Some Pointers on Passive Investment in the World Market Portfolio
by Michael S. Rozeff
by Michael S. Rozeff
This article follows up on my previous article. It clarifies some questions and provides more specifics. My goal is, at low cost, to get the average investor into a reasonably sensible investing ballpark. In my view, investors should not be spending very much of their capital paying for portfolio construction or portfolio management services. I have two reasons for saying this. One is that a do-it-yourself approach is feasible. There are many index funds that are easy to buy and sell on exchanges as ETFs using a good discount broker, like Scottrade, or through no-load mutual funds. Second, the fees that many portfolio management services charge are too high. The market bears it because many investors lack financial knowledge.
Investors vary in age, income, occupation, tax status, risk preference, and other personal variables. There is no one investment solution suitable for everyone. But, with adjustment to one's cash position, one portfolio of risky securities can serve surprisingly well to achieve the investment goals of preserving capital, obtaining some growth of capital, and keeping risk to a minimum. That portfolio is the world market-value weighted portfolio.
Suppose W is this world portfolio. Suppose you have money to invest, say $1,000. You can vary the risk of your portfolio by what fraction you place in W and what you keep in short-term liquid securities like treasury bills or a bank account. A risk-tolerant person might place $1,000 in W and none in t-bills. A person more risk-averse might place $500 in each. The fact is, however, that W has rather low risk. Many people will want to invest most of their investable funds in it.
The proportions that the values of major asset classes have within the world portfolio are suitable for a passive investor to mimic. The world's many investors have an immense amount of information that you and I do not have. If they think that all the stocks in the world should have twice the value of all the bonds in the world, as shown by their market values, then so should we. We should hold twice as much money in stocks as in bonds. If we don't, we are betting (speculating) against the market and saying that the world is wrong. If we hold all bonds, we are implicitly denying that stocks are worth what the world says.
The world market portfolio is likely to be of moderate risk, and the return it might provide of 7 percent will seem too low for some. But it will provide the highest return for that level of risk that one is likely to find. One can place a greater amount of funds into it to make up for the moderate return. Over time, one will be able to stomach placing a greater fraction of one's wealth in the portfolio because the fluctuations won't be as large as if one held all stocks.
Some will want to go for the 9 percent or more that stocks may deliver. Someone asked me why they shouldn't just hold all stocks and no bonds if they had a long investing horizon, because stocks tend to outperform bonds once the horizon is 20 years or more. The answer is that this is feasible, but it has added risk because one is undiversifying. It is a form of speculation. The fact that stocks have made 9 percent or more in the past and outperformed bonds doesn't mean they will do it in the future. In fact, bonds did as well as stocks in the 80s and 90s as interest rates fell. You could place all your money in stocks and be making 9 percent for many years. Then suddenly you could run into that rare occasion when stocks decline by 90 percent and then do not recover for 20 years. Stocks are risky. If you place all your eggs in the stock basket, you are speculating. And then you'd better know the principles of speculation. I have nothing against speculation. I speculate. Most of us will do some speculation. I suggest keeping one's speculations separate from one's passive investments. Management of them requires very different knowledge and principles.
Now, debt. If you want to build up wealth through investment, you must postpone consumption. You must avoid going into debt to finance consumption. $1,000 invested at 7% doubles in about 10 years. If you are 20 years old, $1,000 invested now could become about $16,000 by age 60 or so. If you borrow to buy something, not only will you not see that $16,000, but you will be paying someone else interest. Your wealth will not only not grow, you will be enduring something akin to slavery. You will have sold off the rights to your future income from working. You will have to work simply to pay the debt and interest on the debt. You will lose control over your income and wealth. That is the price you pay for borrowing to consume now.
When I speak of real estate investment, I most definitely do not mean your home. You should not consider your home as an investment no matter how economists define the term. It's better to think of it as a consumption item. You are buying a bundle of future housing services when you buy a home. Any price change in it is incidental. Sure, there are people who speculate on houses. There are people who buy them, fix them up, and sell them. There are people who buy land lots and speculate. People do lots of things. Let them. Unless you intend to specialize in homes as a speculative business, forget it as an investment. A home usually requires a mortgage, so you are in debt. It requires tax payments and maintenance. Buying and selling it is very costly. A home eats money. This is not what you want in an investment.
By real estate, I mean commercial real estate. This includes such things as office buildings, warehouse and commercial space, malls, and apartment rentals. It means that you are the landlord. You collect the rents. Now, you are not going to do this yourself. You will do it by buying shares in companies that own and manage commercial properties. A few decades ago, this market began to open up to individual investors, but the arrangements were quite bad. There were limited partnerships governed by horrendously long and complex agreements. Many investors got burned. Today, the real estate investment trusts provide a stock investment that serves the purpose.
By bonds, I mean corporate bonds. I do not include government bonds in the market portfolio. The market portfolio contains securities behind which are real assets that produce income. Behind corporate bonds are the company assets, which provide net wealth. Behind government bonds are future tax payments that come out of taxpayer income. There is no net wealth in these bonds.
It is difficult to submit to the market's pricing and not have a speculative view of our own. One might be reluctant to place funds in bonds if interest rates are low. But if one avoids bonds, one is betting on a rise in interest rates over some period of time that will make capital losses offset the interest income. This again is speculation. If you have strong views about the pricing of some sector and you still want to hold the world portfolio, consider phasing in your investment over time. If you think bonds are too high in price, select some horizon, like 12—18 months. Then gradually buy into the bond market. You will be mixing in a moderate amount of speculation into your investment decision. This may satisfy your urge to act upon your own views.
The world portfolio involves a global asset allocation. Investment results hinge primarily on the asset allocation proportions. Managers that advertise tactical asset allocation are speculating on the pricing of various sectors. Passive investment avoids this. Its asset allocation depends on the market value weights.
I have two different methods to estimate market value weights. Both are rough, but they come out close. If the numbers do not all add up, don't worry about it. I've had several classes look into this over the years, and the results always come out about the same. They are approximate, but good enough for practical purposes. We are not sending a rocket to the moon here.
First, for high net worth investors, who hold most of the world's wealth, these weights in risky securities (disregarding cash assets) are about as follows:
- 35 percent in stocks
- 24 percent in bonds
- 18 percent in real estate
- 23 percent in other assets
The other assets include all sorts of real assets like gold, timber, art, and commodities. They include foreign currencies, hedge funds, venture capital, private equity, and managed funds. The average investor will not be concerned with many of these things, but we reserve some allocation for real assets below. If and when these assets prove themselves and can be bought by individual investors at a reasonable fee and if they are diversified, then some part of the portfolio could be allocated to them.
The second method uses all sorts of estimates. The amount of real estate in the market portfolio is unknown. By one estimate, there is $14.5 trillion in commercial properties available for investment. One-third is in the U.S. and two-thirds overseas. By other estimates, bonds are worth $45 trillion. Non-government bonds are worth some $32 trillion and stocks worth about $35 trillion. The S&P 500 is worth about $15 trillion. One estimate places world investable wealth at $123 trillion (including government debt). Foreign debt securities are about equal in value to U.S. domestic debt securities. The U.S. stock market, if it is worth $20 trillion in total, would be 20/55 = 0.36 or 36 percent of the world total.
Starting from $123 trillion, subtract $13 trillion for government bonds. That leaves $110 trillion, of which $32 trillion is bonds, $35 trillion stocks, and $43 trillion is other, mainly real estate. The proportions are
- 32 percent stocks
- 29 percent bonds
- 39 percent real estate and other.
These numbers are close to those found for high net worth investors. It's not worth getting too fussy about all this. If other real assets are 10 percent, that leaves 29 percent for real estate, which is $32 trillion. This is inconsistent with the one estimate of $14.5 trillion, which I think is too low.
The precious metals, art, timber, commodities and such are not as large as one might think in contributing to overall world investable wealth. Without going through an elaborate calculation, they add up to 10 percent at most. I allocate 10 percent. That is generous. One might make it 5 percent.
Putting all this together, I suggest these approximate proportions for the world market portfolio.
- 35 percent in stocks
- 25 percent in bonds
- 30 percent in real estate
- 10 percent in gold
Then I suggest dividing the bonds into half domestic and half foreign bonds. The real estate may be divided into 1/3 domestic and 2/3 foreign. However, I could not argue with a 50-50 split. The stocks can be divided as 40 percent domestic and 60 percent foreign, based on estimates above.
We then have
- 14 percent U.S. stocks
- 21 percent foreign stocks
- 12.5 percent U.S. bonds
- 12.5 percent foreign bonds
- 10 percent U.S. real estate
- 20 percent foreign real estate
- 10 percent gold
This portfolio definitely avoids the "home bias" that is typical of many investors who stick too heavily to their own countries. Furthermore, it leans toward the faster growing and less socialistically constrained corners of the globe.
The next step is to choose mutual funds for these categories. I can do that in many ways. Whatever selections I might make will be merely suggestive. I have not done a thorough study of all the available indexes and what they contain. I haven't broken down the above classes into finer categories. There is a great deal I have not done. It's not clear that it pays to do a great deal more. This is where you can do your homework. You also can subdivide some of the categories still further if you like. My job is done. I have shown you what the passive investing ball game is about.
For U.S. stocks, there is VTSMX, Vanguard's total stock market index. Also look for their exchange-traded fund that may avoid some costs, which is VTI.
For foreign stocks, there is VGTSX, Vanguard's total international stock index. See also their VEU.
For U.S. bonds, a mix of maturities is best or else a duration of about 5 years. One may wish to avoid bond funds that have mortgage-backed securities and stick with traditional bonds. One may wish to avoid high-yield bond funds. Keep it simple. One might want tax-exempt bonds. Many bond funds contain government bonds. This won't matter much. The fund VBMFX is a possible choice. Also see BIV.
For foreign bond index funds, a possibility is EMB.
One might choose RWR for domestic real estate and RWX for foreign real estate.
There are plenty of advisors on how to hold gold. I make no suggestion.
In sum, with about 6 mutual funds and/or ETFs in the proportions suggested, plus a commitment in gold, one can attain an overall portfolio that will be about as worry-free as one can make it. Not only has one diversified very well across sectors and the world, but also within each fund are hundreds and sometimes thousands of securities. Your bet is on the world economy. You cannot make it any more basic than that. You are not speculating on any individual sector, country, company, or type of security. You are so well diversified that a catastrophe in one area should leave you almost unscathed. If the world survives and grows, you will earn a normal rate of return on your investment.
There will be taxes to pay. This is very disturbing. Having paid taxes on your income, you will then pay taxes on what you save. When you die, there will be more taxes. You will wonder why you bothered building up wealth. The government encourages us to be wastrels. It's a wonder that some of us still save. In America, the official saving rate is zero or negative.
Perhaps your best investment is in travel. You can find another place in the world to live, one that doesn't tax investments the way the U.S.A. does.
January 21, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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