Last of series on diversification, sector/country funds

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larryswedroe
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Last of series on diversification, sector/country funds

Post by larryswedroe » Fri May 04, 2012 7:25 am

And a summary of why people fail to diversify, the mistakes they make
Hope you find it helpful


http://www.cbsnews.com/8301-505123_162- ... ountries/?
Best wishes
Larry

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Re: Last of series on diversification, sector/country funds

Post by Lbill » Fri May 04, 2012 9:00 am

Larry-

In your article you say:
Investors are rewarded with higher expected returns (risk premiums) for taking systematic risks, risks which can't be diversified away. With stocks, there are three types of risk:

Beta (exposure to the overall stock market)
Size (exposure to small-cap stocks)
Value (exposure to stocks with high book-to-market or low P/E ratios)
And yet, in their 1992 paper "The Cross-Section of Expected Stock Returns", Fama & French state that when size is accounted for, Beta (market risk exposure) is unrelated to returns. What is the explanation of this apparent contradiction?
"Life can only be understood backward; but it must be lived forward." ~ Søren Kierkegaard | | "You can't connect the dots looking forward; but only by looking backwards." ~ Steve Jobs

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Re: Last of series on diversification, sector/country funds

Post by larryswedroe » Fri May 04, 2012 10:24 am

lbill
Have to run but short answer I believe is best from the paper by Moskowitz and Ronen

Working paper. The Role of Shorting, Firm Size, and Time on Market Anomalies

Remember that FF found that the three factor model does a better job, much better, than the one factor model of explaining the cross section of returns.
What research I think has found since is that once you account for beta the risk premium in small is not abnormal. If memory serves that is what the paper found.
But don't have time to check now.

Larry

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Re: Last of series on diversification, sector/country funds

Post by Jerry_lee » Fri May 04, 2012 11:23 am

Larry,

An offshoot of your comment on single country funds can be seen in the views of a particular advisor here that recommends holding equal percentages of Europe and Asia/Pacific Vanguard fund instead of the EAFE. While not an egregious mistake, it sends the wrong message.

The real purpose of adding international stocks to a US portfolio is to improve risk adjusted returns. And whether you hold the EAFE or Europe/Asia separately, your big blue chip Int'l stocks will be very highly correlated with your big blue chip US stocks inside your S&P 500/Total Stock/Core fund. You are much better served not slicing and dicing individual countries or regions, and instead focusing on the factors that drive returns (all developed countries have the same expected returns): size and value.

So in going international, you are better off sticking with value and small cap stocks exclusively, or a Core fund that holds all international stocks but tilts to smaller and more value oriented companies. For retail investors, that means EAFE Value and EAFE Small.

After a few years of disappointing size/value premiums, it is easy to forget the basics of portfolio construction.
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Re: Last of series on diversification, sector/country funds

Post by grap0013 » Fri May 04, 2012 12:24 pm

Jerry_lee wrote:
So in going international, you are better off sticking with value and small cap stocks exclusively, or a Core fund that holds all international stocks but tilts to smaller and more value oriented companies. For retail investors, that means EAFE Value and EAFE Small.
Why not small cap value exclusively for domestic as well?
There are no guarantees, only probabilities.

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Re: Last of series on diversification, sector/country funds

Post by larryswedroe » Fri May 04, 2012 3:59 pm

Jerrylee
First, there is some argument for equal weighting, as it minimizes the risks of a bubble--the Japan problem. However, this can also be addressed by structure inside of the funds that limit country exposure to a maximum for any single country.
Second the negative of course is that for taxable accounts you have now imposed tax costs for rebalancing between the two, and possibly some transactions costs as well


Grap,
The argument for only small and small value and EM for international is not that there are no diversification benefits from int'l large, but that the benefits are much greater for int'l small stocks than for large stocks. Of course all US asset classes are exposed to US risks, so might want to diversify those sources of risks.

Best wishes
Larry

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Re: Last of series on diversification, sector/country funds

Post by yobria » Fri May 04, 2012 11:15 pm

I liked the beginning:
Investors buying sector funds are assuming that somehow the market has mispriced not just single (or a small group of) stocks, but an entire sector. There's no logical reason or any evidence to suggest that the market either misprices entire sectors or that investors can profit from any such mispricing
Except for those corners of the market you've dubbed a "free stop at the dessert tray", correct?

The idea that mining historical data patterns (which we know will not repeat going forward), and using the results as an excuse to toss out the rules of diversification and market efficiency, as you suggest at the bottom of the article, is dangerous and nonsensical. Equally contradictory is the quote:
Investors are rewarded with higher expected returns (risk premiums) for taking systematic risks, risks which can't be diversified away
A developed small cap stock may offer higher risk than a developed large cap, but so would an emerging market large cap. You can diverisfy away both risks to the same degree.

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Re: Last of series on diversification, sector/country funds

Post by larryswedroe » Sat May 05, 2012 1:22 pm

There is no evidence that markets have mispriced sectors but there is evidence that the market has either mispriced small growth stocks or that investors simply have a preference for assets with lottery like characteristics (which means it not mispricing but taste). Other asset like penny stocks and IPOs have also been found to be either mispriced persistently or the behavioral explanation must hold. One of the two. Take your pick. Either way investors without such tastes can exploit that knowledge--though only in a very small corner of the market, about 2% (by avoiding it)

There are no other rules of diversification that are violated by a "slice and dice" portfolio as suggested---all the idiosyncratic risks have been diversified, accepting only systematic risks

As to this
which we know will not repeat going forward
, that is also a false statement. We don't know any such thing. If there is a logical risk story to the pattern then it is likely the pattern will repeat (stocks outperforming bonds, small outperforming large, value outperforming growth, EM outperforming developed), though of course there is no guarantee or there would be no risk. The risk premiums are only ex-ante. We expect them to be there ex-post but accept the risks that they won't. It's like I expect the Yankees to be in the playoffs every year because they have largest payroll, but it's not guarantee.

again more examples of if something doesn't agree with Yobria's (false) paradigm, he ignores all evidence to the contrary.

Best wishes
Larry
Last edited by larryswedroe on Sat May 05, 2012 2:33 pm, edited 1 time in total.

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Re: Last of series on diversification, sector/country funds

Post by Beagler » Sat May 05, 2012 1:37 pm

yobria wrote: The idea that mining historical data patterns (which we know will not repeat going forward), and using the results as an excuse to toss out the rules of diversification and market efficiency....
Watch out for that market-cap weighting pattern: it's resulted in TSM concentrating over 1/6 of the fund into just the top 10 stocks. https://personal.vanguard.com/us/funds/ ... hist=tab:2

VTSMX now holds fewer stocks than at any time in the fund's history, reducing its "broad diversification."
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Re: Last of series on diversification, sector/country funds

Post by sanfran2012 » Sat May 05, 2012 4:04 pm

somebody on the page of the original article posted the following question:

"by mwoerner100 May 4, 2012 11:36 AM EDT
Larry, I enjoy your columns. Burton Malkiel has suggested that the broader indexes are underweight China on a GDP basis, which suggests that investors should add a China fund to be properly diversified. What do you think about that?"'


anybody?

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Re: Last of series on diversification, sector/country funds

Post by larryswedroe » Sat May 05, 2012 4:48 pm

see my blog where I answered it
Larry

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Re: Last of series on diversification, sector/country funds

Post by Muchtolearn » Sat May 05, 2012 4:55 pm

For a reason I cannot articulate I don't like international funds. I was just thinking about this and checked the Vanguard website. There were 1 or 2 at the time high-cost managed international funds about 30 years ago. About 20 years ago the index funds appeared. So we thus had a whole bunch of people prior to the 80s who had no choice but to be US investors unless they proceeded by some expensive route such as individual foreign stocks or asset management. And nobody really complained. Although this is heresy here, the markets are getting more correlated, the US funds are a lot less expensive than the international funds and taxes are less and simpler. I just wonder whether its all worth it.

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Re: Last of series on diversification, sector/country funds

Post by stlutz » Sat May 05, 2012 5:12 pm

the US funds are a lot less expensive than the international funds and taxes are less and simpler.
I don't know that a few hundredths of a percentage point higher in ER qualifies as a "lot" more expensive. Foreign stocks, especially in Europe, tend to spin off more dividends as they distribute a much higher percentage of their annual income. I have to fill out one additional line on my 1040 (foreign tax credit) to hold international funds.

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Re: Last of series on diversification, sector/country funds

Post by yobria » Sat May 05, 2012 6:03 pm

Muchtolearn wrote:For a reason I cannot articulate I don't like international funds. I was just thinking about this and checked the Vanguard website. There were 1 or 2 at the time high-cost managed international funds about 30 years ago. About 20 years ago the index funds appeared. So we thus had a whole bunch of people prior to the 80s who had no choice but to be US investors unless they proceeded by some expensive route such as individual foreign stocks or asset management. And nobody really complained. Although this is heresy here, the markets are getting more correlated, the US funds are a lot less expensive than the international funds and taxes are less and simpler. I just wonder whether its all worth it.
It's not a question of correlations so much as the risk the country you bet on (the US) being the underperformer going forward, as Japan was over the last 20 years. Best to spread your risk among many countries.

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Re: Last of series on diversification, sector/country funds

Post by jginseattle » Sat May 05, 2012 6:26 pm

Muchtolearn wrote:For a reason I cannot articulate I don't like international funds. I was just thinking about this and checked the Vanguard website. There were 1 or 2 at the time high-cost managed international funds about 30 years ago. About 20 years ago the index funds appeared. So we thus had a whole bunch of people prior to the 80s who had no choice but to be US investors unless they proceeded by some expensive route such as individual foreign stocks or asset management. And nobody really complained. Although this is heresy here, the markets are getting more correlated, the US funds are a lot less expensive than the international funds and taxes are less and simpler. I just wonder whether its all worth it.
Corellations vary with time.

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Re: Last of series on diversification, sector/country funds

Post by Muchtolearn » Sat May 05, 2012 6:36 pm

You're probably right. I like 1 stock fund. Maybe the total world will get admiral shares and a reasonable ER soon.

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Re: Last of series on diversification, sector/country funds

Post by centrifuge41 » Sat May 05, 2012 6:41 pm

Muchtolearn wrote:For a reason I cannot articulate I don't like international funds. I was just thinking about this and checked the Vanguard website. There were 1 or 2 at the time high-cost managed international funds about 30 years ago. About 20 years ago the index funds appeared. So we thus had a whole bunch of people prior to the 80s who had no choice but to be US investors unless they proceeded by some expensive route such as individual foreign stocks or asset management. And nobody really complained. Although this is heresy here, the markets are getting more correlated, the US funds are a lot less expensive than the international funds and taxes are less and simpler. I just wonder whether its all worth it.
How come? Fear of the unknown? I'm sure that you know at least some of the following companies:
Nestle, BP, Shell, Toyota, Samsung, Siemens, Mitsubishi, Honda, Anheuser-Busch, and Astrazeneca. What do these all have in common?

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Re: Last of series on diversification, sector/country funds

Post by Muchtolearn » Sat May 05, 2012 8:22 pm

centrifuge41 wrote:
Muchtolearn wrote:For a reason I cannot articulate I don't like international funds. I was just thinking about this and checked the Vanguard website. There were 1 or 2 at the time high-cost managed international funds about 30 years ago. About 20 years ago the index funds appeared. So we thus had a whole bunch of people prior to the 80s who had no choice but to be US investors unless they proceeded by some expensive route such as individual foreign stocks or asset management. And nobody really complained. Although this is heresy here, the markets are getting more correlated, the US funds are a lot less expensive than the international funds and taxes are less and simpler. I just wonder whether its all worth it.
How come? Fear of the unknown? I'm sure that you know at least some of the following companies:
Nestle, BP, Shell, Toyota, Samsung, Siemens, Mitsubishi, Honda, Anheuser-Busch, and Astrazeneca. What do these all have in common?
International. Point well made. These are big caps. Let me ask (not being argumentative). These companies are multinational like big US companies.
BP and shell - should they differ much from exxon and hess
Astra Zeneca - should it differ much from US pharma
Etc.

So is a US company really a US company and vice versa for foreign companies. It seem you get currency risk (or benefit) with foreign companies. Do their businesses really differ that much?

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Re: Last of series on diversification, sector/country funds

Post by umfundi » Sat May 05, 2012 9:08 pm

Larry,

Your posts and writings are extremely instructive.

Thank you,

Keith
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Re: Last of series on diversification, sector/country funds

Post by nisiprius » Sat May 05, 2012 9:29 pm

Beagler wrote:Watch out for that market-cap weighting pattern: it's resulted in TSM concentrating over 1/6 of the fund into just the top 10 stocks.
sanfran2012 wrote:Burton Malkiel has suggested that the broader indexes are underweight China on a GDP basis, which suggests that investors should add a China fund to be properly diversified.
The total market is the total market. It is what it is. And it has characteristics that arise from the fact that it is the total market. Saying one should invest according to weighting by GDP is just like any number of theories that maintain that you can improve somewhat on the total market by adjusting the weighting to something different.

(And for the record, yeah, I believe in one of them myself--I believe that global cap-weighting is suboptimal because of the effect of currency risk which makes international stocks have fundamentally different characteristics--more variability, same return--as U.S. stocks. John Norstad, in his essay on Investing in Total Markets, calls this one of the "efficient" reasons for varying from the total market).

Once you depart from the total market, you lose the characteristic of canceling out the effects of speculative trading on your portfolio. And, perhaps this is the same thing, Jeremy Siegel says
Capitalization-weighted indexes... under certain assumptions give investors the "best" tradeoff between risk and return. That means that for any given risk level, these capitalization-weighted portfolios give the highest returns, and for any given return, these portfolios give the lowest risk. This property is called mean-variance efficiency.
Siegel says this only then to knock it down, saying that the market is not fully efficient because it is "noisy," and that under those conditions his thing, "fundamental indexing," can improve on the total market.

The fact that e.g. large-cap stocks constitute most of the total market is not an objection to total market investing. Because these stocks are so large, the same speculative trade that moves a smaller stock a lot will move the larger stock only a little. And because they are so large, if Exxon has a bad year, well, yes, the economy as a whole and the market have a bad year. Saying you do not want to own Exxon because it's large is just another way of saying you think you can cherrypick parts of the economy that will do better than the economy as a whole.

I believe all this talk--new to me, seems like flavor-of-the-month to me--about trying to reshape your portfolio to fit the market as it would be if it were different from what it is--if companies that don't issue stocks did issue them, or if countries' share of the global stock market were the same as their share of global GDP--I think it's just the latest in the unending series of arguments against indexing. An unending marketing push to get people to buy unique funds for which companies can charge more, instead of commoditized index funds. You can see this, for example, in the difference in between the 0.35% expense ratio for Schwab Fundamental US Large Company* Index Fund SFLNX and the 0.09% expense ratio for the Schwab S&P 500 Index Fund.
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Re: Last of series on diversification, sector/country funds

Post by umfundi » Sat May 05, 2012 9:56 pm

nisiprius wrote:
Beagler wrote:Watch out for that market-cap weighting pattern: it's resulted in TSM concentrating over 1/6 of the fund into just the top 10 stocks.
sanfran2012 wrote:Burton Malkiel has suggested that the broader indexes are underweight China on a GDP basis, which suggests that investors should add a China fund to be properly diversified.
The total market is the total market. It is what it is. And it has characteristics that arise from the fact that it is the total market. Saying one should invest according to weighting by GDP is just like any number of theories that maintain that you can improve somewhat on the total market by adjusting the weighting to something different.

(And for the record, yeah, I believe in one of them myself--I believe that global cap-weighting is suboptimal because of the effect of currency risk which makes international stocks have fundamentally different characteristics--more variability, same return--as U.S. stocks. John Norstad, in his essay on Investing in Total Markets, calls this one of the "efficient" reasons for varying from the total market).

Once you depart from the total market, you lose the characteristic of canceling out the effects of speculative trading on your portfolio. And, perhaps this is the same thing, Jeremy Siegel says
Capitalization-weighted indexes... under certain assumptions give investors the "best" tradeoff between risk and return. That means that for any given risk level, these capitalization-weighted portfolios give the highest returns, and for any given return, these portfolios give the lowest risk. This property is called mean-variance efficiency.
Siegel says this only then to knock it down, saying that the market is not fully efficient because it is "noisy," and that under those conditions his thing, "fundamental indexing," can improve on the total market.

The fact that e.g. large-cap stocks constitute most of the total market is not an objection to total market investing. Because these stocks are so large, the same speculative trade that moves a smaller stock a lot will move the larger stock only a little. And because they are so large, if Exxon has a bad year, well, yes, the economy as a whole and the market have a bad year. Saying you do not want to own Exxon because it's large is just another way of saying you think you can cherrypick parts of the economy that will do better than the economy as a whole.

I believe all this talk--new to me, seems like flavor-of-the-month to me--about trying to reshape your portfolio to fit the market as it would be if it were different from what it is--if companies that don't issue stocks did issue them, or if countries' share of the global stock market were the same as their share of global GDP--I think it's just the latest in the unending series of arguments against indexing. An unending marketing push to get people to buy unique funds for which companies can charge more, instead of commoditized index funds. You can see this, for example, in the difference in between the 0.35% expense ratio for Schwab Fundamental US Large Company* Index Fund SFLNX and the 0.09% expense ratio for the Schwab S&P 500 Index Fund.
Nisiprius, you are awesome!

I would nominate this for post of the year, except for many of your other posts.

Keith
Déjà Vu is not a prediction

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Re: Last of series on diversification, sector/country funds

Post by peppers » Sun May 06, 2012 10:33 am

I'll second what Keith said.
"..the cavalry ain't comin' kid, you're on your own..."

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