Ask The Expert with Larry Swedroe, March 2008 Issue

This is the 4th 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 Steve:

I have recently decided that I have too much exposure to US equities and would like to diversify. The problem is that the asset classes I would like to add (developed foreign, emerging markets, REITs, commodities) have all had tremendous runups over the past 5 years. I am buying for diversification, but in this case the result is the same as someone chasing performance. How would you recommend proceeding?

Steve that is a great question. The most important thing is to be sure that the reasons you want to make this decision has nothing to do with the problem of recency. Recency causes investors to buy yesterday’s winners high and sell yesterday’s losers low, almost as if they think they can buy yesterday’s returns, when of course they can only buy tomorrow’s returns.

In my opinion, broad global diversification across many asset classes is the prudent strategy because we live in a world of uncertainty (not risk where you can measure the odds, but uncertainty where you cannot). It is a world where no one has a clear crystal ball. Broad diversification acts like insurance; insurance against having too many eggs in the wrong basket.

My book, The Only Guide to a Winning Investment Strategy You’ll Ever Need, shows you the benefits of benefits of broad global diversification in Chapter 7. Six steps to a diversified portfolio using MPT. And Chapter 8 shows you how to build one. Appendix I offers recommended vehicles.

If you are convinced that broader diversification is the prudent strategy, and your decision is not a mistake of recency, I would make the change immediately and don’t worry about the recent returns. This is not a case of 2000 when we clearly had a bubble in US large cap growth stocks, especially technology stocks. All the asset classes seem at least reasonably priced to me.

Finally, whatever you decide, make sure that you write down your plan, including an investment policy statement, with minimums, targets and maximum percentages for each asset class and then sign it. Then check for rebalancing and loss harvesting at least quarterly and whenever you have available cash.

Question from Mike at Quest for Four Pillars:

I have a general question about diversification. It seems like the various stock markets of the world are more and more correlated — perhaps because of free trade. Do you know if this is the case? If so, is it still worthwhile to diversify to different parts of the world?

In my opinion that is mostly myth. Another bit of “conventional wisdom” that is as wrong as the earth is flat was.

Correlations drift over time, sometimes they fall and sometimes, especially during crises, they rise. And if you think correlations are rising just check the returns of Japanese stocks vs US stocks since 1990. Imagine an investor in Japan in 1990 thinking that correlations are rising and thus there is no need for international diversification for him. Just own Japanese stocks.

Here is some further evidence. From 1970 through 1990 the correlation of the S&P to the EAFE was 0.6. Since then it is 0.62. Seem to you that correlations are rising? That difference has no statistical significance.

There is always reason to diversify even if correlations were rising because they can always fall again. In a world of uncertainty, diversifying economic and political risks is the only prudent strategy in my opinion. And if you believe that markets are relatively efficient, then diversification does not reduce returns, it only reduces risks. Which is why it is called the only free lunch.

My own portfolio is about 60% international stocks. The reason is that the US is only about 41% of the global markets now and also my intellectual capital is in the US and exposed to US economic and political risks. And while that asset is not on my balance sheet, it is an asset nonetheless, and should be diversified. That issue, regarding labor capital is one, unfortunately, that even most professional advisors fail to account for.

Question from LJ from Mommy Gets Paid:

I would like to know more about what a “top heavy” 401K plan is. My husband’s employer recently sent a letter to us stating that he would no longer be able to max out his 401K because the plan is top heavy. They stated that he can only contribute about 1/4 of the maximum, and they would honor the employer matching for only that amount. Also, in light of this, what other options do we have? An IRA would not allow us to contribute as much per year as the 401K;is there other options?

Often times Top Heavy is used to explain that a 401(k) plan failed testing. All 401(k) plans are required to pass annual testing as required by ERISA and enforced by the IRS and DOL. This testing is to ensure that plans are not in place only to benefit the highly compensated employees (HCE). A highly compensated employee is somebody who makes $100,000 a year, is a 5% owner, or is the child of a 5% owner. In order to pass the ADP test (Average Deferral Percentage), as a group, the HCEs cannot contribute more than 2% more than the non-HCEs. For example, if as a group, the HCEs have total compensation of $1 million and they contribute $100,000 collectively, the HCEs have a 10% deferral percentage. If in that same company, the non-HCEs as a group have total compensation of $300,000 and as a group they defer $9,000, their deferral percentage is 3%. This plan would fail testing and after the year end, the HCEs would receive back half of their contribution to bring them to a 5% deferral rate.

These refunds cause employees frustrations as they are typically received after they have filed their personal income taxes and it causes them to go back and amend their tax return. To avoid this problem many employers limit the contribution amount like your husband’s company.

There is other testing that is required for plans and one is specifically a test to determine if the plan is in fact “Top Heavy”. The testing I referred to above only pertains to contributions, which is why it is more applicable to your question. A Top Heavy test is to test the plan to determine if less than 60% of the assets in the plan belong to HCEs. If a plan is Top Heavy based on this test, the employer must make a 3% non-elective contribution for all non-HCEs.

You are correct IRAs have much lower limits. Unfortunately, unless you have other sources of income (like self employment income) they are your only alternative to make tax deferred contributions. If you have self employment income, you could establish an individual 401(k) plan and because there is only one person on the plan, non of the testing applies and in most cases there is minimal administrative expenses.

Question from Patrick at Cash Money Life:

I have been reading about how dividend investing can be a great way to create cash flow over the long run (especially while reinvesting the dividends in the present time). Since it is very difficult for individual investors to beat the market with individual stocks, do you recommend dividend investing to individual investors? If so, do you recommend they purchase stocks in an individual company’s DRiP plan, or are there any indexes or ETF’s that track dividend stocks?

In my opinion owning individual stocks is more akin to speculating than it is to investing. It is not rational because doing so takes what economists call uncompensated risk — risk that can be diversified away without reducing returns. In other words, if you own one large cap growth stock you have the same expected return as all large cap growth stocks, but you have much more risk — the idiosyncratic risk of the company, which can be diversified away.

Investors should only take compensated risk. Risk which cannot be diversified away, like the risk of owning stocks in general. No matter how many stocks you own, you cannot diversify that risk away. The other compensated risks in equities are for small companies and value companies. In bond markets the compensated risks are credit and duration (maturity).

The only prudent way to invest in my opinion is to own broadly diversified index funds, not specialty sector ETFs or similar vehicles. And then you can reinvest the dividends and distributions if you like. However, I suggest that you not do that. Instead you should take the distributions (and dividends) and use them to rebalance the portfolio to the established targets you have for each asset class.

Question from Tony:

I was hit quite hard with mutual fund capital gains and dividend distribution last year in my taxable account. I believe this was the result of all the market volatility we saw last year. This year, the market is not any better and I believe we will see another year of high mutual fund distributions. Do you think I should take the capital gains hit and convert all my mutual funds to ETFs?

Not necessarily. The question is bit more complex. First, it would depend on the size of the gains you would have to pay as a percent of the holdings. Second, I certainly would not do it if I had to pay any short term gains. Third, there are mutual funds that are more tax efficient than others. For taxable accounts you should use only passively managed funds that are also tax managed. Now tax managed doesn’t necessarily mean tax minimization. It means that you want to maximize the after tax returns of the fund. For example, if a small cap index fund never sold the stocks that left the index it would eventually become a large cap fund and would have lower expected future returns. The same is true of a value fund. If it did not sell the winners it would become a growth fund with lower expected future returns.

What you would want the fund to do is to never intentionally take short term gains (the biggest gain from tax management) and perhaps to also use a different definition of the asset class, with wider buy and holding ranges. That reduces turnover and improves after tax returns. That is what the funds of Dimensional Fund Advisors do.

They also have recently introduced core funds that hold large, mid and small caps and also value stocks as well. That is superior to holding the individual asset classes as it reduces turnover when stocks “migrate” from one fund to another.

ETFs do have some advantages in terms of tax efficiency, though offsetting that is some extra costs in terms of transactions and for some higher fees. Remember that with an ETF you are not avoiding taxes, just delaying paying them, which clearly has some value — though not as much as avoiding intentional short term gains. So if you have a well managed passive fund that is also tax managed it can be superior choice overall to an ETF.

One should also consider the expected returns of a fund. The more one is exposed to the risk factors of size and value (the smaller the company, the higher the expected return and the higher the BtM, the higher the expected return) the greater the expected return is. So you might be moving from a high expected return fund to a lower expected returning ETF and even with a bit more tax efficiency end up with lower expected returns. So you have to look at more factors than just tax efficiency.

The right choice will depend on what specific alternatives you are considering and their overall costs and exposure to the risk factors mentioned.

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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.