total market as the zero point for reference.

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by BogleMelon » Sun Jan 07, 2018 11:36 am

willthrill81 wrote:
Sun Jan 07, 2018 11:06 am
BogleMelon wrote:
Sun Jan 07, 2018 10:00 am
willthrill81 wrote:
Sat Jan 06, 2018 10:12 pm
BogleMelon wrote:
Sat Jan 06, 2018 9:44 pm
I am no expert like all the others who replied here, but here is how I understand why the 3 fund portfolio is not flawed in a simple humble way:
Assume that there were only 3 companies in country xyz!
Company A (Large Cap) that has outstanding total stock in the market of $6,000,000
Company B (Mid Cap) with stocks of $3,000,000
Company C (Small Cap), stocks in the market $1,000,000
So all the money being traded now in the market is $10,000,000
Now you are an investor with a $10 million in cash, and ready invest in that country. You decided that monopoly is the game you will play, and that you will buy the entire market. How could you call buying 1/3 large, 1/3 mid and 1/3 small buying an entire market? You will miss some stocks out there, and other people will buy them, and you would end up with cash on hand. The only way to buy the entire is to weight towards company A even if that will make your portfolio 60% in large cap (as a monopoly tycoon, you must buy the entire $6 million of company A, the entire $3 million of B and so on).
Now let's assume that you only have $1,000 and want to still mirror buying the entire market? same thing, the amount you invest shouldn't make a difference, since the entire market consists of 60% large cap, then the only way that you buy a proportional piece of the entire market is to buy $600 worth of large cap, $300 mid cap, and $100 small.
Why weight them according to their market capitalization? Why not revenue, profits, or some other metric?
Because when you buy, you buy the outstanding stocks (AKA market capital), you are not buying the revenue, you are not buying the profits. Buying the entire market = buying the entire stocks of all the companies regardless of their profits.
Why would I care about buying "the entire market" as defined by market capitalization if it's likely to lead to sub-optimal returns? I don't really care what I own; I care about returns.

Here's part of the problem with market cap-weighting. If a firm's stock price doubles relative to the rest of the index, then it will comprise twice as much of the index as before, and investors in the index will hold twice as much of that firm as before. But is that firm likely to be twice as good of an investment now as it was before the price doubled? Research indicates a resounding "no," in particular for very large firms. Again, the largest company, as defined by market cap, in a given market has historically underperformed the rest of the market by 5%, yet this will be the largest single holding in a market cap-weighted index. Market cap-weighting is inherently a large cap growth strategy, yet tilts toward small and value have, over the long-term, outperformed large cap growth strategy.

I'm not saying that a market cap-weighted index is nonsensical nor that it cannot serve investors well. But I am saying that I believe that it is likely to lead to lower long-term returns than other means of indexing a market.
Choosing to tilt towards small, international, factors..etc is completely a different animal! Sure one can choose to tilt towards whatever he thinks make sense. But I only meant to answer OP question on why the total market index fund is not flawed. It holds the market as is, without tilting. If the market "as is" consists of 80% large cap, then the index fund should mirror that. Every investor has the choice of course to mirror what the market holds (total market index fund) vs what he thinks will yield a better returns..
"One of the funny things about stock market, every time one is buying another is selling, and both think they are astute" - William Feather

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by Taylor Larimore » Sun Jan 07, 2018 12:21 pm

willthrill91 wrote: Why would I care about buying "the entire market" as defined by market capitalization if it's likely to lead to sub-optimal returns? I don't really care what I own; I care about returns.
Willthrill81:

You may be interested in "MarketWatch Total Returns For 8 Lazy Portfolios"-- all designed by professional authorities. Allan Roth's Second Grader's Starter Portfolio leads all the rest. It is The Three-Fund Portfolio. Its 10-year return includes a terrible bear market and a lengthy bull market.

"Total Returns for 8 Lazy Portfolios"

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by Allan Roth » Sun Jan 07, 2018 1:07 pm

Taylor Larimore wrote:
Sun Jan 07, 2018 12:21 pm

You may be interested in "MarketWatch Total Returns For 8 Lazy Portfolios"-- all designed by professional authorities. Allan Roth's Second Grader's Starter Portfolio leads all the rest. It is The Three-Fund Portfolio. Its 10-year return includes a terrible bear market and a lengthy bull market.

"Total Returns for 8 Lazy Portfolios"

Best wishes.
Taylor
Thanks Taylor. There are powerful forces that make it hard to keep things simple!

https://www.financial-planning.com/news ... ios-simple

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Re: Does the 3 fund portfolio seem somewhat flawed?

Post by willthrill81 » Sun Jan 07, 2018 2:21 pm

Taylor Larimore wrote:
Sun Jan 07, 2018 12:21 pm
willthrill91 wrote: Why would I care about buying "the entire market" as defined by market capitalization if it's likely to lead to sub-optimal returns? I don't really care what I own; I care about returns.
Willthrill81:

You may be interested in "MarketWatch Total Returns For 8 Lazy Portfolios"-- all designed by professional authorities. Allan Roth's Second Grader's Starter Portfolio leads all the rest. It is The Three-Fund Portfolio. Its 10-year return includes a terrible bear market and a lengthy bull market.

"Total Returns for 8 Lazy Portfolios"

Best wishes.
Taylor
Taylor, this is in direct contradiction to what you said below.
Taylor Larimore wrote:
Fri Jan 05, 2018 11:00 pm
Using past performance statistics to project future performance is useless at best; dangerous at worst. Read what investing experts say about "Past Performance":

What Experts Say About "Past Performance"

Best wishes.
Taylor
Further, I do not consider a 10 year period to be long-term. Factors can easily underperform the broad market for a decade. That being said, the equity side of some of those Market Watch portfolios has indeed outperformed TSM over the last decade.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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