| BUSINESSWEEK ONLINE : FEBRUARY 22, 1999 ISSUE | ||||||||
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| COVER STORY
The Real Decision What to put where? The crucial art of allocating assets hinges on using the right index funds ''WHAT DO I THINK OF CREATING A PORTFOLIO ONLY OUT OF INDEX FUNDS?'' asks Harold R. Evensky of the financial planning firm of Evensky, Brown & Katz in Coral Gables, Fla. ''I think it's a terrific idea.'' Meir Statman, professor of finance at Santa Clara University agrees: ''You can do everything you need to do in a portfolio with index funds.'' Okay, so if you invest with index funds you won't wow anyone with tales of savvy stock picks. No reason to watch CNBC for hot tips, worry about nosebleed valuations on Internet stocks, or struggle to pick the next top-performing mutual fund. Good news indeed. ''The biggest investment mistake people make,'' says Barbara Raasch, partner at Ernst & Young, ''is focusing on last year's mutual-fund performance and not on what really drives returns.'' Using index funds concentrates your mind on the one investment decision that truly matters: asset allocation (table, page 136). Economic research suggests that how you divide your portfolio among stocks, bonds, and other assets is the main determinant of its long-term performance. By definition, with an index fund you make a commitment to a whole market or sector rather than to individual securities or a money manager who may or may not remain true to an advertised goal of sticking to growth, value, or big- or small-cap stocks. When you're allocating assets, you first need to consider the inevitable trade-off between risk and return. How much risk are you willing to take? How much risk should you expect from a particular strategy? For instance, the Standard & Poor's 500-stock index has returned 13.5% annually since 1950. But on the way to earning that return, figures Ibbotson Associates, its value has fluctuated, on average, by 16.8% each year. Long-term Treasury bonds, by contrast, returned 5.9% over the same time period. Reflecting their lower level of risk, their annual volatility was 10.7%. And T-bills returned 5.2% annually since 1950, with only 2.9% annual fluctuations. The trick is to mix asset ''classes'' such as these to get the highest potential return for the amount of risk you're willing to accept. ANTONIO'S ADVICE. Take a young woman who's early in her working career and has a high tolerance for risk. An aggressive investor with a long time-horizon, she might design an overall investment portfolio that's 54% in large-capitalization stocks, 20% in small caps, 24% in international equities, and 2% in fixed income. Her one-year expected return is 11.6%, based on historic data. The expected risk on her portfolio is 13.8%, which means that there's a two-thirds probability that the return over the next year will be between 2.2% and 25.4%, says Raasch. In other words, if the young woman had a $100,000 portfolio, there's a two-thirds probability it would be worth between $97,800 and $125,400 at yearend. An investor wanting lower risk might go with 40% large-cap stocks, 15% small caps, 18% international, and 27% fixed income. The expected return is 10.1%, but the risk factor would be 10.9%. Diversification is the other critical idea behind asset allocation. Antonio in Shakespeare's The Merchant of Venice was unworried because ''my ventures are not in one bottom trusted, nor to one place; nor is my whole estate upon the fortune of this present year.'' But how much diversification do you need and how do you figure that out? Many economists and financial planners agree that the traditional candidates are enough for most investors: domestic stocks, international equities, bonds, and cash or its equivalent. There is some relationship between the movements of U.S. stocks and foreign equities, a weaker relationship between U.S. stocks and Treasury bonds, and essentially no correlation between stocks and Treasury bills. By mixing some of each asset class into a portfolio, you may give up some performance but will lessen the risk of having your savings all go down the drain at once. True, any U.S. equity investor who diversified over the past decade got lower returns compared with ones who kept everything in the Vanguard 500 Index fund or blue-chip stocks. But since no one really knows which markets will soar or sink in the future, investing in all the major asset classes creates an opportunity to catch the next big market upturn--and buy a margin of safety against a major decline. ''There have been long periods of time when stocks do poorly,'' says James Paulson, chief investment officer at Norwest Investment Management Inc. ''These periods can exceed people's psychological ability to handle it.'' KINGS FOR A DAY. Index funds offer a number of advantages when it comes to asset allocation. You can buy index funds that capture the entire U.S. stock and bond markets and much of the overseas capital markets, too. The most important advantage over actively managed funds is low cost. If you had invested $10,000 in 1988 in the average equity fund, your investment would have grown to $42,342 in 1998 after subtracting fees of $5,225, according to Vanguard Group. A comparable investment in a typical S&P 500 index fund would have grown to $57,147 after taking its modest fees of $961 into account. Fees aren't the only costs associated with active management. Time is another. You have to ferret out good fund managers and then monitor them closely. That's tough to do. A study of equity mutual funds from 1971 to 1991 by Professor Burton G. Malkiel of Princeton University makes for sober reading. Among his findings: Even a superb 10-year track record failed to guarantee a winning performance over the following 10 years. A portfolio of the 20 best stock mutual funds from the 1970s underperformed all funds during the 1980s. The job of running ''what if'' scenarios to discover the right asset allocation for you has been made a lot easier with the proliferation of computer-finance software and Web sites devoted to money. To give you an idea, Ernst & Young created a hypothetical portfolio for someone in the middle of a career and with a moderate ability to cope with volatile swings in the market. We then went to Morningstar Inc. to find index funds with low expense ratios and good returns and plugged them into the asset-allocation model. How often should you rebalance a portfolio? Financial planner Evensky looks closely at the portfolios of his clients every quarter. He allows for a 7% drift up or down from the original asset allocation before adjusting the portfolio back to the original ratio. Raasch, however, believes that reviewing a portfolio once a year is enough, and she recommends picking the same day every year--say, Jan. 1--to see what eggs are in which basket. If poring over balance sheets and studying company managements is not your passion, index funds are the best way to invest. Even Warren Buffett, a methodical stock-picker if there ever was one, concedes that point. ''By periodically investing in an index fund...the know-nothing investor can actually outperform most investment professionals,'' Buffett wrote in 1993. Allocating your assets carefully and investing them in index funds may not make you the next Sage of Omaha. But it's a strategy that has worked well for many people so far. By Christopher Farrell in St. Paul, Minn. _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP |
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