Sunday, July 15, 2007

Asset Classes, Diversification & Costs

This is going to be a slightly dis-jointed post. I have several brief and unconnected ideas that I would like to talk about:

Investment Costs - reviewing my parents' investment portfolio this weekend, I was shocked to find that they are paying about 3% in fees to invest in an international stock fund. This is a fund that was recommended to them by a financial advisor.

Academics typically estimate the equity premium at about 6% per year. The equity premium is the extra return that investors receive for investing in stocks rather than in a risk free asset such as t-bills. This means that if t-bills yield 5%, an average stock investment is expected to yield about 11% per year. This increased return is your payment for accepting risk. My parents are paying about half of their equity premium to the mutual fund company. Why on earth would anyone want to do this?

Diversification - it recently struck me that the real-estate portion of our portfolio is not sufficiently diversified. Our real-estate position, which totals approximately 8% of our portfolio, is invested exclusively in Vanguard's REIT Index fund (NASDAQ: VGSIX). This gives us a diversified exposure to the U.S. real estate market, but does not give us any exposure to international real-estate markets.

In recent decades, equity markets around the world have become much more tightly correlated. This means that the diversification benefit gained by investing abroad has declined (it is still well worth it, though). Global real estate markets on the other are far less correlated, which means that they can probably add substantial diversification benefits to our portfolio.

Since my long term objective is to invest 10% of our portfolio in real-estate, I am thinking about increasing our current real-estate exposure by investing only in global real estate markets. If you have any ideas about highly diversified global real-estate funds, please let me know. In my initial research I did not find any global real-estate index funds, so going active may be my only alternative.

Success with My Brother - a few months ago I wrote a post about the fact that my brother was investing his money without a plan and without really understanding what he was doing. In the last few months my brother has gone through an amazing transformation. For one thing, he read a "A Random Walk Down Wall Street" which I had recommended to him, and was fully converted by the experience. Last semester he also took a class in modern portfolio theory, and I am guessing that this was another major factor in this welcome change. Rejoice ye index faithful! We have another convert to fill our ranks!

Now the challenge is to convert my parents. The main problem is the fact that my mother's tolerance for risk is much lower than her appetite for returns. This typically causes her to cash out of the market at exactly the wrong time.

I think I may cover that topic in more detail in tomorrow's post.


Jim Bigham said...

It's an interesting idea to compare the equity premium of the investment with its cost. I've talked at length about the concept of "friction" as money moves through the financial system of manufacturers, wholesalers, and retailers with every segment taking their "piece". I've always compared costs with gross return but your approach makes more sense. I'm thinking that in many expensive, inefficient 401K plans, the costs equal or even exceed the risk premium. Cheers!

Jim Bigham
The 401K Insider

TFB said...

RE: International Real Estate

I wouldn't do it but if you have to, consider the ETF RWX which tracks an index. 0.6% expense ratio. Highly concentrated though. More than 50% in 3 countries: Australia, Japan and UK.

Shadox said...

Jim - I agree that some 401K plans are ludicrously expensive, but expenses exceeding the equity premium? That has a law suit written all over it. Have you actually seen such plans?

TFB - thanks for the advice. RWX sounds a bit too concentrated for my purposes, but i'll take a closer look at it.