Financial Economics Corner: Economics and Investing Part 2

by robekulick

This is a continuation of my previous article on investing I left off depicting two sample portfolios that apply a low-cost, passive investment strategy using ETFs to achieve worldwide diversification. I suggested those portfolios for someone in their 20s or 30s because by virtue of the rather large exposure to emerging markets and the small exposure to Federal bonds, the portfolios are relatively risky. So my first order of business today is to explain how one should alter those portfolios as they age. Economic theory suggests that as we age, we should allocate more of our portfolio towards safer investments and less towards risky investments. The reason for this is that with risky investments like emerging market equities, the high level of volatility means that those investments can behave erratically for long periods of time. On average they will provide a higher return, so if you have 20 or more years before you plan to touch your money, I’m a big fan of emerging markets. However, the sooner you plan on using the money in your investment account, the more of your account should be invested in the TIP fund. Eventually if you are retired and plan on living off the money in your retirement account, having a very large percentage of your portfolio in bonds is the rational thing to do. So to summarize, the more time you have before you plan to use the money, the more you can take advantage of the higher average return on emerging markets and stocks in general. However, if you plan on using your savings in the near future, a higher allocation towards bonds makes a lot of sense.

Now in my first post I described the sample portfolios as 90% optimal. The reason that one may, and I stress the word may, be able to do better than this portfolio is because financial economists have found that stocks do exhibit some trends that investors might be able to use to increase their returns.  For the purposes of this discussion, there are two major trends that are of interest. First, over the long term, small company stocks have outperformed large company stocks. Second, “value” stocks, ie, stocks whose market values trade relatively close to their book values outperform “growth” stocks, ie stocks that have relatively high market value to book value ratios. How can you take advantage of this information.?Well, all the big ETF and index fund companies offer funds that focus specifically on small cap stocks and value stocks. For instance Vanguard offers:

(1) a “Small Cap” fund with the ticker symbol VB,

(2) a “Value Fund” with the ticker symbol VTV,

So investors looking to increase their returns over the sample portfolios I depicted in my first post may want to split their investment in US markets between VB and VTV as well as VTI (described in the previous post). Now these funds do have slightly higher expense ratios, but at 0.17% and 0.12%, from a pure expense ratio standpoint it makes sense to try achieve higher returns through these funds. Indeed, some financial economists believe that on average you can increase your average return 1% per year investing this way. However, I should also warn you that many financial economists believe that these types of investments offer higher returns because they are riskier. The jury is still out on that, but I am of the school of thought that the increased returns associated with these investments are a product of increased exposure to risk. So the discussion of how long you plan to stay invested applies here as well. So should you buy these two funds instead of the total market fund in the first portfolio? That depends. I personally like to invest in the small cap and value funds because I like to increase my risk level and this is a good way to do so while still maintaining significant exposure to the US. However, if you’re concerned about it, don’t do it. As I said, at best people who do this might make 1% a year more, but it’s also possible that people investing this way will end up doing exactly the same as people using the portfolios described in my first post.

A few other points I want to discuss today. For people with over $100,000 to commit towards investments, there is a mutual fund company called Dimensional Fund Advisors (“DFA”) which combines passive indexing with economic analysis of market factors like the ones I described above, to offer a sort of “enhanced” index fund. DFA is associated with two of my favorite financial economists, Eugene Fama and Kenneth French and everything I’ve seen about their returns suggests they’ve done quite well. However, you need over $100,000 to invest in DFA’s funds because you can only access them through financial advisors who are certified by DFA to trade in the fund. Why do they do this you might ask? Because to keep investment costs low, DFA will only work with financial advisors who they trust will advise their clients to buy and hold. This reduces the trading DFA’s funds need to engage in and allows them to pass on these lower costs to consumers. Here is a link to their website:

As you might have guessed, I’m a huge fan of DFA and if I had $100,000 to give them I would. But I don’t. So I’ll have to wait.

Also, so far I’ve lumped index funds and ETFs together, but they are actually slightly different. Index funds are traditional mutual funds whereas ETFs can be bought and sold like stocks. For most investors, there isn’t much difference, however, for those with a lot of money to invest, sometimes by investing in the Index Funds, rather than the ETFs, you can achieve slightly lower expense ratios. I don’t think this is a huge deal because we’re talking about extremely low expense ratios already, but it is something to consider.

Finally, a lot of people have recently been talking to me about insurance products that behave similarly to index funds. Some of them even guarantee a certain minimum return but also keep any money over and above a certain maximum return level. There are two reasons I’m dubious of these products. First, insurance companies generally charge higher fees for their services. Second, the Investment Act of 1940 stipulates that that mutual funds are actually owned by their investors. Vanguard or Fidelity simply manage the fund on your behalf. Thus, if Vanguard or Fidelity go bankrupt, your mutual fund will still be safe!!!!!!!!!! This is immensely important because otherwise you wouldn’t be truly diversified. On the other hand, insurance products do not work this way. If the insurance company defaults you are simply out of luck. According to Wikipedia over 62 insurance companies have defaulted since the 1990s:

Obviously, this represents a very small proportion of insurance companies, but it’s still a terrible risk to take with your retirement. I avoid insurance company investment products.

I’m going to stop here, but my next entry on financial economics will be about my actual portfolio and why invest in the specific way that I do. Thanks for reading! By the way, I love discussing financial economics, so anyone with additional comments or concerns should feel free to post and I will reply.