To much fanfare, Warren Buffett made a $1 million bet with an active manager in 2007 that a blue chip stock index fund would outperform a basket of hedge funds over the subsequent 10-year period. Armed with the Vanguard 500 Index Fund, the 'Oracle of Omaha' wound up whipping his rival's hand-picked lineup of alternatives by gaining 94% versus 24%, according to the Associated Press.²

The wager's lore continues to shine as index fund enthusiasts keep pointing to it as another example of active management's failure to deliver oversized returns over the longer haul. At the same time, Buffett's big bet has also raised awareness of a key portfolio allocation question — one that IFA's wealth advisors are often asked to address. It goes along the lines of:

"Is putting all of our money into a passively managed fund primarily focused on a single asset class — like large-cap U.S. stocks — really going to be enough to meet our long-term financial goals?"

The interactive chart below shows return patterns of different benchmarks compared to a range of various IFA Index Portfolios. The key word here is 'portfolio.' Instead of simply using a single benchmark to cover, say large-cap domestic stocks, such full-fledged portfolios are constructed by our investment committee to passively cover six major asset classes (including 15 different sub-asset classes) across 45 countries. 

The idea isn't novel. The roots of IFA's portfolio designs trace back to research by Harry Markowitz. His pioneering work led to development of what's known today as Modern Portfolio Theory, which studies the effects of asset risk, correlation and diversification on expected investment portfolio returns. In 1990, he was awarded a Nobel Prize along with two other academics whose findings also have influenced our investment process -- Merton Miller and William Sharpe. 

According to studies by such investing luminaries (including Eugene Fama), a wealth of academic evidence points to the benefits of building portfolios along the so-called efficient frontier. In short, Markowitz and others have shown that 'betting the ranch' on a single — or even relatively small — group of securities and asset classes increases an investment's exposure to risk. 

The table below illustrates how random returns can be across different types of assets. At times, annual rotations between leaders and laggards in stock asset classes have been extreme. Such data also suggests that different bond asset classes haven't been any less susceptible to big yearly swings, either. 

Now, throw into such an asset allocation dilemma the task of trying to pick and choose between countries. (See table below.) It's enough to make more narrowly focused investors reel from market whiplash, whether they're looking over a shorter or longer frame of time. 

A common measure of market risk is a mathematical formula called standard deviation. This is an important statistical tool in analyzing portfolios since traditional economic theory suggests that higher expected returns must be associated with higher risk. So even if a fund gains more over a certain period, our portfolio managers will consider how much excess risk was involved in order to achieve those increased returns. 

Let's take a closer look at the first chart above, starting with IFA Index Portfolio 100. It represents an all-stock allocation utilizing tilts to small and value companies across the U.S., international developed and emerging markets. As our portfolios of passively managed funds reduce exposure to stocks, bonds are added to the mix to lower overall portfolio volatility, thereby cushioning portfolios from a higher-risk profile. (For example, Portfolio 80 holds 20% in bonds and 80% in stocks.)   

Notice this graph compares returns against standard deviation. A pattern develops in which portfolios with greater returns (i.e., a higher percentage of stocks) come with greater risk. As a result, we've created this particular analytical tool to enable our clients to hover their cursors over a particular portfolio to compare its results over different periods and various indexes. 

Another caveat worth considering is the impact of adding high-quality and shorter maturity bonds to an all-equity portfolio. On closer inspection of the Risk Return Scatter Plot at the top, you can see that portfolios in which bonds have been added produced less volatility with corresponding lower returns. 

How can you make sure what's the best combination of funds to use over time? A necessary first step in our asset allocation process is to take IFA's Risk Capacity Survey. It's designed to methodically assess how much risk a person really needs to be exposed to in order to meet his or her long-term financial goals. 

Footnote:

1.) The Associated Press, "Buffett wins $1M bet with hedge fund managers," Feb. 19, 2018.  

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This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. IFA Index Portfolios are recommended based on investor's risk capacity, which considers their time horizon, attitude towards risk, net worth, income, and investment knowledge. Take the IFA Risk Capacity Survey  at www.ifarcs.com to determine which index portfolio matches your risk capacity.