An interesting conversation about core and explore developed in the comments of yesterday's post with references to the Pareto Principle. A couple of readers expressed an interest in having the majority of their portfolio in some sort of core allocation that I presume they would want to leave alone and then put a smaller portion (the number 20% was mentioned) into what most would call explore. The idea being that "the 20% of your portfolio which can make 80% of consequences" as one reader put it.
Despite a peculiar comment to the contrary it is very worthwhile to explore portfolio ideas that may not be what you would do but are still valid nonetheless. 80/20 is not what I would do but it is valid.
The 80/20 idea is like every other reasonable idea anyone can come up with; it has strengths and weaknesses. I think the positives were spelled out in the comments. Beating the market over time is difficult, managing a portfolio is taxing (time spent and emotionally) and constructing a portfolio can be difficult too. So in that light a couple (or more) broad-based index funds for the 80% becomes attractive and then the investor would try to add value or extra return or something else with the 20%. It being a smaller portion of the whole pie the consequences for mistakes should be less and since it is less money it should require less time.
The first drawback that comes to mind is the visibility for having to really be right with what you buy with that 20%. What I mean is that if someone has a $600,000 portfolio and they put 20% into some potentially great themes and they are one way or another don't work out you do create a big drag for for the portfolio. Explore-ish themes could easily take a 20% hit if something goes wrong with the story (biotech comes to mind as an example of an idea that could lose more than 20% very quickly).
It makes sense that over any reasonable period of time there would be years where 80/20 would work out great, years where the result is really bad and a lot of years where the result is not much different than anything else.
This is not to say someone should not do this but that every strategy has drawbacks (80/20 has more than the one I touched on here) and before you change course you need to understand the drawbacks in addition to the benefits and weigh all that out for yourself.
An unpleasant administrative note. We are at a point with the hecklers that I get asked about it by co-workers, clients, friends and relatives. Reader responses to the hecklers all try to rationally tell these guys to hit the bricks but the problem is of course that someone who takes the time that these guys do to visit, read and comment so regularly just tell me what an idiot I am or how dishonest I am is never going to do the rational thing. I don't get it, you don't get it, anyone who is rational and respects their own time will not get it.
There are several things I can do. For now I am going to start out immediately deleting the comments from these guys. I mind the store the vast majority of the time so they will usually be deleted very quickly (I get an email when a new comment gets posted and when I look at the blog there is a little trash can icon to quickly delete a comment).
This is a much faster process than moderating all the comments that come in (but it may come to that).
I really could care less what anyone says but it is clearly a distraction for readers which then becomes a time-suck for me. Everyone will understand this except the two or three hecklers who will be confused by this. If moderating comments becomes necessary, well we'll cross that bridge.
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30 comments:
"The idea being that "the 20% of your portfolio which can make 80% of consequences" as one reader put it."
Something tells me that for a long-term investor we should invert the numbers.
Good. Dump the hecklers. They are a distraction. Jon
Several points. First, you run a great blog - I learn some things and just ponder some things from your comments. Short of taking the hecklers out be3hind the barn and smothering them, your approach is best - there are certainly some strange people out there.
Re the 80/20 - what am I missing? Why is this not just gambling with 20% of your portfolio? Who is the wizard who will decide what the "explore" will be put into? I thought that portfolio management was all about asset allocation, diversification and risk/reward management. I understand the "explore" concept but why would you do this with 20% of your assets?
Maybe I just don't understand
I admire your restraint with the
hecklers. Keep the faith.
Jay Charles
that was the point I was trying to make. Even if not viewed as gambling by the person implementing that could be what it looks like.
The idea as I understand as it was put forth in the comments was that you only need to understand a few things for the 20% while putting 80% into broad index funds.
I don't know why you would even have any second thoughts about banning assclowns from your "house". Ritholtz or Cara, for example, don't tolerate them.
I'm a core and explore kind of guy. I enjoy managing my own money, but I recognize the potential to mess things up badly as well. For that reason, I readly widely and limit my discretionally funds to 10% of my portfolio.
The crux of the issue is how one defines and practices "exploring."
In my case, it's not Vegas-like bets on hot tips, but over-weighting themes that have the potential to deliver outsized returns. Examples include defense, water, and clean energy. I use ETFs to reduce the risk of a single stock imploding, but also expect more volatility than my core holdings exhibit.
That may not work for everyone, but seems to add alpha (not to mention fun and satisfaction) to my returns.
Dumb question - why allow anonymous comments? It's simple to create a Google login, yet it might deter lazy people.
For the exploring part of your portfolio(20%) here are some thoughts. you can have high octane funds or etfs, double longs or double shorts. Important thing is limit each position with a stop-loss so maximum loss to each position is limited to 1% of your total portfolio. A simple yet concret % number fo such positions is 4%(with a 25% stop-loss). Hey, I will go for CGMFX, FXI, GLD , TWM and the like.
It is always difficult to identify how much to save. You probably need to save a lot. If you do save a lot 80% is likely to be sufficient for a modest retirement.
People are different, but someone should determine over time if they are good at managing the 20% or not. If not they can make it 100% instead of 80%. I think 80/20 is a great start for many people to evaluate themselves over time.
Deleting disruptive hecklers, not those who simply disagree is a great idea. I think logins would discourage many people. Some of us hate constantly being tracked and others will provide any information requested (why I do not know).
I think login would be a bad idea. You read every post any way moderation might not be as bad as you think (except if you are traveling etc.)
hopefully the deletions will discourage and frustrate people enough to move on to some where else.
One good aspect of the heckler issue, is that if they spend their time focusing on their inner emotional need to heckle, at least they are not running for political office...
I say just burn'em.
Tom
I don't believe Pareto's Principle is intended to be precise nor does it really imply a particular portfolio composition, in fact it's not even necessary for it to total 100% AFAIK. The message I think is that regardless of portfolio composition or allocation the bulk of the returns will come from relatively few assets or asset classes and finding a way to capture some of that is a good idea.
Could be by: overweighting/underweighting, core/explore (with the understanding the 'core' may occasionally be the source of outsize returns), momentum allocation, long-tail diversification (seeking outsize returns in less efficient markets), or what have you, or even periodic portfolio rebalancing since assets gaining the fastest overweight themselves and realigning them now and then prepares the ground for the next set of leaders, at least in principle ;-)
In that last vein I've seen some research that lends support to the idea that rebalancing more frequently (twice a year rather than once for e.g.) when times are bad and less frequently when times are good (maybe once every 18 to 24 months) can add to returns but unfortunately I can't find the reference right now. Assuming I'm recalling that correctly it would lend some support to the notion that this provides a way to rotate into the next set of Pareto leaders.
I don't believe Pareto's Principle is intended to be precise nor does it really imply a particular portfolio composition, in fact it's not even necessary for it to total 100% AFAIK. The message I think is that regardless of portfolio composition or allocation the bulk of the returns will come from relatively few assets or asset classes and finding a way to capture some of that is a good idea.
Could be by: overweighting/underweighting, core/explore (with the understanding the 'core' may occasionally be the source of outsize returns), momentum allocation, long-tail diversification (seeking outsize returns in less efficient markets), or what have you, or even periodic portfolio rebalancing since assets gaining the fastest overweight themselves and realigning them now and then prepares the ground for the next set of leaders, at least in principle ;-)
In that last vein I've seen some research that lends support to the idea that rebalancing more frequently (twice a year rather than once for e.g.) when times are bad and less frequently when times are good (maybe once every 18 to 24 months) can add to returns but unfortunately I can't find the reference right now. Assuming I'm recalling that correctly it would lend some support to the notion that this provides a way to rotate into the next set of Pareto leaders.
PS: WRT hecklers - what Tom said, burn 'em. A good heckle now and then gets the blood flowing, particularly when there's some substance to it, but a constant diet with the same underlying message is extremely boring. Gian Gravina once (not so famously but very accurately) remarked that "the bore deprives you of solitude without offering companionship" -- the online equivalent is the troll with the main difference being they intrude on conversation while depriving the community of thoughtfulness.
Shoot, sorry for the messed up post above; got called away to the phone and wound up pasting part of it twice when responding to Tom's comment; i.e., the first three paragraphs are redundant, if you want to delete those Roger be my guest.
Now back to work.
Re: rebalancing.
I'm not a tax expert, but I believe that the main reason that investors are told to rebalance once a year at most is because of the capital gains tax issue.
I might add as well that this blog may need to be rebalanced to zero weight hecklers and back to 100% non-hecklers about twice a day. :)
JackS
that might be right about the tax issue but I would say that rebalancing based on the calendar is a distant second choice to rebalancing when things get too far away from their respective targets.
The trigger point depends on the person but if it need to be done three times in a year or if after two years it is only off kilter by 2% so be it.
I use a core-and-explore for the kid's custodial accounts, which are currently ~90% BSV and ~10% "other" (from 100% BSV). This was driven primarily by market conditions, though, and will certainly change over time. The accounts are only several months old, so putting them in equities at the time, was a non-starter. It is interesting how much more conservative I am with OPM, even though it's my kid's accounts! It has been a good lesson for me, though, to be patient and let the opportunities present themselves.
As I mentioned a few times when proportional ideas about an investment scheme are floated, I use a Permanent Portfolio(s) for my core holdings that are about 75%of my security position. Funding my Permanent Portfolio(s) are monies that are precious to me and are diversified in securities across a spectrum of market sectors throughout the world, including some bonds. Most pay dividends.
About 25% of my securities and some higher risk bonds are in my Speculative Portfolio(s). I can afford to loose money here and still sleep at night. I have been lucky in that this 25% has done very well over the years, but I admit that luck rather than brilliance has played a higher role in its success.
I maintain that an investor with everything but their home in equities is not diversified. Rental real estate, for instance, is a wonderful investment, especially for the cash buyer in this foreclosure-laden market.
David Rosenberg, chief economist with Merrill Lynch may be saying to put your 20% in cash for a while. (not to mention most of your 80%)
http://tinyurl.com/29b2xy
JackS
'T': Bet there are blog visitors who lack the funds (or the ability to be successful landlords - not as easy as it looks) but would like to gain access to rental markets anyway. Since some markets are beginning to overshoot to the downside and offer good opportunities (in the Pareto sense too) what are some of their options and how might they learn more about them?
Core and explore sounds like a valid idea me so long as "explore" isn't viewed as a license to gamble. Every strategy should be a play to win with appropriate risk management.
I prefer strategy diversification myself. Perhaps it's a psychological crutch but using more than on strategy helps me stay disciplined over long periods.
Monte Carlo testing has shown that adding non-correlated assets boosts returns. I think that's where you start with your non-core. So don't add GE to your SPY, add a foreign small cap or bond fund, then rebalance to capture the relative outperformance.
I personally don't have any money to "throw on a flyer" and tend to think that's what "explore"
I think that some readers have misunderstood Pareto's principle. I think he suggests that 20% of investors win, while 80% lose(By the way, this is very consistent with recent Nobel prize winning research on investor and financial advisor performance.)
Signed,
Joe Sixpack
Regarding periodicity of rebalancing:
See Mebane Faber, World Beta - Engineering Targeted Returns and Risk
...not much these days has low correlation to the "market"..in the old days you could buy small cap or REITs...but with the huge bull market in those over the last 7yrs....I guess you could use an inverse fund, now that has negative corr. I read somewhere, in the text to learn stuff for the CFA exam, that TIPs have a low to neg. Corr. If you put the SPY and TIP up on a chart together, you can see how if MAY work. Caveat Emptor.
good convo. though. there are just some time periods where things move together. Oh! I thought of one more or the present only--don't know how it would work long term...but the Japanese Yen goes inverse to the SPY...mho
Joe.
If 80% lose it's usually because they sell their stocks low when in panic mode durring the usualy corrections and down markets. Many other folks buy the latest mutual fund magazines and try to chase lasts years winners.
That covers a lot of losers but I'm not sure it adds up to 80% of investors. What do you suppose makes up for the other losers needed to reach the 80% number?
JackS
Roger--doing a search and destroy on the trolls makes great sense. Of course that will rob me of something to get incensed about, but I have kids, so they'll fill in.
Regarding the "explore" portion of the portfolio. I keep a separate account that had some left over money in it from options/ESP. It was small, about $5-7K. I used that as my speculative (explore) money, giving myself permission to buy more speculative things than I wanted to. I've grown it to just over $20K in about 20 months. In terms of absolute dollar increment, it is not much. However, at $20K, it is no longer a small amount of money to me in absolute dollars as was $5-7.
Because of the earlier limitations of the account, I had to find ways to get more bang for the buck. I ran across some interesting finds--most good, some bad!
A clarification: The point that I wish to clarify is be clear about exploring v. speculating. To my mind, a speculative investment is one that you can wave bye-bye to without shedding tears.
While I listed a carved out piece of dollars that had natural parameters, I would never consider having 20% of my portfolio in speculative positions.
I am 100% cash....this is a classic bear market in the making.
I am not trying to spread fear, just looking at the reality. Dollar has bottomed, gold will fall, oil will fall. Every rally has been sold for the past 2 weeks.
100% cash? If you are in a pure safety mode you should then make sure you're in a 100% treasury MM fund like VMPXX.
Perhaps you could put 80% in that fund and roll the dice with 20% in a regular money market fund netting a cool half percent more. Think of the excitement of then having a true 80/20 portfolio!
Of course I'm being facetious, but it's good advice now that if you are wary of a possible meltdown in the financial markets to have your cash accounts in US backed treasuries. We have recently discussed just that here a week or so ago.
I recently transferred my 401K to Scottrade and it's still in their core cash account as I put together my diversified buy & hold portfolio. I am going to soon transfer it to VMPXX myself and wait out the storm. A sure 4% doesn't sound too bad right now.
Of course I still have so-called 20% account (it's more like 40%) in my ROTH IRA in Fidelity with some ETF and stock positions. Even that account is 50% in cash right now.
JackS
This is not a critical issue with VMPXX since it is fairly conservatively run as are virtually all Vanguard offerings but virtually all money market funds including treasury and govt agency-based funds use various techniques to goose returns including repo's: repurchase agreements where the fund's assets are loaned out to other parties for a fee. That introduces counterparty risk and in cases where the majority of the fund's portfolio has been loaned out (not an uncommon occurrence although AFAIK VMPXX doesn't loan out a large % like that) there is a possibility of loss if the counterparty runs into trouble regardless of the quality of the assets loaned; e.g., the assets could be tied up in bankruptcy proceedings.
This was a significant issue back in the 70's when Harry Browne was recommending one of the only treasury backed money market funds that did not allow repo's or any other counterparty risk as a matter of fundamental policy; that was the Benham Capital Preservation fund (CPFXX) and, now owned by American Century, it still has the same fundamental policies AFAIK.
Why would that matter? Well, if an investor believes a serious financial crisis is coming then that must assume some companies are going to fail, assets are going to deflate, reserves are going to become depleted and some money market funds are going to "break the buck" - shares will be worth less than a dollar. If that isn't part of the assumption during crisis then, for a long-term investor, the logic of moving 100% into cash via a money market doesn't hold up very well; better to buy t-bills directly or bury the cash in the back yard along with some gold doubloons.
Disclosure: I've got some CPFXX and some gold doubloons too but am not 100% in cash FWIW.
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