With the end of the year in sight, it’s a good time to consider some investment housekeeping. What’s worth your attention? Last week, I discussed the importance of asset allocation. According to the research, this is the single most significant portfolio decision you can make. But while asset allocation is important, it isn’t the only decision. Within each of the major asset classes, there is another set of considerations that’s worth reviewing.
Bonds. Earlier this year, I conducted a survey, asking whether a diversified total-market bond fund would, on its own, be sufficient to fill an investor’s bond allocation. Nearly three-quarters of respondents said no, and I share that opinion. Why? The bond market is larger and more diverse than the stock market, and for that reason, a diversified basket of bonds may not be what best serves investors. Instead, investors may wish to narrow their bond holdings along several dimensions.
The first key determinant of bond returns is what’s known as duration. To oversimplify a bit, the duration of a bond is similar to its maturity. It measures how long it would take an investor to get their money back. And bonds with longer durations—or bond funds with longer average durations—face more risk when interest rates rise. That’s precisely what we saw in 2022, when total-market bond funds, which have a duration of around six years, lost 13% of their value. In contrast, funds with shorter durations experienced much more modest losses. Vanguard’s Short-Term Bond ETF, for example, with a duration around 2.6 years, lost just 5.5% last year.
The next consideration in the world of bonds is the type of issuer. Bonds are issued by the Federal government, by state and local governments, by foreign governments, by universities and by corporations. And all of these, with the exception of U.S. Treasury bonds, are available from issuers of all different levels of creditworthiness.
A final consideration when choosing bonds: whether to invest in a bond fund or to buy individual bonds. You can find high-quality, low-cost funds covering each of the corners of the bond market described above. And in general, investing through a fund makes life simpler. There is an exception to consider at the moment, though: With yields at 15-year highs, you might want to build a ladder of individual bonds to lock in today’s yields for a period of years. If you do go this route, though, I’d offer one caution: Because the bond market is much more opaque than the stock market, the only type of bond I would try purchasing individually would be a U.S. Treasury. Because of its size, the market for Treasurys is much less opaque.
To be more specific about this opacity risk, the bond market—in contrast to the stock market—has no centralized exchanges and no quoted prices. That makes it much easier for more knowledgeable bond traders to take advantage of individual investors. That’s why, for bonds other than Treasurys, I would opt for a fund or, depending on the size of your portfolio, a dedicated bond manager. I would not try buying municipal, corporate or international bonds individually.
Real estate. For many years, real estate seemed to only go up. But with elevated interest rates, some corners of the real estate market are seeing declines. This presents an opportunity for buyers. But the real estate market, like the bond market, is diverse and inefficient. There are at least four key decisions to make.
First, decide whether you want to participate via equity or debt. In other words, do you want to own a property, or do you want to be a lender to others buying properties?
Second, if you opt for being an owner, decide whether you want to own property directly or through a fund. Owning a rental property directly generally results in much better economics for the investor, but it also means more work. There’s no right or wrong answer here, but it’s probably the most important decision for real estate investors.
Third, decide how you want to allocate your available funds among properties. If you invest all your money in one single-family home, for example, you’ll gain simplicity but give up diversification. Choose a multi-family or a collection of smaller homes, on the other hand, and you’ll have more to manage, but a problem with any one unit won’t be as damaging.
Fourth, think about geography. If you’re managing a rental yourself, it’s ideal if it’s close by. On the other hand, if you don’t mind hiring a property manager, you might benefit from diversifying across geographies.
Stocks. In another survey I conducted earlier this year, I asked readers whether a total-market stock fund would be sufficient to fill an investor’s stock allocation. As with the bond survey, only a minority said yes, but the percentage was much higher. In other words, many more investors would be satisfied with a simple total-market fund for stocks than for bonds. That result makes sense to me. As discussed above, the bond market is much more diverse, and certain types of bonds simply don’t make sense for certain investors. With stocks, however, for the most part, there is no equivalent distinction. So investors’ best bet, in my view, is to opt for broad diversification. Indeed, with stocks, the key risk is being too concentrated—in other words, being under-diversified.
If you’re reviewing your stock holdings, that’s the primary screen I recommend. Examine whether your stock holdings are too heavily weighted toward one company, one industry or any other narrow slice of the market. Because of the runup in technology shares, for example, it’s not uncommon to see portfolios that have too heavy a dependence on a handful of stocks, such as Apple, Amazon or Microsoft. A variety of tools, including Morningstar’s X-Ray, make it easy to look under the hood of your portfolio for risks like this.
A final note. Across all asset classes, there is another key decision to make: whether to invest only in publicly-traded investments or to get involved with private funds. To be sure, private funds have an allure. But they are also characterized by high fees, illiquidity, lack of transparency and often tax-inefficiency. That’s why the late David Swensen, who promoted the use of private funds during his long tenure running Yale University’s endowment—and had great success with that strategy—went out of his way to advise individual investors to do precisely the opposite. In fact, he wrote an entire book on the topic. As you think about investment choices for the new year, this is a key factor to keep in mind.