When we turn our attention from individual stocks to portfolios of stocks and other assets, we find we’re faced with another set of challenges.
Finding an appropriate asset allocation, which is a mix of stocks, bonds and cash, has long been considered the key to creating a successful, long-term portfolio.
But in chapter three of “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor,” John Bogle said cost is also a factor, and so important it cannot be ignored.
Starting with asset allocation, Bogle wrote there are three principal asset classes:
- Common stocks, which maximize total return.
- Bonds, for reasonable income.
- Cash reserves, for stability of principle.
Regarding bonds, the author wrote he is most interested in intermediate and long-term bonds; short-term bonds are quite insensitive to interest rate fluctuations, while long-term bonds are very sensitive.
Bogle said he continued to advocate for balanced portfolios, with bonds, despite a long bull run in stocks that made balanced investing appear old-fashioned and stodgy. Presumably, these words came from the 1999 edition of his book, and not the 2010 edition.
Four dimensions define his investing guidelines:
- Return.
- Risk.
- Cost.
- Time.
He urged readers to think of these four dimensions as the equivalent of the spatial dimensions of a cube—length, breadth and width—while time is a fourth dimension that “interplays” with the other three. For example, an investor with a long time horizon can take more risk than can an investor with a short time horizon.
Looking at risk, he wrote it is more than just volatility and standard deviations; it is also a personal matter, “how much you can afford to lose without excessive damage to your pocketbook or your psyche.”
Which brought him to balanced portfolios, saying, “The greatest benefit of a balanced investment program is that it makes risk more palatable.” Bonds, he said, would moderate the short-term volatility of stocks, allowing a risk-averse investor to maintain a heavy allocation to equities. And a heavy proportion of equities is essential for optimal growth. Further, time also diminishes volatility and risk.
Having made that point, he turned to his main concern in this chapter, costs:
“Costs rarely amount to much more than a few percentage points per year. So, industry lore has it that asset allocation must be given the highest priority. By ignoring the impact of costs, the industry implicitly argues that cost doesn’t matter. Industry lore is wrong.”
Getting more specific, Bogle argued that long-term investors should focus more on the allocation between equity and bond funds than on which particular stock or bond funds to buy. That is the conventional wisdom with which he agrees, but only so long as costs are held constant and low.
He reported finding a “fairly systematic relationship between the costs and net returns” of balanced mutual funds in one study. After removing costs from consideration, he noted the gross returns of the second, third and fourth quartiles were almost identical at 14% for the 10 years between 1987 and 1997, and at 7.0% for the years between 1994 and 2009. He concluded, “Not surprisingly, in each quartile, lower costs ineluctably lead to higher returns.”
In addition, he found the lowest-cost groups could achieve superior performance without taking on more risk than the balanced-fund averages. Additionally, among top-quartile funds, lower costs “systematically magnified” the gross return average. Specifically, for every 10 basis points of lower expenses, the net return was enhanced by 17 basis points. Bogle thinks of this as another form of financial leverage.
Such improvements would be a welcome, but largely immaterial gain on an annual basis. But after 10 years of compounding, “the advantage is huge.” With that, he said it was now possible to turn to the implications of cost for asset allocation policy, offering four perspectives:
- Conventional view: Thinking of fund expenses as a percentage of assets, or the stated expense ratio. These ranged from near zero when Bogle published his book, to more than 2.2% for the highest-cost equity funds (in August of this year, CNBC showed this headline: “Fidelity one-ups Vanguard, Schwab and iShares, becoming first company to offer a no-fee index fund”; ironically, Vanguard is Bogle’s company). In this first perspective, expenses are considered low enough to be inconsequential.
- Expenses as a percentage of an initial investment “consumed” over a 10-year holding period. In this case, expenses are very consequential. Bogle put the lowest end of the range at 2.8% for the lowest cost funds, at 19.8% of the average fund and 28.1% for the highest-cost funds. He couldn’t seem to resist writing, “As you can imagine, the mutual fund industry is not particularly smitten by this perspective, for it brings the cost issue into sharp relief.”
- Costs as a percentage of the expected annual return on stocks, working on the same basis as in perspective two above. Over a 10-year period and assuming average annual returns of 10%, the cost would look like this:
- The nominal expense ratio of 0.2% would reduce the annual return by 2%.
- The nominal expense ratio of 1.5% would reduce the annual return by 15%.
- The nominal expense ratio of 2.2% would reduce the annual return by 22%
- For the investor, that leaves, respectively, 9.8%, 8.5% and 7.8% out the original 10%.
- Expenses as a percentage of the equity risk premium, which offers what Bogle calls “the most striking perspective of all.” To explain with an example, he posed the case of a long-term bond returning 6% and an equities fund returning 8.5%; the risk premium would be 2.5% (8.5% - 6% = 2.5%). Would you then buy a mutual fund with an expense ratio of 2% plus transaction costs of 0.5%? Obviously, the answer is no because, as Bogle wrote, “Cost would have consumed 100 percent of the equity risk premium.”Â
This exercise underlines the non-obvious costs of mutual fund expenses. And the fourth perspective, in particular, leads us to the connection between asset allocation and costs. For example, assume a 10% return on equities and 6.5% return on bonds, leaving a 3.5% equity premium. Assume also you want an average long-term return of 7.5%.
Following up on these assumptions, Bogle asked, “What allocation would you make, given a choice between a low-cost equity fund and a high-cost equity fund?”
He answered: “If you select the low-cost program, your required ratio would be 30 percent stocks and 70 percent bonds. But if you select the high-cost program, your ratio would be 75 percent stocks and 25 percent bonds.” In other words, investors would need to increase their risk exposure by 2.5 times to earn the same return with a high-cost portfolio.
In summary, this article was partially titled with this question: Is performance determined by asset allocation or by cost? Initially, most of us would have assumed that fund fees of even 2% would be relatively insignificant, but Bogle showed the effects were very significant, even to the point of completely wiping away risk premiums. Asset allocation is still they key to building a successful portfolio, but only if costs are kept in check.
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
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