Saturday, May 13, 2006

Book Review: The Four Pillars of Investing

Wlliam Bernstein is the author behind The Efficient Frontier, the website discussing asset allocation and the theory and tools behind it. Bernstein wrote two books on investing, his first being The Intelligent Asset Allocator, a technical discussion of Asset allocation. This is the book, he says, for liberal arts major. (I did get a Bachelor of Arts in Computer Science, so this book is for me!)

Being a big fan of asset allocation, Bernstein writes:
since you cannot successfully time the market or select individaul stocks, asset allocation should be the major focus of your investment strategy, because it is the only factor affecting your investment risk and return that you can control

This is generally good advice, and his chapters on indexing, market timing, bubbles, and history are really good, and very much worth reading. His actual sample portfolios, however, are excessively complicated. For instance, for a taxable account, he suggests a bond portfolio that looks like this:
  • 25% Treasury Ladder
  • 25% Vanguard Short-Team Corporate Bond
  • 25% Vanguard Limited Term Tax-Exempt
  • 25% Vanguard California Intermediate-Term Tax-Exempt
I can understand not wanting to dump everything into California municipalities, with their risky histories, but it is doubtful that this portfolio with its attendant extra costs and extra manipulation needed would do so much better than one consisting entirely of a Treasury Ladder and the California Tax-Exempt fund as to be worth the extra effort. If you don't trust the California funds, a 75% weighting in the Treasury Ladder would be a better bet. Bernstein also neglects the delicious I-bonds, which have good tax properties and are worthy of an allocation.

For his tax-sheltered example, he goes for something even more complex for the equity portion:
  • 20% Vanguard 500 Index
  • 25% Vanguard Value Index
  • 5% Vanguard Small Cap Index
  • 15% Vanguard Small Cap Value Index
  • 10% Vanguard REIT Index
  • 3% Vanguard Precious Metals
  • 5% Vanguard European Stock Index
  • 5% Vanguard Pacific Stock Index
  • 5% Vanguard Emerging Stock Markets Index
  • 7% Vanguard International Value
There are several problems with this:
  1. Rebalancing between all these portfolio is a chore, and I doubt if most individual investors would enjoy having this many options
  2. Meeting the minimums alone would require a fairly substantial tax-sheltered portfolio
  3. Most 401(k) plans won't give you a good enough selection of Vanguard funds to enable you to cover such diversification.
  4. By having so many small accounts, you ignore the benefit of being able to qualify for Vanguard's Admiral shares, which have a significant reduction in expenses. Such reduction in expenses might cause your ultimate return to be higher than a complex portfolio, also partly because you are more likely to be able to rebalance such a portfolio on a regular basis.
Bernstein also doesn't understand the SEPP 72(t) exception, which is a very useful tool for early retirees, so don't expect help from him on such matters.

Ultimately, there's a lot of value in keeping your portfolio simple and easy to follow. When you see something that seems really complicated and hard to manage, run away and go for something simpler. I doubt if Bernstein's hypothetical tax-sheltered account would do much worse with:
  • 65% Vanguard Total Stock Market Index
  • 10% Vanguard REIT Index
  • 3% Vanguard Precious Metals
  • 22% Vanguard Total International Index
A simpler portfolio with lower costs and much less to go wrong.

[Addendum: The reason Bernstein recommends holding the components of the Total International Index is that you get the foreign dividend tax credit, which reduces your overall costs. This is a big enough deal that it's worth considering. I still think there's value in simplicity, however.]
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