Volume V: Frank Armstrong answers
questions from readers of Investment Strategies for the 21st Century every
Tuesday, at MFI. To submit a question to Frank, write
to us.
Questions and Responses
Are international markets really uncoupled
from the U.S. market?
from Stonne
Q: Are international markets really uncoupled from the U.S.
market?
A: If the US market drops a few hundred points you can
rest assured that the effect will ripple around the world within the next day. It's fair
to say that the US market is a factor.
Of course, the reverse is also true. A disaster in any market will
be felt world-wide for a few days.
So, in the short run markets may appear to be strongly correlated.
But, after all the excitement dies down, each individual country is
much more strongly influenced by basic economic, political and/or psychological factors in
their own market.
Japan and Thailand are two good examples of markets that have tanked
for the last few years while our market has enjoyed a strong sustained run up.
We might suspect that as the world becomes a more global marketplace
that markets will tend to move more in lock step. That doesn't appear to be the case. At
least yet. Over reasonably long periods of time (a quarter or more) there doesn't seem to
be any indication that correlation between markets has increased.
So, the diversification benefit remains intact, and the argument for
international investing is as strong as ever.
Where should I put my money away for the next
25 years?
from Mark
Q: I am a staff sergeant in the US Air Force. I
currently have $30,000 sitting in a money market account getting 5%. I am very interested
in aggressive growth funds. I am not needing any supplemental income and I am capable of
saving around $2000 per month. I want to invest in my future, so that I can retire at age
50...RICH!
I believe that there are some mutual fund companies out there that
only allow military members to invest in them. But, I can not find them. Are they any good
any way???
Could you give me some suggestions on where to put my money for the
next 25 years??
A: If you invest $2000 a month for the next
25 years, you shouldn't have any trouble retiring rich. This assumes you get close to
market rates of returns in a diversified portfolio.
I am not aware of any fund families that restrict ownership to
military. Perhaps you are thinking of USAA, the insurance company. They also have mutual
funds, but I believe the funds are available to the general public.
Because you have a very long time horizon, and no need for either
income or lump sum withdrawals during that time, I would suggest that you consider an all
equity investment plan. There are some sample portfolios included in chapter 12 and 13 of
my book, "Investment Strategies for
the 21st Century" at MFI. You might use that as a start point to build your own
plan. If you really want to be aggressive, you might load up on small, value, foreign
small, foreign value, foreign small value, and emerging markets. They have had the highest
rates of return over the last 25 years.
To reduce the tax bite along the way, you might (strongly) consider
index funds. An index fund strategy will minimize dividend and short term gains (ordinary
income) while deferring the vast majority of your gains until you elect to liquidate
shares. At that time the gains will be taxed at the more favorable (capital gains) tax
rate. Net result: you will have lots more to spend and enjoy during retirement.
It's hard to imagine you could go wrong with the Vanguard Index
Funds. They have a neat web site at www.vanguard.com
that will show you how to index the world's capital markets. It's a no-brainer approach
that will probably outperform 80% of all fund managers over the long haul. Certainly not a
bad place to start.
Learn everything you can about investing as you go along. There are
lots of great resources here on MFI for investors of all levels of experience.
Good luck, and from a former Air Force type myself, thanks for
serving us all in the USAF.
How do I calculate expected risk and return?
from Joff
Q: I have read your
on-line book on Investment Strategies for the 21 Century and am very interested in trying
to apply its methods. It looks relatively easy to select index funds and analyze risk vs
return for various portfolios. The problem that I am having is trying to understand how to
apply the principals to calculate expected risk and return and where to find the data. Do
you have any suggestions?
A: What better source than the owner of
the Nobel Prize in Economics (1990) for his work in developing Capital Asset Pricing Model
and its contribution to Modern Portfolio Theory?
Try William F. Sharpe's home page at: http://www-sharpe.stanford.edu/
He has a number of worksheets and programs to do optimization, and a
source for monthly data. The worksheets can be downloaded and run while offline.
I think that Professor Sharpe would be the first to tell you not to
rely too much on optimizers. They have no common sense, and left to their own devices will
design some very strange portfolios.
Why not stick to asset classes that have
provided the highest return?
from Kirk
Q: I have found your reading very
interesting. Your studies show that overall over the long term, that small stocks and
value stocks have had higher returns - and that a strong tilt towards these in equity
portfolios will handsomely reward long term investors.
I am curious as to why a portfolio needs to include to other asset
classes (such as large growth) - taking this into account. Does the addition of large
stocks asset class actually increase your return over the long term - or is this just to
lower risk?
In an investor is young and willing to take on the higher risk in
reward for higher return - is it suitable to build a portfolio centered around small cap
value (domestic and foreign)?
I understand that different asset classes perform better than others
during certain periods - but for the long haul - isn't it better to just stick with the
asset classes that have provided the highest return?
A: Most of us prefer to follow a policy of
maximizing our rate of return per unit of risk. However, if you are serious about high
risk, high reward strategies you can accomplish your objective using mutual funds. But,
you will need a very high level of discipline. If you lose heart during the downturns and
abandon your strategy, you will most certainly shoot yourself in the foot.
Certain asset classes have higher expected rates of return than
others. Invariably these asset classes have high levels of risk. But, you can build a
diversified portfolio of reasonably risky assets that doesn't have insane levels of risk
when measured at the portfolio level.
Asset classes which are highest in expected return include emerging
market funds, small company funds, value funds, foreign small company funds, foreign value
funds, and foreign small company value funds. If you have lots of time, and the stomach
for the risk, load up on these funds. The downside is that you may experience several
years of significant underperformance if these assets go out of favor, and market
downturns may be more severe in a high risk portfolio.
You are correct that for an investor with a very long term time
horizon, and the stomach for the risk, inclusion of large domestic stocks (S&P 500) or
large foreign stocks (EAFE) will likely reduce rate of return as well as risk.
- copyright (c) 1997, Frank Armstrong.
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.
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