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Selwyn Gerber writes:
For those lucky investors who recognize the wisdom on Rip Van Winkle’s investment style, superior returns can be reached by simply purchasing two ETFs and calling it a day. Nevertheless, even better returns are achievable by applying diligence to investing right. Returns can be further enhanced through proper portfolio maintenance, which includes annual rebalancing.
“To invest successfully does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding the framework.”
- Warren Buffett
Merriam Webster defines religion as “a cause, principle, or system of beliefs held to with ardor….” RVW investing is a highly scientific method of investing that has been empirically tested and has stood the test of time. Much like a religious belief, it requires dedication to – and unwavering commitment to – a core set of principles that have withstood the test of time. In this chapter we will review the fundamentals of RVW portfolio construction and provide a simple 2-ETF portfolio suitable for small investors. Moreover, we will outline the reasons that we believe that nuance and sophistication can be applied to these fundamentals to further mitigate risk and enhance returns.
Fundamentalist Rip
To be clear, successful investing requires less action than most investors, large and small alike, are comfortable with. The Rip Van Winkle approach is based on Nobel Prize winning theories that demonstrate how index investing consistently beats active management. It relies on more advanced research which demonstrates that value stocks, small cap stocks, and international stocks usually outperform the major market indexes. Diversification has been shown in studies to reduce risk, and is employed in this strategy. These principles guiding this investment strategy are derived from Nobel Prize winning theory and extensive research:
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1. Invest in index funds or ETFs: Indexes tend to outperform active managers 90% of the time by eliminating individual stock risk and sector risk, leaving only pure market risk
2. Diversify across asset classes: Asset allocation determines over 90% of the volatility in a portfolio and the greater the diversity of your holdings, the smaller the risk associated with any one component of your portfolio.
3. Ruthless cost cutting: Reduce the layers of cost (taxes and management fees).
These three fundamentals can be applied using an exceedingly simple formula. The following basic portfolio is not recommended for an investor whose total investment is greater than $100,000. For those investors investing more than $100,000 but would like to avoid the headache and lost sleep of employing the more complex strategies discussed later in this chapter, there are quite a few financial advisors that will provide these services for a modest fee. We do recommend, however, that you only employ those advisors that have the expertise and orientation to manage ETF portfolios for tax efficiency, and believe in and apply the RVW philosophy.
While the simplicity is appealing, sophisticated investors should use a skilled investment advisor to develop an enhanced approach to asset allocation and the selection of intelligent indexing. The basic RVW equity allocation will beat 90% of managers, but custom portfolios may include gold, oil, resources and non-cap weighted indexes which will do even better than that.
You can put RVW to work immediately and maintain the portfolio in less than 1 hour annually. Here’s how:
Step 1: Fire your asset manager and move the funds to a discount broker
Step 2: Do a simple asset allocation as outlined below to determine your equity: bond ratio bearing in mind that for the larger investable amounts the key question to bear in mind is for whom the investment are actually being made. (If an allocation to bonds is not appropriate because you are very young or have less than $100,000 to invest, skip step 3). Applying the simple RVW Portfolio Asset Allocation Model ®, the general rule is to take one’s age from 120 and allocate that to the equity percentage. For example, a 20 year old should have 100% in equities and 0 in bonds; a 70 year old should have 50% in equities and the rest of the portfolio in bonds.
Step 3: Determine whether you should be in taxable or tax-free bonds with reference to both your marginal tax rate and the relative interest rates of both categories. (A quick call to your tax preparer will tell you your marginal tax rate and your Alternative Minimum Tax status. This calculation can be delegated to your tax preparer.)
Step 4: Implement the portfolio. (If you are investing any portion of the funds into equities for the first time we suggest you stage that transfer over a period of say 3 - 9 months in a staged and planned manner so as to avoid timing the market. Funds already in equities should immediately be moved into the RVW equity portfolio).
Step 5: Redo this calculation annually to rebalance the portfolio and check the taxable v tax-free bond allocation.
RVW investing is a highly scientific method of investing that has been empirically tested and has stood the test of time. Much like a religious order, it requires dedication to – and unwavering commitment to – a core set of principles that are eternal. For those of us who have seen the light of long term index-based investing, Rip Van Winkle is elevated to “prophet” of a new “passivity pays” approach to investment success
For small investors, those with less than $100,000, the first step of the simple formula is to place 75% of assets into an ETF representing the broad stock market, such as the Vanguard Total Stock Market ETF (symbol: VTI). This ETF includes small cap stocks which research shows are likely to outperform the more popularly followed indexes such as the S&P 500. The remaining 25% of assets should be place into the Vanguard FTSE All-World ETF (symbol: VEU) which includes international stocks of both established and emerging foreign markets. Again, research has shown that international stocks beat the U.S. markets over the long-term. By rebalancing every year, this small investor is likely to generate better returns than more than 90% of mutual fund managers.
Asset Allocation
The basic portfolio above has a distinct disadvantage. While it does capture all of the key advantages of a well diversified global index based approach, it lacks the nuance necessary to optimize the profit potential. Moreover, by neglecting to include bonds, the portfolio will be more volatile than an optimum portfolio and will not generate sufficient cash distributions.
The first enhancement to RVW Investing is: a little elbow grease applied to asset allocation will lead to more restful sleep, and greater potential wealth. While hard work is an anathema to old Rip, statistics show it has its appropriate time and place.
More than four decades ago, Nobel Prize-winning economists Franco Modigliani and Merton Miller, demonstrated the intrinsic relationship between risk and reward. They discovered that asset classes with greater risk profiles generated higher average returns. Building on their research, Eugene Fama and Kenneth French showed a clear relationship between market capitalization, growth rates and returns.
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