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Weekend reading: Costs trump the best asset allocation decisions

Good reads from around the Web.

Once people get beyond trying to pick stocks and embrace the ‘total investing’ religion, they typically displace their former zeal for buying tinpot miners and tiny tech start-ups into agonizing about their asset allocation [1].

Should they put 1.3% into gold [2]?

Maybe 7.2% into commercial property?

Or perhaps 7.4% would do better?

This sort of finickity fiddling is a waste of time for passive investors [3].

Rather, in my view a cheap and simple asset allocation – such as the lazy ETF portfolios [4] – fits the bill for most.

That is not to say that some particular mix of assets won’t turn out to have been the best choice over your lifetime.

While the data from the US [5] suggests that different lazy strategies tend to achieve similar results over the decades (especially once you consider volatility and risk), a percentage point or two of extra growth does make a big difference to how much you end up with, due to compound interest.

However I think it’s hard, if not impossible, to know which strategy will do best in advance, even if you turn to valuation [6] and so forth.

By all means give it a try if you love investing.

It’ll probably be more profitable than trainspotting or crochet.

But don’t feel you have to – that’s my main point.

Far better to focus on keeping your costs low and sticking to your long-term plan, whatever it might be.

Costs count – a lot

I was discussing this with a Monevator reader in the comments the other day.

He had sensibly rejected a hard-charging wealth manager’s expensive investment plan, but he still felt the need to complicate things in order to do a proper DIY replacement job.

Specifically, he started asking how much he should put into private equity and hedge funds…

Now such so-called alternative assets might have a place in the world – though that’s debatable – but any role they do have is hugely undermined by the high fees they charge.

Which is why we preach low-cost investing here on Monevator. It’s very hard for people to grasp the impact of high fees [7].

Again, a reader was arguing with me recently that we make too big a deal of high fees.

We really don’t. Fees are one area of investing you can control, and as Rick Ferri discusses [8] this week the cheapest funds (usually index funds) have historically done far better than the more expensive ones.

Reducing costs therefore scores very high on the risk versus reward scale.

Cutting your costs delivers a clear and known benefit, compared to the huge unknowns and likely wealth-sapping impact of punting on fund managers or fancy but pricy asset classes, or perhaps even venturing into costlier Smart Beta trackers and the like.

Look at them go

Need more evidence? Then take a look at this very interesting article in the FT this week [9] [Search result], which draws on Mebane Faber’s new book, Global Asset Allocation [10].

The FT writer John Authers says the book:

“…shows clearly that the gap between the best and worst asset allocation schemes is narrower than the gap between the highest and lowest fees.

In other words, the precise asset allocation model you use is less important than keeping control of fees.”

Authers runs through the returns from several different asset allocation models over the past 40 years, as illustrated by the following graph:

asset-allocations [11]

Now, you might be looking at this and thinking you’d like some of the one that went up the most – and less of the laggard!

What was all that guff I just spouted about most allocations achieving roughly the same thing?

Firstly, as I said, it’s easy to see which allocation did best in retrospect. That’s very different knowing what will happen during the next 40 years.

Secondly, some allocations are much more of a rollercoaster ride than others – look at the huge plunge in the winning red line, for example.

If you don’t care about risk at all, then the best bet is to dump all you can into shares for most of your working life and cross your fingers.

You may do terribly (especially if shares crash shortly before [12] you retire) but the odds favour a strong result.

But many people just can’t take the deep dives that come with an all-stock portfolio.

High fees are not the bee’s knees

But anyway, I was talking about fees – and this is where Authers’ second graph is really illustrative.

He notes that a portfolio based on US bond guru Mohamad El-Erian’s portfolio would have performed the best since 1973.

But look what happens when hypothetical fees are taken into account:

Fees eat your returns for breakfast. [13]

Fees eat your returns for breakfast.

The impact of imposing fees is dramatic.

The drag from just a 1.25% annual fee is sufficient to pull the returns from the El-Erian portfolio beneath the return from a simple 60/40 stock/bond split.

It only just edges the worst performing strategy – the lower-returning but very stable Permanent portfolio.

And as for the 2.25% fees…

Now you might say you’d never pay 2.25%, and good for you. But I regularly field comments from readers who say we make too much of high fees.

For these people – and the many who never discover sites like Monevator, or even articles like John Authers’ – a 2.25% fee would sound a bargain to pay in order to get invested with what was the best performing asset allocation strategy of the past 40 years before costs were taking into account.

You see how it works?

Don’t fall for it!

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

Other articles

Product of the week: Pioneering peer-to-peer website Zopa [29] is 10 years old this weekend. The Guardian [30] reviews how Zopa [29] and the other P2P players have fared.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1 [31]

Passive investing

Active investing

Other stuff worth reading

Book of the week: Warren Buffett’s latest annual letter recommended John Bogle’s The Little Book of Commonsense Investing [48], which sent it soaring up the bestseller lists!

Like these links? Subscribe [49] to get them every week.

  1. Note some FT articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. [ [51]]