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Advice for today's market? Diversify wisely

October 17, 2008 20:16 IST

As of October 7 retirement plans had lost as much as $2 trillion over 15 months, or some 20% of their value, according to the Congressional Budget Office. That has many workers wondering how they'll be able to retire and whether everything they thought they knew about investing has been turned on its head.

Diversification across sectors and countries, for example, was supposed to protect investments, but few areas of the market have been spared. And what future returns can be expected from stocks and bonds? Have all of our rules of thumb gone out the window?

We asked Jack Bogle, founder of fund giant Vanguard Group and a pioneer in the investment indexing business; and Zvi Bodie, a finance professor at Boston University School of Management, co-author of the leading finance textbook Investments and an expert on retirement security, to discuss issues facing savers and investors today.

The conversation has been edited and condensed.

Jack Bogle: I am a believer in diversification. You buy index funds for stocks, and your bond portion should equal your age. This is how I invest, so I know how little it's hurt me to have a substantial position in U.S. bonds. I'm in half Treasuries, half corporates.

The most common diversification talked about is international. What's wrong is that as soon as people start really talking about it and believing in it, international stocks are overpriced. About 80% of money going into equity funds last year was going into international. If that isn't a warning sign!

Here we are: The U.S. is one of the better-performing world markets. From the market peak in 2007, the S&P 500 is off 42.5%, international [measured by the MSCI EAFE Index of developed countries] is down 49.4%, and emerging markets [measured by the MSCI Emerging Markets Index] by 55.8%.

In recent years, international investing has had a higher correlation with the U.S. market than was traditional. If you invest internationally, you have to invest in foreign companies not as diversifiers but wealth producers. If you like international, get in gradually, maybe with 20% of your portfolio, half in developing markets and half in emerging markets. Europe looks a lot like us, so it's at least possible you might get a better return out of emerging markets. I don't invest internationally myself.

Zvi Bodie: I want to add something that strengthens your case. In markets like China, retail investors can invest only in the tiny fraction of equity investments traded on a stock exchange. So compared with the equity investments there that aren't traded on the exchange, those investments are way overpriced. A much better way to invest is to buy U.S. companies doing direct foreign investment in China.

I distinguish between diversification and hedging or insuring. When I use the term diversification, I use it in the sense that you have a bunch of risky assets, and instead of putting your money in one of them, you spread it across them by paying attention to whether those assets move in lockstep. Because if two risky assets are perfectly correlated, you're kidding yourself if you think you're diversifying.

And then there is insuring or hedging. That's when you've got a safe asset and to my mind that is Treasury Inflation-Protected Securities, or TIPS. One way to protect yourself is to combine a diversified portfolio of risky assets with the safe asset. We teach students that you only need two mutual funds - the risky assets and the safe asset - to generate the entire set of risk-and-reward trade-offs.

Bogle: Amen.

Bodie: And that could be provided at minimal cost. But then a lot of smart people working on Wall Street would be deprived of their high income. So they put all sorts of bells and whistles on these things, none of which has to do with improving the welfare of clients.

Bogle: If people would look at not just a percentage point in costs, but what 1% to 2% in lower returns costs you over a lifetime.

Compound 8% and 6% over 50 years. Or use returns adjusted for possible inflation, so call it 5% and 3%. Take a dollar, and at 5% over 50 years it grows to $11.50. But at 3% it grows to just $4.40. Most people would not want to give that $7 difference to Wall Street, and they're right. Investors earned it, why give it all away? I've been working on this idea of low-cost indexing for a long time, and my record of failure in persuading active managers of its self-evident validity is just about 100%.

Bodie: But that's not true, Jack. Passive indexing is huge today.

Bogle: Vanguard's total assets are $1.2 trillion, and clearly indexing has been the driving force in our growth. But there are two things that are sad about that. One is that many index funds are just ripping off customers. They have 50 to 100 basis points of expenses, and it's ethically outrageous that people can sell these things.

Indexing is now about 14% of equity fund assets, and that's O.K. as far as it goes. I'd have thought it would get to 20% to 25%. It's proven to work and only works in low-cost mode. But the underlying tragedy is that indexing leveled off at around 9% of fund assets in 1999 or 2000, and the growth to 14% is in exchange-traded funds (ETFs). And those are index funds you can buy and sell in real time all day long. What kind of a nut would want to do that?

The other thing that really troubles me is commodities. People need to understand this infinitely important principle of investing, which is that stocks and bonds have an internal rate of return. For a bond, it's the interest rate compounded over the years.

For stocks, it's today's dividend yield of 2.5% or so and implied 6% earnings growth. With commodities, you're betting solely on the expectation that you'll sell at a higher price than you bought. It will give you diversification, but I can't believe the rate of return on gold is going to be 7% to 8% a year, like the long-term return on stocks.

Christopher Farrell: On Wall Street the talk is about return, but both of you emphasize risk.

Bogle: You can control risk. You can't control return. That's up to the beneficence that stock and bond markets are generous enough to bestow on us. That's why we talk about diversification.

We can, however, look ahead and make reasonable predictions. In the bond market, we know with 90% probability that return in the next 10 years will be 4.5% to 5%. That's the historical number. If we have huge inflation and a Great Depression, and lots of bonds default - this is why I like Treasuries - then that's something else again.

In stocks, we know the sources of stock returns. Dividend yield is almost 2.5%, and earnings growth from these levels ought to be 6% over the next decade. That's an 8.5% return.

Market volatility is to be ignored, up to a point. I said in my last book (The Little Book of Common Sense Investing; his new book is Enough: True Measures of Money, Business and Life) that it turns out the stock market is a giant distraction to the business of investing. Think about now, in this orgy of speculation.

In 1929 there was 140% turnover in the U.S. market (meaning the entire market of stocks was bought and sold almost one and a half times). When I came into the business in 1951 it was 25% to 30% a year. Last year it was 280%. It will probably be 300% to 320% this year.

The volatility of the market doesn't really hurt the average retired investor because dividends keep coming in. But some of these dividends are gone. Companies that were paying them have gone out of business, almost entirely, actually, in the financial sector. So dividends are somewhat jeopardized, which I find broadly speaking one of the more challenging things. On the other hand, a lot is behind us.

Bodie: I'd supplement what we've been talking about by saying that everyone should think of his total capital as composed of a financial part and a human-capital part. If your human capital is safe, your nonhuman capital can be very tilted toward equities at a young age and tilted toward bonds at an older age. Let's take my son-in-law who works on Wall Street. His human capital is effectively a risky stock, since his industry is volatile. So I say to him over and over: "You want to be all in fixed income."

Bogle: Did you persuade him?

Bodie: Yes.

Bogle: I'm amazed, because if you're in that business you think trees grow to the sky.

Bodie: I was very forceful because he is in charge of my three-year-old granddaughter, who is the most precious thing in my life right now.

Chris Farrell, BusinessWeek