Posts tagged total stock market

Over on the forum there were some questions about my latest podcast where I discuss Harry Browne’s use of “aggressive” stocks in earlier versions of the Permanent Portfolio. This is a great topic and it was good question that I think I want to talk about here.

To review, in the last podcast I answer a reader’s questions about why Harry Browne probably switched to using a broad based S&P 500 index for the stock allocation vs. his earlier advice. We have to speculate on his reasons, but my own thoughts were basically confirmed by his former business partner John Chandler that picking “aggressive” stocks is very hard to do in the market.

It is no secret that I am a Total Stock Market index guy and is what I said over and over again to use for the portfolio (or the S&P 500 if that’s what you have access to). But people sometimes want to try to squeeze some more performance out of the portfolio and value investing is usually the first place to look. Now Harry Browne did talk about “aggressive” stocks, but this is a really nebulous term. Same with “growth” stocks. They are nebulous because they require a manager often to make these calls. What is one person’s “growth” stock is another’s “Sell it because it’s gone too high” stock.  If the manager makes a good call then you make money above the market returns. If not, well you know the rest…

Counter-intuitively the best place for volatility is not growth usually, but value stock funds. This is because value funds often are filled with companies that have been the most beaten down in price. So, the idea goes, that they are more likely to benefit from a good recovery because they have the furthest to go back up to hit the mean Price to Earnings and Price to Book ratios. Whereas growth stocks have been getting all the attention and the stock prices have been driven very high already. This is usually not a good idea to invest in companies that everyone wants to buy right now.

In fact, if you look at the three IShares Russell 3000 index funds (blend, value and growth) you see that the value funds tend to have slightly more Beta and more volatility as shown in standard deviation. Beta is the measure of a funds volatility over that of the general stock market. The higher the number above 1.0 the more the fund moves in relation to the stock index. Standard deviation is a measure of how much the returns can swing up and down. The higher the standard deviation, the more volatile the fund tends to be on price swings (both in good years and bad years).

http://finance.yahoo.com/q/rk?s=IWV+Risk
http://finance.yahoo.com/q/rk?s=IWW+Risk
http://finance.yahoo.com/q/rk?s=IWZ+Risk

iShares Russell 3000 Blend Beta: 1.03
iShares Russell 3000 Value Beta: 1.07
iShares Russell 3000 Growth Beta: 1.00

And std. deviation

iShares Russell 3000 Blend std. deviation: 18.41
iShares Russell 3000 Value std. deviation: 19.16
iShares Russell 3000 Growth std. deviation: 18.36

Even in small cap you see a slight edge to the Value:

http://finance.yahoo.com/q/rk?s=IJR+Risk
http://finance.yahoo.com/q/rk?s=IJS+Risk
http://finance.yahoo.com/q/rk?s=IJT+Risk

iShares S&P 600 Small Cap Blend Beta: 1.16
iShares S&P 600 Small Cap Value Beta: 1.20
iShares S&P 600 Small Cap Growth Beta: 1.13

iShares S&P 600 Small Cap Blend std. deviation: 22.33
iShares S&P 600 Small Cap Value std. deviation: 23.07
iShares S&P 600 Small Cap Growth std. deviation: 21.85

So in the above you can see a slight edge to the value funds for Beta and Std. Deviation which means they tend to be more volatile than the market in general. But again look at the differences in these funds. It’s negligible. Now these funds have been around less than 10 years, but you get the idea that it’s not a slam dunk as many may believe. When you wrap in the turnover costs, taxes and generally higher expenses involved with the value funds the differences become very blurry in terms of real world performance.

Now we could argue that a tilt to small value is best. And some people do this. But I prefer to optimize for my taxes and a market efficient portfolio so it’s not something I do. BUT if you really want to do it, then just use a good index fund and don’t tinker too much afterwards. Realize that you may have market tracking error and be prepared to wait it out if you are lagging the market every now and then. Most people won’t be able to do this. IMO. I think most are better served by using a broad based Total Stock Market index fund because they will have less regrets.

Lastly, Beta is a backwards looking measure. It tells you what the fund did, not what the fund will do going forward. So building a portfolio on things like Beta (or Alpha) alone is not a good idea. One year Beta could be great, but then a bad streak hits and it can go against you quickly.

The above is why I advocate the Total Stock Market style funds and not to try to get tricky trying to beat the market. When you own the Total Stock Market you hold large and small value and growth stocks together so you benefit no matter what is doing the best. The idea of picking more volatile stocks sounds great in theory, but in practice it’s almost impossible to do consistently.

Hope that explains my position a little better.