Frank Armstrong answers questions from readers of Investment Strategies for the 21st Century. Please note that the opinions expressed in Frank's responses are his, and not necessarily those of MFI or BES, Inc. To submit a question to Frank, write to us.

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Questions and Responses:

• How much does a reasonably sophisticated individual investor have to gain by consulting a professional?
• Passive index fund investing? Include foreign bonds in a 70/20/10 stock/bond/cash portfolio?
• Is a 50% international allocation with 10-15% emerging markets reasonable?
• Please elaborate on how you find Indian Market similar to a Snake Pit ?
• How do you assess the efficiency of the international markets?
• Is my IRA portfolio too risky?
• How can I reduce the risk that comes with international diversification?
• Is graduate-to-be making the right moves?
• Should we include Japan in our portfolios?
• What happens when a significant number of investors rely on highly-diversified mutual funds?
• How many different asset groups do you feel a person needs to cover ?
• Could you please discuss core style for a mutual fund?
• How and when should I move into a stock fund?
• Where can I find out more about investing?
• Should I have a different investment strategy if I'm not living in the U.S.?
• Will I ever be able to buy your book in print?
• Does being a baby boomer hurt me financially?
• Where can I find out about index funds?
• Can you explain how to generate an income stream?
• What software is best for creating an investment portfolio?
• The falling Japanese stock market vs. the rising economy
• How can you predict how much you'll need in the future?
• Have your views on international investing changed recently?
• Do fund managers use MPT?

• Next Volume of  Frank's Q&A

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How much does a reasonably sophisticated individual investor have to gain by consulting a professional?

from William

Q: Given the complexities of MPT you describe, as well as the data input sensitivity of the programs, how much does a reasonably sophisticated individual investor have to gain by consulting a "professional" who may not have the necessary economic background to implement MPT properly? Wouldn't one be nearly as well off by using a "scratchpad" approach to asset allocation, perhaps combined with one of the programs available from companies like advisor software. After all, I stopped using an accountant when I found I could get the same numbers with turbotax for <5% of the price.

A: In the interest of full disclosure, you must note that I am a professional advisor. Accordingly, it may not be possible for me to be entirely objective in my response. I will give it my best shot, because I think it is an important question. You are free to evaluate the extent that my conflicts of interest may influence the answer. Indeed, anyone with a brain must do so.

I started my business because I believe that a professional can add value to the investment process over an above his/her cost. I believe that there is a giant need for this service, and that a fair number of people will be willing to pay for that service.

If I didn't believe that, I could always go fly large aircraft for very fair compensation in exotic parts of the world, an occupation I loved almost as much as life itself. However, there are a number of pilots almost as skilled as I, and relatively few advisors in that category.

By definition, a "professional" must have the economic background to implement MPT. If you are considering the use of an advisor, you should be very certain of his/her qualifications.

The various optimizers available to do the math for MPT are little more than dangerous toys when placed in the wrong hands. There is no substitute for judgement. The consequences of a bad investment policy are far more catastrophic than a math error on your income tax return. The IRS may slap your wrist and asses a small penalty, but you may never recover from a flawed investment program.

In my experience, few investors stumble upon anything like an optimum allocation without help. And very few have the discipline to consistently execute a good plan even if they have one. The most recent update to Dalbar's study on investor behavior showed that over a twelve and a half year period, investors in equity mutual funds were able to achieve less than 25% of the return of the S&P 500!

Still, the investor is faced with making decisions in an atmosphere of uncertainty. An occasional investor may outperform a professional advisor. Through pure dumb luck, I am sure that many will outperform me. My view of the role of an advisor is not to obtain the highest possible return, but to provide the highest possible probability of a successful outcome within the client's risk tolerance. I'm looking for a succession of easy shots rather than a desperate hail Mary three pointer from the far court.

I want to balance the need for a solid return, with the need for a solid night's sleep. So, my investment approach is very risk averse. I don't take any risk for which I don't expect compensation, and I try to spread those risks as far as possible. We don't want to take any big risks in any particular segment of any market. This precludes me from ever being in the top 1 or 2 percent. An investor willing to concentrate his bets and take big risks may either beat me badly, ruin himself, or have an acceptable result. I can only hope that over long periods of time, I will be in the top quartile. Of course, there is no guarantee, and past performance is no assurance of future performance.

Most professionals beat most armatures consistently. That's why if you need brain surgery you don't necessarily ask your plumber to do it. Or, when you put your daughter on an airliner, you hope to see a captain with a few thousand hours of heavy-jet time under his belt. If it's important, get a pro. Why should investing be any different?

Unfortunately, the licensing requirements for investment advisors are not as well regulated as for surgeons or airline captains. So, you must do some homework in picking a pro. A future chapter of my on line book will deal with some considerations you may find helpful.

For some clients, price is a big issue. I agree. But, a good advisor will have rigid cost controls built into his practice. In many cases, because of the availability of institutional class mutual funds, and reductions in transaction fees given to large advisors by the discount brokerages, we can actually save clients money. In other cases, the additional cost is very small. Costs should always be fully disclosed, so you can weigh the advantages in your particular situation.

Finally, a number of successful people simply are looking for someone they can trust to delegate the task to. Life is too short to try to do everything for yourself. I don't try to change the oil in my car even though I think I could learn how.

In the end, it is a personal decision. You will have to weigh the pros and cons. There may be no "right" answer. Life is like that sometimes. But, I do hope I have given at least a reasonable rationale for the use of an advisor.

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Passive index fund investing? Include foreign bonds in a 70/20/10 stock/bond/cash portfolio?

from William

Q: For an all stock portfolio, are you suggesting buying 8 or 9 index funds and being quite passive. Also, would you include foreign bonds in a 70% stock, 20% bond, 10% cash portfolio (midcareer professional with good current income and moderate-high short term risk tolerance)?

A: I prefer to load my portfolios with passively managed funds where possible. Because the evidence that stock pickers can add any value over and above their cost when measured against a relevant index is very discouraging.

In short: 1. The average manager costs you two percent in performance. 2. The few managers that have outperformed the index in the past have no higher chance of outperforming the index looking forward.

If 1. and 2. are true, why not fire the managers and hire an index? Over time this approach will probably put you in the top 75 to 80% in each market segment you choose. Whenever you have lots of people doing something, a few are always going to be on a roll. So, somebody is always going to beat you. But, you can anticipate a very solid result with the lowest risk possible in each market. I am an ardent advocate of the high probability shot. So, this strikes me as an eminently sensible approach, while trying to guess which manager might shine next year appears to be a suckers bet.

There is also lots of evidence to suggest that a preoccupation with manager selection, individual stock selection or market timing is a waste of time. They contribute very little to the end result, and the contribution is negative. The largest detirminant of success in investing is the asset allocation decision. And there we can hope to have a very positive impact.

I have abandoned foreign bonds as an attractive asset class. While the various fund managers hoped for higher yield and capital gains no one has yet been able to produce. They appear to be a pure bet on currency, and in real life have had very disappointing results. High risk, low return, high cost. Not my idea of the perfect asset class. We only use short duration, high quality domestic bonds for portfolios that need bonds.

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Is a 50% international allocation with 10-15% emerging markets reasonable?

from Will

Q: In your book you mention 60/40 domestic/international and small emerging market allocation which I assume is included in the 40%. Now, it seems to me that the US market is in a advanced stage, but still a bull market. That Germany, the UK, and France are more normal with room for improvement remaining, not yet to the top of the mountain. That Japan has sold down again and should now involve less risk. That emerging markets such as China and India, and Central and Eastern Europe have exception growth in GDP and expansion of market P/E multiples ahead.

My estimate would be that international could be expanded to 50% or perhaps a bit more and that emerging markets could be as much as 10 to 15% . Do you think this is reasonable?

A: Your analysis is right on. (At least it agrees with mine!) The often quoted 30%/70% or 40%/60% optimum mix assumes that there are only two asset classes in the possible choice list, S&P 500 and EAFE (Morgan Stanley's Europe, Australia and Far East index).

In fact, if we expand the available choices to emerging markets, small company and value, then the optimal international mix looks better at higher proportions. Each of the other choices has higher long term performance than the S&P 500, and a low correlation with it.

I never set my asset allocation based on forecasts of short term market movements, but my long term outlook is the same as yours.

Of course, we must remember this is just a mathematical model, not a guarantee of future performance. And two professionals looking at the same data could still disagree about the optimal mix. But, this type of asset allocation plan makes great sense unless you believe that: 1. diversification doesn't matter, 2. Modern Portfolio Theory is all wrong, 3. There are no good investment opportunities outside America, 4. The US market is going straight up forever, and 5. The foreign markets will under perform forever.

So, since you and I agree, we can say with great confidence that great minds think alike.

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Will you please elaborate on how you find Indian Market similar to a Snake Pit ?

from Salil

Q: In the Answer to the Question from Stu titled 'How do you assess the efficiency of the international markets?' you wrote: Of course, there are occasional glaring exceptions. For instance, the Indian market continues to be a snake pit, and trading is difficult even for local citizens. But the general trend is very positive.

Will you please elaborate on how you find Indian Market similar to a Snake Pit ?

Based on my personal and family experience I don't think trading in Indian market is difficult for the local citizens. Do you have any examples of some of the difficulties encountered by local citizens ?

A: The Indian market collectively is one of the largest on the planet. Local citizens are quite active in trading on its many exchanges. But, the Indian stock markets have not made great strides to modernize. Clearing procedures are an exercise in torture, require months in some cases, and certificates must be hand stamped by numerous separate entities. The complexity, delay and cost make the market far less efficient than many others recently organized by emerging countries with an eye to attracting foreign capital.

India has not ardently embraced the concept of foreign capital. And, a large entrenched bureaucracy has resisted modernization - not just in the capital markets, but across the entire government structure. These structural problems impact local citizens as well as foreign corporations. But, many foreign corporations have other alternatives for investment, while the locals may not. So, less foreign capital flows to India than might otherwise be the case, and Indians that have the opportunity may export their capital. None of which we may presume is good for India.

I certainly don't consider myself an expert on India, or the complexities of the markets there. But, over the last several years, I have had personal conversations with mutual fund company executives and other major international investment firms that have explored commencing operations in India. Many believe that India may offer better long term investment opportunities than China. In particular they cite the well established court structure, a better educated population, and infrastructure advantages. But for reasons previously given most have given up in despair.

I apologize for the "snake pit" term. I have no wish to offend anyone of any nationality. But, I do favor free flow of capital, and efficient markets as good for everybody.

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How do you assess the efficiency of the international markets?

from Stu

Q: Having read your internet book, Investment Strategies for the 21st Century, I am familiar with your general position on the ability of a fund manager to add value. Does your position differ for international markets, including international emerging markets? How do you assess the efficiency of the international market vs. the U.S. market and do you think that an active fund manager may be more likely to predict market swings in various countries around the world than in the U.S.? Based on this, would you suggest investing in actively managed foreign funds with wide investment discretion (e.g., a general international small cap fund) as opposed to a combination of international funds focused on a particular region (e.g, 50% Euro SC and 50% Japan SC )? I believe the combination of the two may provide greater long-term diversification but can I expect a cost in terms of long-term average annual returns?

A: Foreign developed markets are pretty efficient. But, there are some international funds that beat the indexes by so much that even I have to wonder about the value of active management. To a very large extent, the ones that have done the best have little or no money in Japan. Japan has done so poorly in the last few years that it has been the kiss of death for international funds. Of course we will never know if that was just luck, or a remarkable insight by the manager. Even if it was a remarkable insight, we won't know if that manager can do it again. Still, it's hard to be totally convinced one way or another. So, I have done what any man of conviction would do. I have hedged my bets. I use a core of index funds, but have retained some of the outstanding managed funds in the portfolio.

This dilemma is even worse in emerging markets. No market anywhere is perfectly efficient. And, some are more efficient than others. Emerging markets may not be as efficient as the NYSE, but they are closing the gap rather rapidly.

Most emerging markets not only welcome outside capital but are desperate for it. This is a sharp change from just a few years ago when the Yankee Dollar was despised, markets were closed to outsiders, and capital restrictions deterred all but the most hardy.

To foster the appropriate climate for foreign investment, many emerging markets are requiring full disclosure and internationally accepted accounting standards, have upgraded their local stock markets with modern computer and communications equipment, and have reformed some of their more unsavory trading practices. Today, if you cared to, you could follow many small markets in real time from the comfort of your home. You could also obtain remarkably accurate financial data.

Of course, there are occasional glaring exceptions. For instance, the Indian market continues to be a snake pit, and trading is difficult even for local citizens. But the general trend is very positive.

All these improvements make the markets ever more efficient. Is it still possible to profit from an insider tip, or mis-priced security? Probably, but the ability to do it consistently enough to reap excess profits, especially after the cost of trying, is falling quickly.

Having said all that, emerging markets remain the last bastion of hope for those who want to believe that active management can add value. I'll have to admit that the data is pretty ambiguous. First, there is not a generally agreed upon benchmark. There isn't even a broad agreement about what countries should be classified as emerging. Some observers think the Asian Tigers are developed, some classify them as emerging. Most emerging market funds have very short track records, and no two funds have identical country weights. So, meaningful comparisons are really tough to come by.

I tend to be very skeptical about the ability of managers to forecast trends in countries. After all, where were all these smart guys just before the Mexican crash? How much did they do to protect capital after the crash? Most did a terrible job. They bought just before the crash and sold right after. In case you haven't caught on, this is not a great way to increase shareholder value. Fidelity's reputation as a bond fund manager dropped several notches as a result of their related Brady Bond fiasco.

One nice thing about emerging markets is that while any one has a rather staggering risk, the common risks are few. What happens in Poland is little related to Peru, or the Philippines. So, they have low correlation to one
another. If you have a market basket f ull of them, the total risk at the portfolio level is reasonably low, but the expected rate of return is still high.

So, I concentrate on spreading the emerging market risk as far as possible. I hold a core index fund, and specialty funds (actively managed) in Latin America, Asia, and Eastern Europe. I personally believe a tilt toward Asia is justified, so I overweight it a little. But, there is remarkably little overlap between the funds, and I am able to maintian a reasonable level of contol over the allocation.

I'm sure the data will improve, and shortly I'll be able to give you a better answer about whether managers can earn their keep on the frontiers of capitalism. Deep down inside, I think when the data arrives, we will see that passively managed funds have performed pretty darn well. Till then, I'm hedging my bets, and spreading the risk as far as I can.

How's that for equivocation?

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Is my IRA portfolio too risky?

from Greg

Q: What do you think of the following IRA portfolio? I'm 26, soon to finish med school, and do not have med school debt.

Approx 9-10K total.

20% USAA growth strategy (been in for ~6months, thinking I'm more sophisticated than this fund, now)

~15% Price MidCap Growth

~45% Janus Overseas (I'm concerned that I'm TOO overseas based, given that both midcap and growth strategy have small foreign holdings. I am reasonably comfortable with janus overseas as opposed to janus worldwide, though I recognize it is riskier)

~20% Vanguard index 500.

Again, this is IRA only, not to be touched for quite some time. I do still wonder that I'm too risky, and over-weighted in int'l markets.

A: At your age, and for an IRA, (which we assume has a long-term time horizon), an all equity portfolio seems very appropriate.

Without getting into the particulars of whether Janus Overseas is the very best possible foreign fund, I have no problem with a 45% allocation to an overseas fund, even if the other two funds have a small foreign allocation too.

For my all-equity portfolios, I hold 50% foreign. This makes our allocation model somewhat more heavily weighted than many other advisors. We can never know if this is a perfect allocation until we all look back at it 20 years from now. But, your allocation is in the ballpark.

The rationale for foreign holdings is that we expect both higher returns and lower risk by holding asset classes with low correlations to one another.

Later in the book we will be dealing with the problem of style drift, and the techniques which allow you to more precisely control the asset allocation. (Here's a hint: use index funds. Then you know exactly how the money will be invested.)

As you make further investments, you may want to consider small companies, and a value tilt. This will give you better diversification, and a potentially higher return. The book deals with both those questions later.

For right now, you are on the right track, and I won't quibble with your choices.

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How can I reduce the risk that comes with international diversification?

from David

Q: I'm convinced that international diversification is wise, but I'd like to reduce the risk. Does it make sense, in your opinion, to invest through funds that attempt to hedge their currency risk. Does that reduce overall risk of international investing? If so, what's the most efficient way to find out which of the hundreds of international funds practice currency hedging--without wading through dozens of prospectuses.

A: Opinion on the value of hedging currency in international equity is sharply divided within the industry. But then, why should this be any different than any other question?

US investors in foreign equities have generally benefited from erosion of the dollar for the last 40 years. But the recent short term surge of the dollar has focused attention on the problem again. As you know, there is a cost to hedge currency, and this cost reduces return. In mutual funds the cost is not visible directly, but we all know it is there.

Most of John Templeton's remarks and writings would have us believe that over the long haul currency risk evens out, and shouldn't be a major concern. (Sir John is one of my heroes, having introduced us all to the benefits of foreign investing, value, and emerging markets. Now, if we could just get them into the true no-load camp...)

Roger Ibbotson's work in global asset allocation has convinced him that exposure to currency risk is generally favorable in that it adds a valuable diversification benefit.

Of course, there are always some on the other side of any interesting question. They argue that it doesn't do any good to earn profits in foreign markets if there is a loss in currency. We spend US dollars at the grocery store.

So, some funds hedge all the time, and some just hedge when they feel there is a currency risk. Techniques employed range from fairly simple to mind bending in complexity.

The problem with hedging is that fund managers can often be wrong. If so, they can spend lots of your money on un-needed hedges, then miss a call and lose money in another country. I have seen some spectacular screw ups by companies that have world class names attached to them. Selective hedging calls for forecasting ability which seems to elude most of those who try it. It's even more fun and confusing than trying to guess interest rates.

My feeling is that the weight of the evidence is tilted toward the unhedged position. I try to use funds that don't hedge, and index funds seldom do. I am not aware of any quick and dirty way to screen for hedging. But, most companies have toll free marketing lines, and can tell you their hedging policies. Still, there is no substitute for reading the old prospectus.

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Is graduate-to-be making the right moves?

from Jon

Q: I am 24 years old, in graduate school, and entering my last semester. In Sept. of 1996, I invested $2500 ($5000 total) into two funds-PBHG core growth and 20th century ultra. In Sept. of this year, I will begin working and expect to have 5000 per year over the next few years to invest. I am willing to take risks but would prefer not to lose substantially all of my investment. I have two questions: 1) Based on what you feel the market will do this year, do you believe my current investments are wise choices; and 2) when I begin working, should I make investment decisions through my own research or would it be better to go with financial adviser and pay the commission. If it is okay to do it alone, what is a good way to diversify my investment?

A: The two funds you mentioned get high marks for performance for actively managed funds. Whether they can continue to excel is anybody's guess. I am a believer in efficient markets, so, my gut belief is that periods of out performance by mutual fund managers tend to be brief, and that great past performance by a fund tells us nothing useful about the chance of future above average performance. So, I believe that it is a better strategy to save the money that would otherwise be wasted in management fees. I think that index and passively managed funds are a lower cost, lower risk approach to investing.

I haven't got the foggiest idea what the market will do next year. I share this lack of knowledge with every other investor. But, some are not wise enough to admit it. And, some profit from fooling others. (I really hate to admit that I don't know what the market is going to do next year. It makes me sound like such a nerd. But, that's the unfortunate truth, and I'm sticking with it.)

If your time horizon is longer, then I think we can reasonably say that your portfolio should be heavily laced with equity mutual funds. Assuming you expect to keep building a portfolio over the longer term, then I would start buying equity index funds for markets all around the world.

If you are willing to do a little study there is plenty of good information around to help you get started in the right direction. My book is designed to help novice investors get up to speed and design effective strategies using no-load mutual funds.

There are also some very fine commercial sources. For instance, Vanguard has an excellent library for investors at www.vanguard.com. The library is complete with risk tolerance questionnaires, calculators, research papers and lots more. They can show you how to build a global asset allocation plan to meet your risk tolerance and time horizon. You can build a great investment plan with that information, and just by using Vanguard's no-load index funds.

Since you are starting off with small investments, you may have to build a balanced global asset allocation plan one step at a time by rotating purchases between funds. If you are disciplined and diligent, you can build a very effective, economical, and sophisticated portfolio. Even with very modest size investments.

If you are not willing to do the study, or don't have the time you could seek out a professional and delegate the job. Just make sure that if you pay for advice, you get impartial advice. To eliminate potential conflicts of interst, use a fee-only advisor rather than a commission crazed broker. At some point as your career progresses, the size of your total account increases, and your life becomes more complicated, you will probably benefit from professional help. While professionals add a lot to the process, no investor can ever know too much about finance. So, I would encourage you to do some reading and studying.

I hope that answers your question. You are on the right track with an early start, and an ability to save. Keep up the good work. Good luck.

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Should we include Japan in our portfolios?

from Art

Q: In your response to holding Japan you said "So, inclusion of Japan in our portfolio will serve to reduce fluctuations at the portfolio level better than almost any other single asset we could hold. We shouldn't complain that it is down while we are up, when part of the reason we hold it is for that very reason."

1. I agree, inclusion of Japan in out portfolio would certainly reduce fluctuations at the portfolio level. When your Japanese holdings have been going down for 5 years , there is little volatility at the portfolio level because it reduces your portfolio value to the mean. I don't think I would trade a little volatility for the losses incurred or, most importantly, the opportunity costs that you must pay. If those assets had been placed in a good growth fund for the last 5 years, and those gains were compounded for 25 additional years, your portfolio would have much greater value then your admonition to hold Japan. The inefficiency of your approach will have a major adverse impact on portfolio value for the long term investor. Even if no losses were incurred by holding Japan for the last 5 years (not true), the lost opportunity costs are staggering.

2. You said "Perhaps sooner than later Japan will again be the best performing asset in our holdings. Perhaps? Who says? When? Do we wait another 5 years for Japan to turn around? What is the long term effect of holding Japan for another 5 years if it doesn't turn around. In my opinion this is 20th Century thinking, not 21st Century thinking. It assumes we don't have the capacity to examine the Japanese sector daily, if desired, and decide if the fundamentals of Japan are improving. In the 21st Century, we can track and chart the Japanese funds daily and if they do become favorable, we can then decide to participate in the sector. 21st Century thinking should avoid paying the high opportunity costs associated with the strategy. It's true that there is low correlation between Japan and the domestic market but if a domestic correction occurs, poor portfolio performance would be exacerbated by being in Japan? You would be adding a correction to your recession, a lose lose proposition.

Respectfully, this is the same old 20th Century model promoted by the industry. It ignores 21st Century thinking. Today the individual investor has charting software, Internet research capability and daily nav data that was not available to the individual investor just 5 years ago. In my opinion, holding losing funds for 5 years or more and rationalizing the error by saying that it provides stability at the portfolio level is 20th Century thinking. Continuing to hold funds that lose value year after year may provide stability but I don't think it is the kind of stability anyone in the 21st Century wants. I was hoping for better.

A: Back in the nineteenth century everybody believed that markets were inefficient, and that almost any reasonably bright guy could spot those inefficiencies and trade for excess profits and economic rents. This is what I grew up believing. This is what most of the retail investment business would just love for you to believe. This keeps profits high for the brokerage houses and generates almost unlimited excuses to churn accounts and earn commissions. At the very end of the 20th Century, a few pioneer independent thinkers developed the concept of market efficiency. In a nutshell, if markets are efficient, prices reflect all known information about individual stocks and the market in general. No one is saying that the market is "right" or rational. But trend information, and the consensus belief on the probability of the trend continuing is incorporated into the market price.

Very few American investors at the retail level have been exposed to the concept of efficient markets. Certainly the brokerages haven't pushed the idea. Why should they? If you ever wake up to the idea, it guts their profit picture, and they will all have to go out and get honest work. However, a very large percentage of the institutional investors have abandoned attempts to "beat" markets as an unattainable goal. They have found after long experience that pursuit of an unattainable goal actually results in increased cost, reduced returns, and increased risk.

If you can stop chasing a goal that is clearly impossible, you have time to focus in on achievable performance. Asset allocation, modern portfolio theory, cost control, passive management, and risk analysis offer investors a far better avenue to achieve their objectives. These concepts are the gift of the brightest minds of the 20th century to investors wishing to devise a strategy for the 21st Century.

I think the idea that anyone can examine trend information and divine useful information has been conclusively trashed. Trends are quite easily identified while looking backward. But, they last until they are over, and then they change. There is not the slightest evidence that anyone can reliably predict when that might happen.

On the other hand, the evidence that market timing doesn't work is pretty compelling. As a whole, market timers have lower returns than just about any other approach generates. In the nineteenth century, most market timers attempted to forecast using charts. Today, they have upgraded to computers and "proprietary signals." It's all the same old stuff. As we are all aware, we live in a world of information overload. Unimaginable amounts of data and information are available. Information and data by itself are not wisdom. Attempting to attach a computer to a nutty idea just results in nutty output on a pretty screen. The Japanese market is a good example of the problems that we would have in market timing. All of us wonder how long before they get it together over there. We all can observe serious structural economic problems, and the market's dismal performance is a good reflection of the need for fundamental change. But, The Japanese themselves must muster the political will to address their problems. I certainly have no idea when they might do that. Lots of observers have predicted turnarounds.

When? I don't know. Some of the leading edge research in Chaos and Complexity Theory suggests that we may never be able to answer these types of questions. The world's economy and the world markets are one of the most complex organizations imaginable. They responds quite nicely to news, but news by definition is not predictable. As an economist, and investment advisor of course I would like to know. But, I have to operate in the real world, with the best that is available. This is a rather humbling constraint. I, too, would like better.

All we can say is that a nation as bright, disciplined, advanced and educated as Japan will not allow themselves to go downhill indefinitely. Unless you believe that Japan is going right down the tubes, you want some of your funds there.

Meanwhile, none of us with funds invested in Japan have enjoyed the experience over the last five years. As you point out, the lost opportunity costs are great. We must console ourselves with a great buying opportunity as we re-balance our portfolios. However, a rational asset allocation plan has performed quite nicely in spite of a few under-performing sectors. Japan represents far less than 15% of our most aggressive portfolio position. Judged from the results at the portfolio level, asset allocation has delivered fine returns with minimal risk, and minimal cost. Probably that's as much as we can hope for today.

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What happens when a significant number of investors rely on highly-diversified mutual funds?

from David

Q: What happens when a significant number of investors abandon investing based on stock fundamentals and rely instead on highly diversified (and therefore lightly researched) mutual funds? Would we not now create opportunities for active management to return better-than-index performance?

A: Anyone with half a brain has to have wondered the same thing: "What happens if everybody does this index thing?"

First, I'll have to admit that if everybody did it, the market would have no way to set prices. But, then I have to say that I never expect that to happen. The temptation to try to beat the market is going to be too much for a few people to ever resist. Even if most people went to indexing, it only takes a very few active traders to keep the market honest. I would have to guess that less than one percent could enforce market discipline and keep prices rational. Even then, I am not sure that those few could benefit to the extent of consistently reaping excess profits.

In effect, the index followers get a free lunch, because they benefit from all the research that the others are doing. Since there are so very few free lunches around, I prefer to grab one whenever I can.

While this question makes for some lively debate, in the real world, I don't think either one of us needs to spend too much time worrying about this problem.

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How many different asset groups do you feel a person needs to cover?

from Andy

Q: There is domestic and international; small, mid, and large; value and growth. That multiplies out to 12 funds. Anything else that should be covered?

A: First, let me say that any selection of asset classes and the weights assigned to each class are somewhat arbitrary. Other practitioners will have other opinions, and we will have to wait twenty or so years before we find out whose plan is the best. All we can say is that it appears to be a pretty good plan that will probably perform well in a wide variety of foreseeable financial and economic scenarios. Absent a better crystal ball, that's about the best we can do.

My equity strategy includes nine asset classes: Large, large value, small, and small value in both the domestic and international markets. In addition, we utilize emerging markets in the international sector.

I don't use mid caps as a separate asset class, because they appear to be just part way between large and small in terms of both rates of return and risk. There is not a strong diversification effect in terms of correlation. So, to keep things simple, we don't use them.

Of course, there are other potential asset classes that might be included: Some advisors utilize precious metals. I don't. My reasoning is that while an argument might be made that there is a wonderful diversification effect (low correlation with other asset classes), rates of return over long periods of time are right down there with T-Bills, and the risk it huge. It doesn't seem smart (to me) to tie up any funds in an asset class with high risk, and low return.

Lately I have been deluged with "research" indicating that real estate in the form of REITS ought to be a separate asset class. Most of this research seems to have been done in house by sponsors of REIT mutual funds. They argue that the nature of the REIT funds has changed over the last three years. That is probably true. Institutions have been unloading real estate as fast as they can, and REITS allow them to turn an illiquid asset into a liquid one. So, the total market value of REITS has soared.

How well REITS reflect the underlying performance of the asset class is open to debate. Long term returns in real estate appear to have been about 80% of the S&P 500 with higher risk. For numerous valid reasons, real estate has had a different market cycle from the stock market. But, it is not clear at this point that REITS will continue that pattern. I am not now convinced that there are huge benefits to REITS as an asset class. However, in a few years I may want to re-visit the data.

There is some interesting research floating around on the subject of managed futures contracts as a separate class. The argument is fascinating, and the concept has been teasing investment advisors for some time. But even if all true, at the time there is no practical way for me to execute the strategy in an economical and effective manner. Reliable real world data is pretty sparse at this point. Again, down the road I may want to review the question. I would much rather be a few years late than jump into something I don't fully understand.

Venture capital is another attractive candidate for asset class. But, there is just no way to effectively and economically execute a venture capital strategy right now. I am hopeful that in the very near future, no-load funds will find an attractive way to access new asset classes. One thing is for sure, we are never going to be able to write the final chapter. New research and new tools are constantly coming on line. I wouldn't have it any other way.

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Could you please discuss core style for a mutual fund?

from Tim

Q: Your Portfolio 5 in Chapter 12 (stay tuned!) includes "S&P500" and "EAFE" as core funds as opposed to Small, Value, Small Value. What defines the core funds? Do they cover the range of "Growth," "Growth & Income" etc.? I have gravitated toward Morningstar's Style boxes to select, but even they migrate over time. Have you noted Morningstar's recent effort to define investment styles based on actual 3 year investment portfolios rather than the MF's marketing department hype? Would appreciate your contributions to this notion.

A: My investment process is called strategic global asset allocation. Under this process, mutual funds are a building block for the asset allocation plan rather than an end in themselves. Once we have selected an asset class, my goal is to pick funds that will faithfully duplicate the performance of the asset class. They are further required to remain fully invested, and have very low fees and costs. The last thing I would put up with is for a manager to stray from his designated area of the market. Style drift is the natural enemy of asset allocation. It is simply not acceptable. I also believe that markets are efficient enough that it doesn't make much sense to try to "beat" them. I certainly don't want to take the chance that some manager will make a big sector bet that causes him to underperform his benchmark. I would never pay to expose myself to that type of risk. So, you can see with that type of mindset I want to use index or passively managed funds wherever I can.

To represent the S&P 500, I use an institutional class mutual fund which tracks the S&P 500 almost exactly for a total cost of .15%. I am oblivious to labels like "Growth", "Growth & Income" etc.? I know a great deal about what to expect from an S&P 500 index fund, and very little about what a "growth" fund might do. Labels like that hide more than they reveal.

Wherever I can find an institutional class passively managed or index fund that's what I use. That works well for every class except some areas in emerging markets. For instance, I can't get an index fund for Eastern Europe or Latin America yet. I am sure that one will be available soon.

The style boxes that Morningstar introduced a few years ago, and the re-organization of their data along those lines will be a big improvement in the way investors think about types of funds. While it's not perfect, it's a great leap forward from the old hype and marketing definition.

For investors that still believe that markets can be beat I would suggest that they screen the data base for objective criteria that match their style definition. Morningstar's Principia allows you to build very sophisticated queries with just a few clicks. For instance you might screen domestic funds with an average market capitalization below $1 billion by price to book ratio (the inverse of Book to Market). This would give you a pretty good universe of small cap growth and value funds. Then you could examine performance and other factors that interest you within your universe. I suggest this will give you a much better feel for investment style than the boxes.

Style drift will still be a problem in many funds. You may wake up one day soon to find that your carefully constructed portfolio doesn't really look like it used to. If you are willing to tolerate style drift, and most large institutions would never put up with it, you can always invest in a style analysis software package. However, for my money I prefer not to deal with the problem. So, to keep my life simple, and to control my asset allocation I use asset class index or passively managed funds.

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How and when should I move into a stock fund?

 

from David

 

Q: We have a sum of money that is currently sitting in a money market account that we are going to invest in a stock fund. How should I move it to the stock fund? I understand and believe in the concept of monthly investing to reap the benefits of dollar-cost averaging. We currently contribute monthly to a 401(k) plan through my work. But with this money (about $10k) the choice is either to move it from the money market fund to the stock fund over a period of months or do it all at once. Where are my risks greater: the risk of losing growth by having this money sit in the money market account, or of buying into the stock fund all at once at a potentially high price?

 

A: Dollar-cost averaging is a powerful way for investors in their accumulation years to take advantage of fluctuating prices to obtain lower-average purchase prices. However, it is not necessarily the best way to invest a lump sum. I most often encounter this question from clients who have just received a lump sum from a retirement plan and are concerned about putting it all in the market at once. If we keep in mind that the market movements are random but with a strong upward bias, we can reason that the majority of the time, any delay in investing the funds will result in a loss. One study I've seen tested this assumption over numerous time frames and came to the same conclusion. Without a perfectly functioning crystal ball, there is no hard and fast answer. We just have to go with the odds. And the odds suggest that the biggest risk for long-term investors is being out of the market.

The question often masks a market timing concern. I have been in the business since 1973, and with the painful exception of 1973-1974, the market was almost always at or near an all-time high. People who waited for the market to fall before committing their funds generally regretted it. Absent the crystal ball, the best time to invest is when you have the money!

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Where can I find out more about investing?

 

from Eduardo

 

Q: Can you recommend any related books or articles?

 

A: I've put together a short list of recommendations for anybody interested in financial economics and investments. All the books should be available at most public libraries and can be purchased or ordered through any of the national book chains. In particular, I like Capital Ideas and A Random Walk down Wall Street. I've picked up some great research papers by cruising the FEN web and FIN web sites. Many of the academic articles are available only in Post Script versions. So get yourself a copy of Ghost Script Viewer to use with your Web browser if you don't already have one. If you really get into it, subscribe to the Journal of Finance.

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Should I have a different investment strategy if I'm not living in the U.S.?

 

from Dennis

 

Q: How about a Canadian perspective for those of us north of the border? Your views on other countries might also be of interest.

 

A: Principals of investments don't seem to change much as we cross national borders. Indeed, they seem to have a universal dimension. Diversification will always be the key investor defense. Cost control is important wherever you are. Mutual funds are available in most developed markets or can be obtained through globally recognized market leaders in offshore versions. New research indicates that small company stocks and value stocks obtain higher rates of return in almost all markets.

Most investors in developed countries will want to hold the majority of their assets in their own currencies, but we all benefit from the diversifying effects of holding foreign investments. If your national currency is a risk, as it seems to be here in the U.S., you may hedge it by purchasing assets in more stable economies.

If investors live in developing markets or countries where the political risks are very high, they may wish to hold a larger percentage of their portfolio in developed markets. Offshore mutual funds may provide the same type of protection for "flight capital" that Swiss banks provided for our parents and grandparents, and the returns should be higher.

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Will I ever be able to buy your book in print?

 

from Zoran

 

Q: I wanted to buy your "book" as soon as I read the second chapter over the Internet, but since it was not in print, I obviously had problems finding it. Your approach and treatment of the subject appeals to me as a very educational one and suits my level of knowledge (or lack thereof) perfectly. I've been traveling and have yet to read several back chapters. I can hardly wait to print them and read them to gain additional insight into this black hole of my investment knowledge.

 

A: Perhaps someday I'll publish Investment Strategies in hard copy. Right now, it's exciting and a great deal of fun to publish on the Net. The Net gives me a free printing press, and GNN (Ed. note: GNN formerly published Frank's book. Its site has since ceased operation.) gives me a credible forum to counter all the investment pornography that permeates the mainline financial media.

After years of counseling investors who have suffered greatly at the hands of Wall Street's traditional brokerage and sales system, it's great to get the chance to help level the playing field. By distilling the best financial research of this generation and presenting doable, achievable strategies for investors with less than mega-bucks, I hope to show readers how to match or exceed what large institutions offer their multibillion-dollar clients.

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Does being a baby boomer hurt me financially?

 

from Susan

 

Q: I have a very long-term question for you. Being an early baby boomer, I wonder what will happen in 10 or 15 years when the next, smaller generation becomes the driving force in the economy. Will the housing market bust? Who will buy my equities? Will the stock market turn out to be the world's biggest Ponzi scheme, based on the fact that the following generation has always been bigger than the previous generation?

 

A: I was born a year too early to be a baby boomer, but in my heart I feel like one. Yours is a great question, and one that I am not fully qualified to address. On the other hand, you and I may be as qualified as anybody to speculate.

Perhaps the baby boom phenomenon is a uniquely American problem. Over 70% of the world's population are in emerging markets, and over half of them are under 21. So, finding workers for America's production facilities will not be a problem, although we may have to adjust our immigration policies to admit more qualified workers. We can presume that American business isn't just going to shut the doors as the boomers retire.

Somewhere along the line, as the boomers retire, the next generation is going to get a sudden career boost. I hope they will then have the salary to buy our houses.

Today, we have one of the largest, most liquid stock markets on the planet. Foreigners have been active players in U.S. markets, and I wouldn't expect them to abandon one of the most productive economies around. So, somebody will be out there to buy our stocks.

The real problem for the boomers is whether they will have accumulated sufficient financial assets to support themselves during retirement. If not, they shouldn't expect the next generation to roll over and rescue them from their own folly. Even if the next generation wanted to, the burden of such a large population of impoverished retirees will strain the system to the breaking point. The possibility of a really nasty fight over how the pie will be sliced is already apparent.

In a best-case scenario, boomers will increase their investment rate and invest more effectively, and the government will ease its disgraceful treatment of capital that we have adopted here. As it stands now, the boomers aren't saving, and the government isn't doing much to make saving and investing an attractive alternative to immediate gratification. Those chickens may soon come home to roost.

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Where can I find out about index funds?

 

from Noreen

 

Q: I never see the index funds you describe advertised. But you make a compelling case for them. Where should I look for companies selling index funds?

 

A: Here is a list of all the index funds available for general purchase by the public. There are also a number of specialty funds available only to investment advisors or institutions. Many of the ones I use for my clients are designed to access particular portions of a market such as international small-cap value. The funds have restricted access to inhibit market timers from creating unusual cash flows and to keep expenses low.

To date, there has not been a large retail demand for the international value strategy. You are 10 steps ahead of the average investor who has never even considered it. But if enough investors make their interest known, one of these fund families will make those types of funds available to the retail market. As more and more investors get the word that indexing is a superior investment strategy, and expand their investment horizons to include these additional asset classes, index funds will appear in greater numbers. Capitalism is a great system!

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Can you explain how to generate an income stream?

 

from Lloyd

 

Q: In the latest chapter, in the last two paragraphs under the heading Dual Horizons (Chapter 11 -- stay tuned!), you present information I desperately need as a down-sized employee. However, since I'm kind of new at this and not a math type, I don't fully understand this information. I was hoping you could expand on the 6% a year, 30% set aside, 30/70 mix, good year/bad year procedures and allocations. Perhaps you can give an example using hypothetical figures.

 

A: There is nothing magical about the 70/30 mix. I just said to myself that I know that for the next five years I want to withdraw 6% a year -- or a total of 30%. Five years is a very short-term time horizon. I know that the market can get a little flaky in the short term. I don't want to have to sell any of my equities at a time when they might be depressed to finance a known income need. If I could set aside enough to finance at least five years of income need, then I wouldn't be as concerned about short-term market fluctuations with the balance of my funds. I have time for the market to get back on track. On the other hand, if I don't have enough set aside, and I have a large income need, then I run the risk that I may invade my principal to the point where it will never recover.

An investor with a larger income need, or who has a smaller risk tolerance, may want to set aside more -- perhaps up to 50%, or even more. However, if the investor sets aside too much he runs a risk that his portfolio will not keep up with inflation. Most retirees will need growth of income and capital, and will need to balance the risks.

I assumed that the investor would re-balance the portfolio so that in good years he would replenish his hoard, and in bad years he would draw it down. This idea isn't entirely new. A similar technique was used by Pharaoh about 3,000 years ago with some notable success.

This is not the only possible exit strategy, and in future chapters we will be looking at other ways to handle the problem of generating a long-term income stream.

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What software is best for creating an investment portfolio?

 

from Margaret

 

Q: What is the best software available for applying the techniques of modern portfolio theory to construct and analyze an investment portfolio? I am looking for something more sophisticated than the 10 question interviews from various mutual fund families which return a list of what percentage of your assets you should invest in their various funds.

 

A: I am not aware of any shareware or freeware available to individual investors. Professional software contains efficient frontier optimizers and databases on multiple-asset classes and/or mutual funds which must be updated on a regular basis. It doesn't come cheap. Ibbotson Associates sells several powerful software programs and supporting databases. Their software can accept downloads from Morningstar's mutual fund service. Prices for the entry-level software start around $500 and you can quickly spend your whole allowance.

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The falling Japanese stock market vs. the rising economy

 

from Neil

 

Q: Early on in your book, you stated that investors must make the basic assumption that, over the long term, the stock market will continue to go up. I have heard two common arguments in favor of this assumption: 1) The stock market has always gone up (over the long term) and therefore it will continue to go up; 2) As the economy grows, the net value of the companies in the economy will increase, thus driving up their share price and the stock market as a whole. Doesn't what has happened to the Japanese market over the past five years contradict these arguments? The stock market has lost half of its value while the economy has continued to grow, albeit slowly. If I had my money in the Japanese stock market, my time horizon for profit would certainly have stretched out a long way. Any thoughts?

 

A: Japan is an interesting problem for financial economists. There are some who argue that Japan's market was greatly overpriced due to unique structural elements. They cite interlocking ownership of securities, government intervention, a lack of fundamental analysis applied to stock prices, and a tradition of purchasing stock to cement corporate relations. Those clinging to this view argue that the market is now reacting to more rational fundamental analysis.

The opposing view is that Japan's market is one of the largest and most liquid. Prices correctly responded to the enormous growth potential of Japan's industries during its emerging market stage. Now, the plunge in prices correctly forecast the deterioration of the economy.

Japan's economy could hardly be called healthy. Actually, it's a pretty sick puppy. Many of their giant banks and insurance companies are in grave danger of failure, the equity and real estate markets are in the tank, the high yen is choking exports, their leading indicators point to a recession, and a closed market boosts the prices of almost all imported items far above most world markets. Complicating Japan's problems are an entrenched bureaucracy and a weak government. Perhaps only the government of Italy provides more entertainment or scandal value.

But it would be a big mistake to count Japan out. They have an extraordinarily high savings rate, an educated and productive work force, and a world-class work ethic. They will solve their problems and muddle through just like the rest of us.

American investors have been sheltered from the full effects of the Japanese stock market losses by a relentlessly rising yen (or falling dollar). As with any asset class, investors should put caps on the weightings they wish to hold in their portfolio. Japan provides a great example of why a properly designed asset allocation plan should not be overweighted in any asset class. Any asset class can dramatically under-perform its long-term track record for an extended period of time. That's why we must maintain a long-term horizon and diversify no matter how attractive an asset class looks based on past performance.

While we wait for the Japanese market to recover, we can console ourselves that Japan has not only provided American investors with above-average returns, but has about the lowest correlation to our domestic stock market of any asset class we could own. So, inclusion of Japan in our portfolio will serve to reduce fluctuations at the portfolio level better than almost any other single asset we could hold. We shouldn't complain that it is down while we are up, when part of the reason we hold it is for that very reason. Perhaps sooner than later Japan will again be the best performing asset in our holdings.

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How can you predict how much you'll need in the future?

 

from Walt

 

Q: Why do you write all this stuff about figuring out how much you will need in the future? There's no way in the world you can know that unless you know how long you will live. "The most you can get, the best you can do," is how much you will need. Frankly, this step in the analysis seems like baloney. It seems to me one's strategy should be to achieve "the best you can do" and not a "sufficient" amount which may or may not turn out to be enough in the end.

 

A: Poverty can often easily be achieved without much planning, but wealth creation usually benefits from some type of advanced consideration.

I admit that planning isn't the fun part of most enterprises, but I have seen the results of no planning or poor planning too often to ignore the real disasters that result. I will also admit that planning for very long time horizons will introduce serious errors. But a plan with a clear goal is far better than no plan and no goal, even if the plan must be constantly revised.

For instance, a young couple that is blissfully unaware of how much retirement will cost can hardly be expected to be motivated to invest for their old age. An executive considering whether to accept an early retirement offer should have an idea if his present assets will be enough. A retiring worker needs to have a clear idea how much income to expect from his assets, and whether he will need to adjust his lifestyle.

For most of my clients, how long they will live is not an issue. We plan our investment strategy so they will have constantly increasing income and capital for their entire lives. That way they don't have to plan to die at any particular time just to avoid the inconvenience of running out of money.

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Have your views on international investing changed recently?

 

from Ken

 

Q: I've been reading your articles with interest, and have long been a believer in the benefits of international investing (higher returns, low correlation to the U.S. market). However, in Jane Bryant Quinn's column in Newsweek (May 15, '95, page 67) she said recent research from Rex Sinquefield at Dimensional Fund Advisors has cast doubt on the advantages of foreign funds. To quote selectively from the article:

• "Diversified international funds have not significantly improved investment returns. Nor have they materially reduced our risks. Big foreign stocks behave pretty much like big U.S. stocks. You can get more diversification from a mix of American funds alone."
• "EAFE (Europe, Australia, Far East index) knocks your socks off only when its gains are transposed into dollars. When measured in ... local currencies, EAFE has been growing more slowly than the S&P 500 index."

These claims appear at odds with Chapter 5 (coming soon), and fly against what I had assumed was the consensus of investment experts. I am wondering if you have any comments on Quinn's article, and whether your views on this matter have been changing.

A: I have read Rex Sinqfield's paper, and I have read the Quinn article. I also met with Rex at a seminar last week. I think the point of the paper is that while the EAFE index has provided good diversification, there are now asset classes available to investors that do a far better job. In particular, International Small Cap, International Large Cap Value, International Small Cap Value, and Emerging Markets all provide a great deal higher expected return, and a lower correlation to the U.S. domestic market than does EAFE. (EAFE is primarily a large company, developed nation, growth-style index.)

There is no particular reason why an investor in Germany, for instance, should receive a higher return on an investment in a German, large-company stock than an investor in New York would get on an American, large-company stock. However, both should expect to receive a premium if they invest in a smaller company, or a value stock (high book to market). And both would demand a higher rate of return if they invested in an emerging market. Fortunately, all these different market segments or asset classes have low correlation to one another. This happy situation allows sophisticated long-term investors to achieve the best of all possible worlds (higher expected return with lower portfolio risk) by constructing a properly diversified, asset-allocation plan.

Currency risk adds an element of diversification in itself. American investors have benefited if they owned most foreign assets during the last 40 years since the once mighty dollar has experienced a dreary and depressing downward spiral.

So, I haven't changed my thoughts on international investing -- I just have better tools to obtain (hopefully) even better results in the future.

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Do fund managers use MPT?

 

from Rosa

 

Q: Do any fund managers actively use MPT to manage their funds? Mean/variance optimization is interesting, and in theory useful, but is anyone really using it?

 

A: Many large funds and institutions use optimization to design their portfolios. Harry Markowitz (1990 Nobel Prize in Economics) runs a fund investing in Japan, and I can promise you he uses it. However, for our purposes -- that is for those of us with less than $50 million to invest -- perhaps the best use of MPT is with asset classes rather than individual issues.

In my practice, I design a portfolio based on experience and feel, and then check the results with an optimizer. I do it this way because optimizers will zero in on one asset that looks the most optimum within any particular day or time series it is fed. The results will not look like a properly diversified portfolio. As Bill Sharpe (1990 Nobel Prize in Economics) says: "Optimizers will immediately seek out the one error in your data, and then put 100% of your client's money into it."

copyright (c) 1995, Frank Armstrong.

The right to download and store or output the materials found in Investment Strategies for the 21st Century is granted for viewing use only, and materials may not be reproduced in any form without the express written permission of Frank Armstrong. Any reproduction or editing by any means mechanical or electronic in whole or in part without the express written permission of Frank Armstrong is strictly prohibited.

Disclaimer

Investing in equities involves a serious principal risk, and no assurance can be given that the techniques described here will be successful. Returns vary and you may have a gain or loss when you sell your shares. Past performance is no guarantee of future results. Index returns shown are historical and include the change in share price, reinvestment of dividends, and capital gains. Indexes are unmanaged and do not reflect the impact of transaction costs. Transaction costs would have reduced the total returns.

International investments, especially those in emerging markets, entail greater risks (as well as greater potential rewards) than U.S. investing. These risks include political and economic uncertainties of foreign countries, as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less-established markets and economies.