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Bill Jones Simplify Your Investment Life

by Bill Jones

Congratulations! After a year or two of study, research, and reflection--including watching your stock holdings rise and fall alarmingly--you may have a strong enough understanding of investing to confidently make your own independent decisions. You can explore new possibilities such as:

Using mutual funds outside the family you started with.
Exploring other kinds of equity investments for diversification, such as sector funds.
Buying stock in individual companies.
Shifting among various kinds of stock investments, depending on market conditions. This is called market timing, because you are saying that certain times are much better than other times for investing in a particular market.
Shifting between stocks and bonds, depending on market conditions. This is "classic" market timing.

Although some people feel that market timing of assets will increase earnings substantially, many others think it will not make a significant difference in returns in the long run. It takes a lot of time and effort, whether it is profitable or not. You should make up your own mind about the effectiveness of market timing; after all, it is your money to lose or gain.

Many people do not want to spend much time on managing their investments. They just want an overall strategy that works reasonably well and takes very little time. That’s where the Four Corners Strategy comes in. Here’s what you need to do:

Keep whatever amount in cash is appropriate for your personal tolerance for risk.
Divide up the rest equally among four very different classes of assets: U.S. large-cap stocks, U.S. small-cap stocks, foreign stocks, and bonds.
Rebalance these four asset classes once each year.
That’s it!

The buy-one-of-everything principle gives a simple reliable strategy for investing that only requires a few hours each year. You should spend a dozen or so hours learning the basics of investing; but if you do not want to spend much more time than that, this strategy is very simple to understand, easy to use, and known to give very good results in the long term.

Research by T. Rowe Price showed that the Four Corners Strategy outperformed the majority of full-time professional money managers over the 20-year period 1973-1992, and with significantly less risk. It certainly beats the strategy of the average individual investor. Almost any other decent investing method requires more time and effort, though you may get 1 to 5% more return each year (or, you may get 1 to 5% LESS return; in the stock market, effort does not always pay off in higher returns when it comes to investing).

Implementing a plan

Follow these steps to implement the Four Corners Strategy:

Step 1: First, decide on a percentage of your total assets that you want to keep in cash. It should be whatever YOU are comfortable with (if in doubt, put more in cash for now and reconsider the situation in a year or two). "Cash" includes money markets, one-year treasuries, bank CDs, demand bank accounts, guaranteed income contracts, and bond funds with an average maturity of one year, at most. This amount can include your cash reserve for emergencies only if you expect to use it rarely.

Step 2: Split the rest of your assets equally among American large-cap equities, American small-cap equities, international equities, and bonds (fixed income securities with maturities greater than 1 year). If you decided on 40% cash in Step 1, that leaves 15% in each of the four classes. If you decided on 16% cash in Step 1, that leaves 21% in each of the four classes. For each class you only need one or two mutual funds. For bonds, you can use individual treasuries.

Step 3: Once each year, rebalance the four asset classes to your predetermined percentage allocation. If each of the classes has the right amount plus or minus 1%, you need not make any adjustment at all.

Step 4: Every few years, reconsider your chosen cash allocation to see if it should be changed based on your personal circumstances and comfort level. For instance, you might gradually shift from 0% cash to 40% cash as you get closer to retirement age. Or, you might have started with 40% in cash because you were uncomfortable with less, but after several years you feel that you should tolerate 20% in cash. It is important that shifts be done gradually; you should not change your cash proportion by more than 5 to 10% of total assets every three months. You should also review your choice of non-indexed stock funds once a year to be sure that they are still good choices.

Step 5: When you add money to your assets, add to the one that makes the ratios closer to your chosen proportions. Similarly, when you take income from your assets (in retirement, for example), keep the ratios of what remains fairly close to your chosen proportions. The general rule is, KEEP CLOSE TO THE TARGET PROPORTIONS REGARDLESS OF MARKET UPS AND DOWNS.

Deciding how much to keep in cash

Close your eyes and take this simple risk tolerance test to figure out how much to keep in cash:

Visualize that your holdings lose 7.5% over the next month. Then, they lose another 7.5% in the next two months, and 7.5% more in the next 3 months. When you think things can’t get much worse, they drop another 7.5% in the six months thereafter. Now, you’re down 30% in a single year. And moreover, the majority of popular articles on investing are saying that it is not very likely there will be a recovery any time soon.

How would you feel? Would you decide to strongly cut back on, or completely eliminate, your stock holdings at that low point? Remember, you have many years to go before you retire, and the markets are likely (though not certain) to rise soon strongly.

If you would hold on to your allocation with this kind of loss (even in fear and trembling), consider having 75% of total assets in stocks, 25 percent in bonds, and nothing in cash. But if you would exit stocks at a 25 to 30% loss, you cannot tolerate such a volatile holding.

Now, modify the scenario by envisioning a total loss of 24% in one year. If that is tolerable, you can perhaps manage a 60% allocation to stocks, with the rest equally divided between bonds and cash. Still too hard to stomach? If an 18% total loss over a year seems easier to swallow, a 45% allocation to stocks (with 15% in bonds and 40% in cash) may be the ticket.

An encouraging note: These general formulas are based on historical data which indicates that stocks rarely lose more than 35 to 40% before recovering. In this century, it has only happened in 1929-32 and in 1973-74.

Remember, having a high percentage of your total assets in stocks makes greater losses, or gains, possible. I personally think that most people who have not yet retired should strongly consider having at least 60% of their retirement assets in stocks. This is because most of those assets will not even be used until ten years AFTER retirement, assuming you have other sources of income. Even past age 90, I think that most people should have at least 15% of assets in stocks.

Special Considerations

If you are a person who inherited a large amount including a sizable stock ratio, you have presumably adjusted the percentage of stocks to your own comfort level. Analyze the stock holdings you have and group them into the three asset subclasses described. If you are quite happy with the current percentage distribution, and it includes at least a moderate amount in each class, leave it; you can apply this strategy with the exception of unequal proportions, and it works about as well.

Tax tip: Rebalancing in post-tax accounts can have adverse tax effects if you often sell shares that have high unrealized capital gains. But almost all of the tax costs of rebalancing can be avoided if you have all stock dividends and capital gains distributions paid into the money market as they arise, and rebalance by taking money from that account.

Or, as long as you have at least one-quarter of total assets in IRA-like vehicles, you can rebalance easily; just keep the four different kinds of funds in the IRA, possibly even the same four mutual funds that you keep in a taxable account. Then make apparently massive shifts within the IRA to make the overall total come out correctly rebalanced. But even if you have nothing in tax-shelters, the tax cost of rebalancing only averages around 0.1% of total assets each year.

Why does this Four Corners Strategy work well? First, you buy "one of everything" in stocks, so you must logically achieve average performance. No matter what other investors do, about half of their stock investments must do worse than yours.

Second, if you use indexed funds, your fund manager does not expend time and money trying to find the "best" choices; this cuts your expense ratio by about half-a-percent annually. Finally, this annual rebalancing tends to produce a gain in the long term of between 0.5 and 1.5% annually over what buy-and-hold without rebalancing would produce.

In effect, rebalancing requires that you sell part of a class when it has risen more than average, and buy into another that has risen less than average. So it forces you to buy low and sell high. So, in the very long term, you are fairly sure to beat the average investor by 1 to 2% in overall annualized return with the Four Corners Strategy and indexing.

William C. Jones, Jr. was born in Chicago in 1944. He obtained the Ph. D. in Mathematics from Purdue University in 1969. He has taught full-time in the Departments of Mathematics and Computer Science at Central Connecticut State University since then, except for a year teaching at the Bundeswehr University in Hamburg, Germany in 1981-82. He earned a Master's degree in Computer Science in 1989 and has had three textbooks in Computer Science published, by Harper & Row and by John Wiley.

Dr. Jones has been investing all of his retirement assets in equity and bond mutual funds since 1974. He is married to Virginia, who also teaches Mathematics and Computer Science at CCSU, and they have a daughter working on her Ph. D. in Mathematics. Dr. Jones is also a frequent contributor to the MFI newsgroups.

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