The 5 and 7 Year Itches

One of my friends invests with Raymond James Financial. After reading about the merits of indexed investing, he’s going to ask his advisor what he thinks.

The advisor will suggest something like this:

“Look, index funds might be fine for part of the portfolio, but you need to adjust your risk. Plus, we can find funds that beat the indexes.”

One of the first things an advisor likes to assume is that the client doesn’t understand the concept of portfolio allocation. True, for most people, a portfolio with a 100% stock index would be risky—about as risky as having a portfolio with a handful of actively managed stock-based mutual funds.

But if the client understands “portfolio allocation”, the advisor will start to sweat…

At the investment seminars I’ve given, I’ve suggested that people keep things simple:

1. The U.S. market constitutes nearly half of the world’s total stock market valuation, so it should constitute nearly half of the stock market money in your portfolio.

2. The international market makes up the remainder of the world’s stock market capitalization, so it should constitute the remaining “equity” portion of a portfolio.

3. If the client is between the ages of 40 and 50 (and if they don’t have a pension) then they could take a page out of John Bogle’s book and have 40% to 50% of their portfolio in bonds. Respected professor, Burton Malkiel, suggests a similar bond allocation.

Just three funds would accomplish the task:

40% in a Vanguard bond index

30% in a Vanguard total stock market index

30% in a Vanguard international stock market index

People can argue the merits of whether the investor should have a higher U.S. representation, or a higher or lower bond representation or a real estate income trust component or even a precious metals component.

And that’s fine. There are loads of trains of thought to defend and attack the above position.

That said, it will be tough to find an educated investor (with a financial education) who will suggest that an advisor charging a wrap fee of at least 1%, and then buying actively managed funds for my friend, will come close to the returns of the above portfolio over a lengthy period of time.

My friend has his money in a taxable account, and this is where it will be even more costly for him to remain with Raymond James. Actively managed mutual funds are not very tax efficient, when held in taxable accounts. Index funds are tax efficient.

If the advisor is good and honest, and if my friend presents these arguments, then he’ll say to my friend: “You’re right. You really should change your account. I’m sorry. I really could have cost you tens of thousands of dollars over your investment lifetime.”

If my friend is curious to see how he would have done with the simple arrangement above, I’ve tracked the results of such an indexed portfolio.

He could do this, to make a comparison with his own portfolio. Look at where his portfolio value was 5 years ago, near the end of June, 2005 or the beginning of July, 2005. He could then look at his portfolio value today, and then subtract the contributions he has made to the portfolio over the past 5 years.

For instance, if his portfolio was worth $200,000 five years ago, and if he deposited $1000 a month, then we could look at his current portfolio value, subtract $60,000 in contributions, and see what his dollar gain had been. From there, regardless of what his value was, he could work out an overall gain or a loss.

If his account was $150,000 five years ago, and if it was worth $200,000 today, we would take today’s value ($200,000) subtract his monthly contributions (say, $60,000 total) and come up with a number amounting to $140,000. In this case, my friend would have lost money over the past five years. To find out the percent lost, you’d divide 140,000 by 150,000, to get .933. This means that his account would be 93.3% of what was deposited into it, for a loss of 6.7%

I’ll be honest. The picture probably won’t look pretty for any investor. The markets are lower today than they were five years ago. But he needs to have a look.

If he had invested in Vanguard indexes in 2005, as suggested above, and if he hadn’t changed a single thing about them (and hadn’t added fresh money) his $200,000 invested five years ago would be worth $204,806.79, for a total growth of 2.4%.

You can see the portfolio here, titled “5 Year Itch”

Portfolio: 5 Year Itch          
Date: 06/21/10 09:24 AM          
Ticker Company Name Cost Shares % of Total Current Value Gain / Loss Gain / Loss
VBMFX Vanguard Tot Bd;Inv $10.27 7,789.00 40.35% $82,641.29 $2,648.26 3.31%
VGTSX Vanguard Tot I Stk;Inv $12.60 4,761.00 31.22% $63,940.23 $3,951.63 6.59%
VTSMX Vanguard T Stk Idx;Inv $28.77 2,085.00 28.41% $58,192.35 ($1,793.10) -2.99%
        0.02% $32.92    
          $204,806.79 $4,806.79 2.40%

If he had invested in the same manner at the beginning of 2003 (my friend can do the same calculation from this date, if he wants) then his $200,000 would be worth $269,599 for a total gain of 34.78%.

You can see the portfolio here, titled “7 Year Itch”

Portfolio: 7 Year Itch          
Date: 06/21/10 09:23 AM          
Ticker Company Name Cost Shares % of Total Current Value Gain / Loss Gain / Loss
VBMFX Vanguard Tot Bd;Inv $10.38 7,600.00 29.91% $80,636.00 $1,748.00 2.22%
VGTSX Vanguard Tot I Stk;Inv $7.72 7,772.00 38.72% $104,377.96 $44,378.12 73.96%
VTSMX Vanguard T Stk Idx;Inv $20.07 2,989.00 30.95% $83,422.99 $23,433.76 39.06%
        0.42% $1,122.93    
          $269,559.88 $69,559.88 34.78%

If my friend has been lucky, his performance will be similar to the indexes. If he hasn’t been lucky, his portfolio will lag the indexed portfolio considerably.

If he wants to increase the odds of future success, he’ll index the entire account, with stocks and bonds, and he’ll use a Vanguard representative to help him set up his account with the above allocations.

Then he’ll do nothing but wait, and contribute fresh money.

If he wants professional tax advice, he’ll pay out of pocket for that, and save himself a bundle in the hidden fees (and the not so hidden fees) currently charged by his advisor.