In Part I, we discussed the reason why trading does not replace long-term investing. In this installment, we will review the cornerstones upon which an investment portfolio is built.

These cornerstones may be unfamiliar to most traders, but as John Maynard Keynes wrote, “The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future,” while directional trading is relatively a straight-forward beauty contest.

Cornerstone: Total Return

Traditional asset classes earn dividends and interest payments that compound over time to produce total returns. This fact is rarely mentioned in “avoid bear market” sales literature designed to promote trading as a “risk management” tool.

This chart shows the power of total return. The Dow Jones Industrial Average closed the first week of October 1987 at 2,640.99. The total return index (pink line) shows the true return for the buy-and-hold investor while the blue line is the index quoted in the newspapers. So the next time someone tells you that “the Dow has gone nowhere since 2000?, just smile knowing they have no clue and walk away.

• The Dow Jones Industrial Average: The Impact of Fixing its Flaws (DOWNLOAD PDF)
  Clemens Sialm; John B. Shoven, Winter 2000
  Ignoring dividends dramatically underestimates the long-run returns earned by stock market investors. If Dow Jones & Co. had included dividend returns in the DJIA when it was formed in 1928, the index would be over 250,000 today.

Cornerstone: Asset Allocation Policy

As the old saying goes, do not put all eggs in one basket. We would go further to check that none of those eggs are rotten to begin with, and not always keep them in baskets. Some eggs should be stored in the fridge, while the golden ones should be locked in a vault.

How your assets are allocated will influence the returns on your investments a great deal:

Defining and selecting asset classes constitute initial steps in producing a portfolio. Many investors simply allocate among the asset classes popular at the time in proportions similar to those of other investors, creating uncontroversial portfolios that may or may not address institutional needs. By relying on the decisions of others to drive portfolio choices, investors fail to consider the function of particular asset classes in a portfolio designed to meet specific goals. — David Swensen, Pioneering Portfolio Management

Be on the lookout for managers that “tactically” shift their asset allocation to hot or “alternative” asset classes (that generally do not pay dividends or interest) to boost return. It’s market-timing in disguise. Investors must not chase performance, use hindsight and follow fads and fashion.

Cornstone: Vanguard’s Nine Commandments

Please keep in mind that Vanguard is not referring to buying-and-holding QCOM, TASR, CROX, AAPL, GOOG or any individual stock du jour as a long-term investment strategy like many retail investors do.