Once you’ve decided on an asset allocation for the client, you must now pick the specific assets. Which stock sector will outperform? Will emerging markets regain their lost mojo? Will unhedged international bonds be the ticket?
If you are tempted to make a big bet and follow a narrow investment focus, you are flirting with disaster. Research from Vanguard demonstrates that narrower funds produce larger gaps between investor returns and fund returns.
Last October at the Bogleheads 2013 conference, the Vanguard senior investment strategist Joel Dickson gave a presentation on the crazy things investors do: move into stocks after surges and sell after plunges. This causes investor returns to lag fund returns. Using Morningstar data, Dickson illustrated this lag in the categories below.
Investors chased performance in every category, but the narrower the category, the greater the shortfall. For example, stock sector funds lagged by 1.53% annually versus only 0.58% annually for broader stock funds. Though not on this chart, Vanguard determined that investor intermediate-term bond funds lagged by 1.37% annually, while narrower bond categories like high-yield bonds lagged by 2.45% and emerging-market bonds lagged by 3.36% annually.
The implication is that broader is better; it leads to less performance chasing. Don't fiddle with your clients’ asset allocation. Stay away from any narrow investment strategy, especially if it has recently been hot.
Broad low-cost funds like total U.S. stock, total international stock and total bonds are much better. In addition, rebalancing regularly has historically led to higher investor returns over the fund returns.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.