Posted by: Aaron Pressman on March 17, 2009
The brutal bear market has been less than kind to almost everyone who ever gave investing advice. In some cases, the press has picked up on it but not in every case. Exhibit A today is the continued praise showered on David Swensen, head of Yale’s endowment and author of the 2005 book, Unconventional Success: A Fundamental Approach to Personal Investment. In the book, Swensen lays out a simple asset allocation strategy relying on inexpensive index funds. Sock away 30% of your assets in U.S. stocks, 20% in real estate investment trusts, 15% in U.S. Treasury bonds, 15% in U.S. Inflation Protected Securities, 15% in foreign, developed stocks and 5% emerging market stocks. That’s it. That’s the magic formula.
In an interview in the March/April issue of the Yale Alumni magazine that went online the other day, Swensen says the magic formula is still the way to go:
Q: It may be fascinating to you, but it’s discouraging for those of us who have watched our 401(k) values plummet. Given all the turmoil and uncertainty, what should individual investors do?
A: If an individual investor followed the program I outlined in Unconventional Success [see box], they probably did reasonably well, through the crisis, thus far. They’d have 15 percent of their assets in U.S. Treasury bonds. They’d have another 15 percent in U.S. Treasury inflation-protected securities. Those two asset classes have performed well.
Of course, the other 70 percent of assets are in equities, which have not done well. With all assets, I recommend that people invest in index funds because they’re transparent, understandable, and low-cost. So, the equity holdings have gone down step-by-step with the declines in the market.
I recommend that investors rebalance.
But I also recommend that investors rebalance. Rebalancing is even more important amidst these huge declines in the stock market because it presents a great opportunity. People can sell the Treasury securities that have appreciated dramatically to bring their allocation to the 15 percent target, and they can redeploy those funds into domestic equities and foreign equities and emerging market equities and real estate investment trusts, all of which are now much cheaper, and therefore have higher prospective returns.
Of course, there’s one big problem with Swensen’s answer. His magic formula didn’t do so well during the crisis. If you take a simple mix of exchange-traded funds, allocate per Swensen’s book and look at the results over the past year, the bottom line is pretty ugly: -32%. (I used funds with the symbols IWV, TLT, TIP, EEM, IYR and EFA). That beats the S&P 500, but it’s much worse than a simple mix of say 70% U.S. stocks and 30% bonds, which lost only 25%. A 60/40 mix dropped 19%.
And a year-end rebalancing wouldn’t have helped — at least not yet. If you set Swensen’s allocations up at the beginning of 2008 (and lost 23%) and then rebalanced at the beginning of 2009, you’d be down 17% so far this year. But if you let your winners ride, so to speak, and went with the portfolio as it stood, you’d only be down 12%.
There are any number of reasons why Swensen’s magic formula wasn’t so magical of late. The main reason is that most of the various asset classes involved started to mirror each other’s performance more and more as the bear market grew more severe. Thus, the benefits of diversification shrank. It’s a predictable effect, the increasing correlation of different asset classes in volatile markets that’s been identified in numerous academic studies. One asset that would have helped improve results is gold, but Swensen’s not much of a commodity fan, at least in his book.
So what do you think? Should Swensen have his investing guru credentials repealed or is his advice still worth following?
[UPDATE: We’ve started a new thread about Swensen with more data and more arguments here.]