Ask The Expert with Larry Swedroe, February 2008 Issue

This is the 3rd issue of the Ask The Expert column by Larry Swedroe. You can see Larry’s full biography and important disclaimer below. If you are interested in having your question answered by Larry, please send me an email via the contact page.

Now, let’s get to the questions and answers (please note that the emphases and links are mine).

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Question from Mike at Quest for Four Pillars:

Regarding REITs (real estate investment trusts). In my asset allocation research I’ve come across a lot of different opinions on real estate in a portfolio.

1) One field of opinion is that if you own a house, then buying REITs will increase your exposure to an asset class where you are probably already overexposed. Personally I don’t count my house as part of my asset allocation so I’m inclined to ignore that opinion. What are your thoughts?

I completely agree with you. The problem with a house is that it is totally undiversified exposure to real estate. Not only is it not geographically diversified, but it is not diversified by type of real estate either. The only prudent way to invest in real estate in my opinion is to own a REIT index fund, like the one that is run by Vanguard. The fund invests in hotels, apartments, office buildings, warehouses, shopping malls, etc. And it is geographically diversified. Note that this subject is covered in detail in my book Rational Investing in Irrational Times, Mistake 48 (of 52).

2) Now that I’ve decided I want REITs in my portfolio the question is how much? I’ve seen various numbers quoted from 5% up to 20%. Do you have a “number” that you recommend or is there some sort of methodology to figuring out how much real estate you should have - sort of like how you might figure out how much fixed income you should have.

There is no right answer to that question. In my view the most prudent approach to investing in a world where we do not have clear crystal balls is to diversify across many asset classes. So that means domestically investing in large and small, value and growth, and real estate.

For international, all the same (including real estate) and adding exposure to emerging markets. You should also consider including a small allocation to commodities (my recommendation is PCRIX, PIMCO’s Commodity Real Return Strategy Fund). Commodities, because they are negatively correlated to both stocks and bonds act as portfolio insurance. Thus, the more risk averse you are, the more you should consider including commodities in the portfolio. Appendix H of The Only Guide to a Winning Investment Strategy You’ll Ever Need covers the subject of commodities in detail.
Then add in the right amount of very high quality fixed income assets to reduce the overall risk to the appropriate level for you based on your ability, willingness and need to take risk (subjects covered in The Only Guide to a Winning Investment Strategy You’ll Ever Need).

Also keep in mind that because real estate is a highly tax inefficient asset class you want to hold it in a tax advantaged account, so the amount you can hold might be limited. Having said that 5-15% of equity holdings I would think would be appropriate.

From Patrick at Cash Money Life:

My wife and I want to fully fund our Roth IRAs for ‘08 and we have the funds to do so in one lump sum without hurting our cash flow or emergency fund. Is it better to fund the IRAs all at once, or use DCA on a monthly basis? Also, assuming the asset classes are identical (based on a major index), is it better to invest in an index fund or an ETF? Our time horizon is 30 years, so we are not too concerned about recent market volatility. Thanks for considering my question.

This question is addressed in What Wall Street Doesn’t Want You to Know. The bottom line is this: Because stocks are riskier than bonds they must provide higher EXPECTED returns. Thus everyday you are out of the market you are giving up that expected risk premium. Thus, the answer is logically to invest all at once. However emotions often get in the way.

As to the second question, at least for now ETFs are all index funds. And the major benefit of ETFs are they can be more tax efficient than regular mutual funds. But since you are in IRA this is irrelevant. Also ETFs are bad for regular small transactions because of transactions costs (commissions and bid/offer spreads). The way to identify which is best is to identify first the asset class in which you want to invest and then look for the lowest cost, the lowest turnover, the largest number of holdings, and for small stocks the lowest weighted average market cap and for value stocks the lowest weighted average P/E or highest BtM. Those are the factors you should consider.

From Plonkee at Plonkee Money:

I want to know about bond funds. If I’m diversifying into bonds, do I want index-linked, long term, short term, etc. I haven’t got the faintest clue. Basically, what is the standard bond index to track (assuming that bonds have indices).

I would urge you to read my book The Only Guide to a Winning Bond Strategy You’ll Ever Need. That will give you all the clues you need. But the short answer is this. Buy short to intermediate bonds of the highest quality and avoid any hybrid bonds (e.g., convertibles, junk bonds, preferreds, etc.) that have equity like characteristics. And TIPS by the way should dominate your fixed income allocation if in tax advantaged account. If buying funds, look for only an index type fund and it should be very low cost. But read the book!!!

From Ryan at Millionaire Money Habits:

I’m curious about your perspective on annuities for a younger generation. Is it worth it? I recently heard you can buy annuities for babies now. That’s something I’d like to learn more about.

First, the ONLY type of annuities you should consider are what are called immediate payout annuities — avoiding variable annuities. Second, there is almost no reason to even consider an immediate annuity until you are in late sixties or better even into your seventies.

From Julie via My Dollar Plan:

I’m doing this Suze Orman thing that I got and it recommends a revocable trust and states that I should transfer all of my assets to the trust. Can you tell me more about this type of trust and why I would want it?

I am not an expert on estate planning. You should consult an attorney. Note I have a well thought out estate plan developed in conjunction with my attorney.

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About Larry Swedroe

Larry Swedroe is a principal and director of research at Buckingham Asset Management, LLC, an SEC Registered Investment Advisor firm in St. Louis, Missouri (www.bamservices.com). He is also principal of BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.

Before joining Buckingham in 1996, Larry served as senior vice president and regional treasurer at Citicorp and vice chairman of Prudential Home Mortgage. Larry is author of The Only Guide to a Winning Investment Strategy You’ll Ever Need (updated and re-released in 2005), as well as five other books. Most recently, he authored Wise Investing Made Simple (2007).

His Books

• The Only Guide to a Winning Investment Strategy You’ll Ever Need
• What Wall Street Doesn’t Want You to Know
• Rational Investing in Irrational Times
• The Successful Investor Today
• The Only Guide to a Winning Bond Strategy You’ll Ever Need
• Wise Investing Made Simple
• The Only Guide to Alternative Investments You’ll Ever Need

Disclaimer

• Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.
• Not all questions will be answered
• By submitting a question, you grant us the right to publish your question.
• The answer is given based on the information provided in your question. Please seek professional assistance for more personalized advice.

If you are interested in having your question answered by Larry, please send me an email via the contact page.