For years, Harold Evensky has preached the value of diversification. You might be a lot richer today if you'd taken that advice.
A principal of
Evensky Brown & Katz an investment advisory firm in Coral Gables, Fla., Evensky is a fan of spreading your assets broadly. Instead of betting the farm on big-cap tech stocks, which many investors did during the past few years, he thinks investors should own stock and bonds, getting exposure to different industry sectors and global markets. He
defended this strategy in these pages last year vs. big-cap growth evangelist Robert Markman. Now that the tech sector has collapsed, the bow-tied planner could point to the scoreboard, but he's far too kind to talk trash.
In the wake of what he calls a "classic mania," he lays out how to build a diversified portfolio that will flourish in up markets, but not fall through the floor when the sector or investment style du jour tanks.
1. I get a lot of email these days from rattled investors, particularly those who have loaded up on funds that had particularly big bets on the technology sector. What advice would you offer these folks today? Evensky: Don't cry over spilled milk, consider it part of your investment education. Use it as an opportunity to revisit your whole investment policy. Figure out where your money is now, decide how much should be in stocks and bonds and then reposition for the right places, and in the future, don't make sector bets.
If folks had stuck to the old saws, things wouldn't have been as painful as they might be today. Evensky: Yeah. Diversification works.
2. If someone is a fairly aggressive investor with, say, a 10-year time horizon, what kind of breakdown do you prescribe between stocks and bonds? Evensky: Probably 80% equities, maybe a little more. Part of the reason for leaving some of it in fixed income and bonds is it gives you an opportunity to buy in more equities as the market's down as you rebalance.
If you start off with 80%-20% and the market collapses and you find out you're 60%-40%, then you've got the money there to go buy 20% more in stocks when it's low.
When someone is building a stock portfolio, by and large, for most investors, is there anything wrong with simply buying a broad, diversified index fund? Evensky: No. And when they're finished, there's probably nothing wrong with it. But we'd certainly suggest someone start off with a core domestic holding, expand beyond that in core domestic and then in small-cap. Start with a core-domestic diversified and then split it between large and small, roughly two-thirds, one-third.
Next step would be to add some international, maybe three-quarters domestic and a quarter to 20% international. Next step would be to start splitting up by styles -- split your large-cap into growth and value, and split your small-cap into growth and value.
Do you recommend that style split be 50%-50%? Evensky: We believe in a value bias. So we're probably 40%-60%, 30%-70% -- growth being the smaller part of the two. That's what we'd recommend, but obviously people have to make their own decision.
But even 50-50 can make some sense if you're buying pure growth and pure value -- they don't cancel each other out. If you take a fund that says well, we're buying half of the
S&P that's growth and the other half is value, then you just end up back at an S&P holding.
I think a lot of people have learned a painful lesson that buying a few Janus funds and then layering on a tech-sector fund really was not diversified at all. Evensky: They basically owned the same thing.
But the problem a lot of them have now is, if they don't own any tax-deferred account where there are no tax consequences in terms of shifting the money around, how would they go about doing rebalancing? What are the strategies you prescribe for folks that maybe come to you and have a kind of a tech overdose in the portfolio. Evensky: First thing, they need to just finally accept that the markets don't give a damn what happened to them. The fact that they took a loss, and maybe they can't use it because it's sheltered, really doesn't matter.
The fact that they'd like it to go back up, and they don't understand why it doesn't, doesn't matter. If it is not a good investment, or it's an inappropriate investment, they should get out of it now. Waiting is just a fool's game.
Is there a way to lighten the blow by using your new money to broaden out instead of strictly selling and triggering some cap gains? Evensky: If it's the only way you'll move, then that's a good solution, but basically it's not a good solution because while you're waiting to average it out, you're still exposed to positions you shouldn't be in. And people need to remember it can get dark before it gets pitch black.
Sometimes it's darkest before the dawn, sometimes it's darkest before it gets completely dark. Evensky: Right. I'm not saying they won't boom back tomorrow. But if it does, people will be lucky, and if it collapses, they'll be unlucky. But they won't be smart either way.
Just because they're there is not a reason to stay there. The question that everyone should ask: If I had the cash today, would I buy back these positions? If the answer is no, get out.
It's an excellent guiding principle. It's the tax tail wagging the dog. There were lots of people when they had twice what they had now didn't want to get out because they said I can't, I'm going to pay all these taxes. And I guess the good news is, they don't have those taxes to pay any more.
And I think they probably take very little consolation in the fact that they have less in taxes to pay. Basically, tax management, in general, makes sense, but keeping the wrong thing to avoid paying taxes is stupid. You want to pay taxes. It means you made money.
Safety First
A techier portfolio would've topped a more diversified fund over the long term, but the past year would've been tough |
 | 60%: Vanguard 500 Index
40%: Avg. Tech Fund | 90%: Vanguard 500 Index
10%: Avg. Tech Fund |
| 1-Year Return | -30.5% | -14.1% |
| 5-Year Return | 19.3 | 16.9 |
| Source: Morningstar. Returns through Feb. 28. |
3. Just about every investor out there needs to have a certain amount of emergency money, or just money you always have on hand. And a lot of people in recent years just forgot about that. What do you usually recommend to clients? Evensky: There are a couple of things that people need. The first thing is they need what we call emergency reserves. And it's a wide range, but as a very rough guideline, if you've got a reasonably secure job, good disability, then two-to-three-months worth of your out-of-pocket living expenses. You don't factor in travel; you don't factor in taxes because if you're not making money you might end up not paying taxes.
So it's not three months worth of expenses, it's three months worth of those expenses you'd have to be paying if everything had gone to hell in a handbasket -- basic living expenses.
If you're less secure, it could be as much as six months. In addition to that, you want to keep fairly liquid in big expenses you know you're going to have in the next three-five years. I've got a wedding in two years; I've got a kid to send to college in three years; I should be relatively liquid. Short-term bond funds, money market, that sort of thing. And then finally, what we call the hidden goals, which is insurance.
But your first dollars need to go to pay for disability, life, health, property/casualty insurance, because it really won't matter if you invested this money and you did great, if your house burns down and you're not insured, or you're disabled and you can't work for the rest of your life. That extra return in your portfolio is going to be diddly squat. So that's where the first money has to go.
4. What we saw, in 1999, and last year, the obsession with the technology sector by both amateur and professional investors, was pretty breathtaking. In your career, have you seen anything where this much money went into one sleeve of the economy? Evensky: It was breathtaking and it was not new. It was a classic mania -- going back to the tulip bulbs and the South Sea bubble. It's just amazing that people continue to get caught by this stuff. So it was nothing new.
Look at the Nifty Fifty back in the '70s. The Nifty Fifty were the 50 global stocks with international franchises, and they could do no wrong, ever -- the
Cokes and that sort of thing. We had a huge collapse in '73-'74, and Nifty Fifty were decimated.
When all this was happening in 1999, when the average tech fund gained 136%, did you lose clients that wanted to take a lot more risk? Evensky: The answer is yes, we did have a few that just weren't happy with what we said and decided, I'm making more money than you, why should I stay? That was the exception; in hindsight they probably weren't a good fit for us to begin with.
But it was a tough time because what we were doing in 1998-1999, indeed, looked stupid. People would say, well why don't you just buy things that go up? Why do you buy things that don't go up? That's pretty silly. And we said, well, if we knew it was going to go up, I wouldn't need clients.
5. Would you lay out what kind of strategy you use in building portfolios? Evensky: To start with, we think people don't get rich from investing. We think that you get reasonable returns for appropriate risk. And reasonable returns are historic market returns.
People get rich by inventing widgets, or by doing whatever they do for a living. So, the first thing is, our philosophy is, you don't go into the market to get rich.
Two, when you go into the market, you can get better returns with less risk by investing in different areas of the economy. What's important is not the risk of an individual investment, [but] is how that investment fits within the framework of everything else you've got. And we believe that most people should have some stocks and some bonds.
We think that, in general, everyone should have diversified domestic, which means large- and small-cap; they should have some international developed and probably a little bit of emerging markets. These we consider the core holding. Once you get beyond that, we think it makes sense to give some thought to growth and value in any of those sectors.
But we tell people, we don't make you rich, we don't make you poor, we help you sleep well. We think that the key to focus on is risk-adjusted after-tax returns. Return by itself doesn't mean much, unless you factor in how much risk you took to get there.
And how much you have after you pay your tax bill. Evensky: How much you have after you pay taxes. But when we focus on taxes, it's after you pay taxes, not on the gimmicks to get there. Tax-managed funds, in most cases, or tax-managed portfolios are more of a story than anything.
6. When new clients come to you with portfolios that they've built on their own, what are the most common mistakes you see? Evensky: The most common mistake is not knowing where their money is. If you ask the average person how much they have in stocks and bonds, they don't know. Maybe they know the total amount, but they don't know what the breakdown is. And certainly they rarely know what the difference between large and small growth and value is.
Someone comes to me with a great stock and, "Oh, this is really good, it's great," I'd say: "Who's the president of the company?" They haven't got a clue. We joke people will spend far more time buying a new washing machine than they do buying a stock.
The second mistake is, they don't know where it should be, even if they know I've got 50-50 -- half stocks, half bonds, they haven't got a clue if that's appropriate for them.
So, the first thing when someone comes in is we gather the information and we lay it out so we can see where it is. [It's] not so important as to what the name of the investment is, but how much is in stocks and bonds, large and small.
The next thing we do is try to determine, based on what their goals are, how much does that portfolio need to grow in order to accomplish their goals?
The other factor is: What can they live with? At least theoretically, there is no perfect portfolio. If you tell me you need a certain return, there is, at least theoretically, a best combination. That combination has a certain risk, so we need to balance what investors need and what they'd like to have, and what they can live with, without jumping out the window.
And sometimes we have to counsel a client, well, do you want to eat less well or sleep less well? You can't have both the things you want. So, people need to come together in their mind and make the decision between those two balances. Once they've done that, that'll tell them how much they need in stocks and bonds, large and small, and then they need to move it from where it is to where it should be.
7. One concept that might have saved folks consternation and perspiration last year is "mad money," or "play money." It's natural for an investor to get excited about some hot investing idea that comes across their plate -- a niche fund or a hot sector. But with "play money," instead of making this part of your core portfolio, investors use their bonus money or money on the side -- money someone might take to Las Vegas -- to invest. Do you advocate this notion? Evensky: A qualified absolute agreement. The qualified part is first determining if an individual can afford that; but we have a number of clients [with whom] we do exactly that. We've got one we call the Derby Portfolio. We determine how much can an investor afford to enjoy.
Our basic rule of thumb is they can afford to lose half of it. And whatever that number is, we say, go have a good time. We'll help you do some research, if you want. Our attitude is, look, wines are my hobby. I spend a lot of money on wines and people think I'm crazy. When I drink it, it's gone. I mean, that's not investment, so if that's what people enjoy then it makes good sense, as long as they can afford the enjoyment, and they're not counting on sending their kid to school as a result of it.
The only other thing that we would suggest is that if you're going to do it, then monitor it appropriately so you know how you're doing. And very few people do that. We do it for our clients, but decide how you're going to manage it, and then find an appropriate standard to measure yourself against.
If you're playing highflying technology stocks, then find a good technology-fund manager and use it as a benchmark to see how you did compared to how they did. But the idea is absolutely appropriate, it makes a lot of sense, with the caveat that you do it with an amount of money that you can afford to put at risk.
All in moderation, I guess. Evensky: Right. Moderation for some people might be $5,000; for someone else, it might be a million dollars. It's not a magic number; it's not a percent. It's as much what your personal wealth looks like.
8. Now do you folks typically favor funds that track indices or actively managed funds or a blend of both? Evensky: A blend of both. Right now we're probably close to 50%-50%. First thing we do when we look at an active manager is say, OK, what's your benchmark?
There's a
Wilshire large-cap growth, a Wilshire small-cap growth, Wilshire large value, small value -- a typically active manager is going to be in a certain area. So we're looking for something a lot more specific than just a broad market or an S&P. It doesn't make much sense to compare a large-cap growth manager to a
Vanguard S&P. Unfortunately, people do, but that's apples and oranges.
When it comes to index investing, people have a pretty good idea of what kind of funds they're going to look at in the core category. Most folks would probably look at either Vanguard 500 or the Vanguard Total Stock Market -- that kind of thing. Evensky: That's the problem. Most people don't know about indexes; they think there's maybe two, that's the problem. There are far more than that.
What indices should folks be focusing on? Evensky: For the retail investor, probably the best are: the Vanguard, and then the Wilshire. Vanguard has a few specifics, and then Wilshire has a whole series. They have large growth, large value, small growth, small value, which are very good. So those would be the two families I'd look at.
When we talk about active fund managers, what are the funds that you folks prefer? Evensky: In large-cap, we're 100% passive, because we've concluded we can't find a manager to beat the indices.
By the way, the other thing we're beginning to use a lot of and investors should look at are the ETFs -- exchange-traded funds. There are a number of indexes -- there's
Russell, 1000 value, 1000 growth -- so there are good alternatives there.
Where do you come down on the argument of ETF vs. mutual funds? If it's a choice between Vanguard Total Stock Market or an ETF that tracks the same index, you'd go with ETF? Evensky: We'd go with ETF. I think it's going to seriously threaten the fund industry.
Is that mostly for cost? Evensky: It's cost, and there is potentially less tax exposure.
9. Everyone, at some point, becomes a short-term investor. What would you advise people if they're getting to be within five years of their goals? Evensky: In general, we have a five-year mantra. If you don't have a five-year warning to take your money out, then basically, get out now. Meaning, if you're getting out within five years, now is the time to start thinking about liquidating it.
If the market's way down, at least you say, thank God, I've got five years before I have to do anything. So, it doesn't mean get out right this second, it just means now's the time to start thinking about getting out.
And would you advise doing so gradually -- the opposite of dollar-cost averaging 
in, averaging out? Evensky: No. If this were a year and a half ago, I'd say get out. Get out now. It may go up, it may go down, but if you're waiting, you're just gambling.
What about today if someone's five years away? Evensky: Today, if they have a reasonably diversified portfolio, I'd probably say wait, you've got five years. Between now and five years, we're likely to get a certain amount of recovery in the market.
So at this stage, we'd be telling people not necessarily to get out right now. Once again, that's assuming they're reasonably invested. That's the whole idea of the five years, that you have that ability to manage when you're going to get out.
10. I've been getting a lot of letters recently asking: How should I get into this market? Should I dollar-cost average? How would I put new money to work? Evensky: In the long term, the most effective strategy is just to invest when you're ready. If it makes you feel more comfortable, and if you're afraid if you put it in today and it drops more, you'll bail out, dollar-cost averaging is an intelligent, appropriate alternative.
The catch is, you've got to stick with it and don't get weak-kneed if you feel it's going down. Dollar-cost averaging means putting a fixed dollar amount [in] on a fixed schedule. Like clockwork, no changes. It needs to be over a long enough period, I would say at a minimum, from three to five years.
