What the smart money has to say about your mix of stocks, bonds and exotic investments.
How much of your savings should be tossed into the stock market casino? Just about all, if you think like Warren Buffett. None, figures a panic-prone colleague of mine who just sold off his last share.
Bonds? These days they yield not much more than nothing. Maybe you should own not a single one.
What follows is a survey of noteworthy portfolios, ranging from the playthings of billionaires to a classic balanced mix held by the Fed chairman. I’ll show you how to implement some of these strategies using exchange-traded funds.
Our starting point is the $88 trillion collection of property held by American households, the data selected from a national balance sheet maintained by the Federal Reserve. This everyman portfolio is a conservative blend of equity-like and fixed-income assets.
The real estate category consists in large part of people’s homes. For average Americans they are indeed a retirement asset: When you get too old to live in your own house you can sell it to pay for a nursing home. Like stocks, a house adds a dose of inflation protection but also risk to a balance sheet.
The slice for fixed income includes the value of old-style pensions ($X a month for as long as you live), which are a bond-like retirement asset, plus the fraction of IRAs and 401(k)s invested in bond funds. It includes bank CDs and bonds held outside retirement accounts. I haven’t reduced the fixed-income allocation by mortgage debt; with such an offset, the blue slice would shrink considerably.
Social Security is not included here as an asset, but it would have been a big item: This inflation-protected annuity can easily have a discounted present value upwards of $1 million (see What’s Your Social Security Benefit Worth?). The “alternative” category is mostly equity in private business (e.g. a pizza parlor).
Think about how your own balance sheet compares with this portfolio. If you own a big house with a big mortgage you might want to reduce your risk by leaning toward bonds in your retirement accounts. If you rent, lean the other way to get more inflation protection.
Now let’s look at a model portfolio as constructed by investor Warren Buffett. In a letter to his Berkshire Hathaway shareholders, he explained that instructions in his will have the money being left to his wife invested 90% in a stock index fund and 10% in short-term government bonds.
Is this mix right for you? Maybe—if you can shrug off the next 50% crash. But even if you are not so cavalier about risk, you should take note of two things that are conspicuously absent from the Buffett portfolio.
One is long-term bonds, which would deliver much pain during a resurgence of inflation. Bonds have been a Buffett bugaboo for a long time. I recall him explaining, at a Columbia Business School forum three decades ago, why he didn’t want to own pieces of paper so obviously exposed to the tendency of governments to devalue their currencies.
Since that speech, inflation and interest rates have come way down and long Treasurys have delivered terrific returns. But the bond bears may yet be vindicated, perhaps in Buffett’s lifetime.
The other item missing from the Buffett testament is any allocation to hedge funds. Some do well, but collectively they just shuffle corporate assets back and forth at great expense without adding to those assets. Buffett has a long-term bet going on a horse race between his recommended stock index fund and another player’s assortment of high-cost funds. So far he’s way ahead.
To implement the Buffett 90/10 plan, use these cheap index funds: Schwab Short-Term U.S. Treasury ETF (SCHO; expense ratio, 0.08%); Vanguard 500 ETF (VOO, 0.05%).
Quite a contrast to Buffett is deal maker Carl Icahn, whose money is carved up this way:
Mere mortals can’t do this. You could, though, follow both the billionaires by dodging bonds, then make a small side bet in Icahn Enterprises (IEP, $53). This Nasdaq-traded partnership might do well if Congress doesn’t crack down on the tax gimmicks used by hedgies.
How about people who are prosperous but not Buffett-rich? The pie chart below is taken from a survey of investors done by Capgemini, a consulting and tech outsourcing company.
The percentages are for residents of North America who have at least $1 million of investable wealth. Capgemini estimates that the group numbers 4.8 million and has a collective $16.6 trillion.
Here, the real estate slice excludes primary residences. The alternatives category includes hedge funds, commodities, stakes in private-equity partnerships and businesses like pizza parlors.
You can’t replicate all of this with liquid investments, but you can get close for some of the categories. To replace the investment real estate you could own the Fidelity MSCI Real Estate ETF (FREL, 0.08%). It owns real estate investment trusts like Simon Property Group and American Tower Corp. Commodity investing is problematic for investors who care about costs, but a partial fill could come from another Fidelity sector fund, its MSCI Energy ETF (FENY, 0.08%). This has stakes in oil and oil-service companies like Exxon Mobil, Chevron and Schlumberger.
Now let’s turn to an illustrious college endowment. Yale’s $26 billion (as of June 30, 2015) is run by gunslingers who disdain the sort of tradable securities that you get at your online broker.
Yale’s mingy dose of tradable stocks (two-thirds of which are shares of foreign companies) is accompanied by a tiny allocation to bonds.
Small investors can copycat the tilting to foreign equities. Emulating Yale’s results in alternatives is a much bigger challenge. The endowment’s prestige has hedge funds, private equity managers and other vendors of investing products begging for attention. They offer Yale terms that ordinary people do not get.
Consider the largest piece of the alternatives allocation, the 20.5% of the university’s money devoted to “absolute return” strategies. The idea is that a clever mix of bullish and bearish stock positions can have you hauling in a positive return in both up and down markets.
This might work for Yale, but it doesn’t for the retail crowd. Morningstar lists nine equity funds that have “absolute return” in the name and records going back three years. The group’s annualized returns over that period average out to -1.4%.
There’s more exotic fare in the Yale curriculum. The university has made a pile on venture capital, betting early on Amazon, Google, Facebook and LinkedIn. You can’t get the same terms, but you can get technology exposure via the PowerShares ETF (QQQ, 0.2% expenses).
Yale has stakes in oil and gas, timber and mining ventures. It wouldn’t make sense to emulate its private deals unless you have $1 billion to commit to natural resources. But you could get resource exposure with a sector fund like the Fidelity Energy ETF or a real estate investment trust like Rayonier (RYN, $27), which owns timberland in the Northwest and New Zealand.
A much tamer endowment is maintained by the taxpayers of California to fund government pensions. Calpers has $295 billion divided this way:
Note how small the alternative category is. Two years ago Calpers announced that it was disappointed by the high fees and the low returns on its hedge funds and would be cutting back. What’s left in the purple pizza slice is mostly a combination of inflation-linked bonds and private equity deals.
Imitation flavors for this part of your portfolio: Schwab U.S. TIPS ETF (SCHP, 0.07%) and shares of a leveraged buyout operator like KKR (KKR, $14) and Blackstone (BX, $28). Be aware that Treasury Inflation Protected Securities have a real yield not much better than 0% and that the LBO kings don’t have much in the way of honest (GAAP, that is) earnings.
How do very smart people invest? Let’s look at the holdings of Fed Chairman Janet Yellen and her husband, Nobel economist George Akerlof. From Yellen’s public financial disclosures we can estimate this breakdown:
The percentages are not certain because disclosure forms show assets in ranges rather than exact amounts, but they are probably very close to the truth. I have included defined-benefit pensions in the fixed-income category, using values derived from annuity calculators.
This power couple’s allocation to alternatives is 0%, so you can replicate the portfolio using ETFs. They have a tiny amount in individual stocks, preferring cheap index funds for the bulk of their money. Their ratio of domestic to foreign equities is a chauvinistic 2:1.
You can’t get more mainstream than this. For comparison go to Fidelity’s asset allocation tool and declare yourself to be a moderately risk-tolerant investor. You’ll get something that looks like a carbon copy of Yellen-Akerlof.
Implementation is easy. For the U.S. stocks, go beyond the S&P 500 companies suggested by Buffett to include, as does the Yellen family, smaller companies. A good full-spectrum domestic stock fund is Vanguard Total Stock Market (VTI, 0.05%). Get foreign equities with Vanguard Total International Stock (VXUS, 0.13%). Get fixed income with Schwab U.S. Aggregate Bond (SCHZ, 0.05%).
Boost your bond allocation if you have a mortgage. Lower it if you have an old-style pension. You can get a value on your pension rights with the calculator in Maximize Your Pension.
Our final portfolio is from a 19th century investor, presented by way of illustrating an element of risk not often addressed by the experts. My source is The Hare With Amber Eyes, a saga of the rise and fall of a European fortune. Ignace Ephrussi, the second richest banker in Vienna, had an 1899 asset ledger that was divided as follows:
(The cash consisted of gold, at that time more a form of money than a commodity speculation.)
Risky? Yes, but not so much for the high allocation to stocks as for the domicile of the assets. When the Nazis swarmed into Austria they confiscated everything.
That puts your risk assessments—all your betas and Sharpe ratios and correlation coefficients—into perspective. You could build the perfect portfolio and then see it taxed away or stolen. No formula will protect you from all anxiety.
