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A Real-World Benchmark For Asset Allocation

 January 18, 2013 02:23 PM

There are two main channels for engineering successful outcomes for strategic-minded investors, but there are many ways to fail. To boost the odds that the former will work in your favor, it's important to stay focused on key factors that will drive investment results, for good or ill. The first is asset allocation. It's easy and inexpensive to diversify across asset classes on a global basis, thanks to the proliferation of ETFs and mutual funds. Why would you do that? Risk management. Rebalancing is the other big variable. The two together are a powerful combination. By holding a broad array of assets you're in strong position to exploit price volatility, which is the raw material for earning a rebalancing bonus. But before you do anything, ask yourself one question: Are you confident that you can beat the pros by doing it yourself?

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There are a number of strong choices for one-stop shopping when it comes to multi-asset class funds. Yes, many charge excessive fees and use questionable strategies. No wonder that most of these products compare poorly with a passive asset allocation. Among the handful of exceptions is the Vanguard Star Fund (VGSTX). Its fairly long track record, impressive performance history, and low expense ratio (0.34%) is a winning mix. It also adds up to a robust real-world benchmark for multi-asset class investing. Even if you don't own it and have no plans to buy it, it's worth your time to periodically check in with its performance. It's also a handy reference point for stress testing the many professionally managed products that claim to offer some secret sauce for investing.

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For some perspective, here's how VGSTX compares to a few of the usual benchmarks that show up on these pages, including the Global Market Index, a passive mix of the major asset classes:

As you can see, Vanguard Star is competitive with GMI, and then some. Not only has it earned a modestly higher return for the decade just passed, it's delivered that result with roughly an equal amount of risk relative to GMI. The comparison is even more impressive once you recognize that VGSTX incurs real-world costs, whereas GMI is a paper index that suffers none of the frictions that otherwise plague investors and money managers.

I'm not trying to say that VGSTX is the only fund you need, or that it's the absolute best of the bunch and so stellar results are a given for all of eternity. Instead, the point is simply that it's a reasonably strong benchmark that reminds us that when you diversify across a broad set of asset classes, you do two things. One, you remove a fair amount of the risk that inhabits, and has been known to plague, individual asset classes (and their components) from time to time. Two, it puts you in a strong position to take advantage of volatility.

Asset allocation doesn't remove the systematic risk that lurks across asset classes, of course. But that's a story (and a risk-management issue) for another day. Meanwhile, it's worth repeating that multi-asset class diversification is a simple and efficient way to minimize quite a lot of the standard demons. It's a powerful message, and one that's all to often lost in the noise of the day-to-day news cycle in financial media.

Rebalancing a wide mix of assets adds another dimension that further enhances risk management's results after diversifying across asset classes. VGSTX offers both. Is it perfect? No. For instance, I'd like to see a bit more variety in its asset allocation strategy—foreign bonds, for instance. In any case, history suggests that you could do a lot worse than VGSTX. Can you do better? Yes, but that takes work, mainly via a stronger rebalancing strategy that's optimized to squeeze more risk premia from the major asset classes.

Are you up to the challenge? The answer for many investors, and quite a few institutions, is clearly "no." Trading costs, taxes, and emotion are the main challenges. Even the brightest of the bunch will have a hard time beating VGSTX (and comparable strategies) through time. The real tragedy is that many investors are clueless that basic investment strategies are so tough to beat. The good news is that you can hitch your star to Vanguard's Star, or build something similar on your own.

There's one small catch, though: you'll have to undergo an attitude adjustment relative to the crowd's view of money. How so? Charlie Ellis said it best in his classic book on investing: It's all about focusing on Winning the Loser's Game.
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