Excerpts from The Intelligent Asset Allocator - Part II

After building a solid concept of asset allocation and portfolio theory, the second part of Bernstein’s book (Chapter 7 to Chapter 9) elaborates on what is value investing, and guides the readers to build a portfolio which suits them well in a top-down approach. And finally some useful resources prepare you to be on the road of financial success.

Chapter 7 Odds and Ends

Value Investing

  • Small stocks outperform large stocks in the long run. Unfortunately this comes at the cost of higher risk. (Page 111)
  • Stocks outperform almost all other assets in the long run because you are buying a piece of our almost constantly growing economy. (Page 111)
  • Three commonly used measures of individual stock or of aggregate stock market value: price/earnings (P/E) ratio, price/book (P/B) ratio, and dividend yield. (Page 112)
    • P/E: P/E has only limited value. Ben Graham made the astute observation that corporate earnings provide useful information only when averaged over several years.
    • P/B: The net value of a company’s total assets, which is a rough number. The book value of a stock is very stable; corporate accountants usually have no need to fudge this number.
    • Dividend yield: it is simply the amount of dividend remitted to the shareholders divided by the price of the stock.

Studies on Value Investing

  • Dow P/E strategy: buying the 10 lowest P/E stocks of the Dow 30. (Page 115)
    • The lowest P/E stocks greatly outperformed the market, and the highest P/E stocks greatly underperformed the market.
    • The low-P/E stocks are actually the least risky when looked at from the perspective of the total number of losing years or of losses greater than 10%.
  • Dow dividend strategy: buys the five highest-yielding (cheap) Dow stocks. (Page 116)
  • Variation in return among stocks: The cheapest (lowest P/B) one-tenth of the market returned 19.6% annually, and the most expensive tenth, 7.7% annually, counting from July 1963 through December 1990. (Page 117)
  • A very hard concept for both small investors and professionals to grasp: (Page 117)

    Good companies are generally bad stocks, and bad companies are generally good stocks.

Value versus Growth

  • Looking for cheap stocks is called value investing. The opposite of this is growth investing, looking for companies with rapidly growing earnings. (Page 118)
  • Stock price movements are essentially an unpredictable “random walk.” Interestingly, it turns out that earnings growth also exhibits random-walk behaviour. (Page 119)
  • As Ben Graham said, in the short term the markets are a voting machine, but in the long run they are a weighing machine. And what they are weighing is earnings. (Page 119)
  • The risk of value stocks is lower than that of growth stocks. In other words, there is a free lunch. (Page 120)

The Three-Factor Model

Any stock asset class earns four different returns: (Page 121)

  • The risk-free rate, that is, the time value of money. Usually set at the short-term T-bill rate.
  • Factor 1: The market-risk premium. That additional return earned by exposing yourself to the stock market.
  • Factor 2: The size premium. The additional return earned by owning small-company stocks.
  • Factor 3: The value premium. The additional return earned by owning value stocks.

Investing in the New Era

  • Over the long term value beats growth, and small value may very well beat everything else. (Page 127)

Hedging: Currency Effects on Foreign Holdings

  • All of the foreign stock index funds recommended in Chapter 8 are unhedged, and the only low-cost foreign bond funds are hedged. And, as we’ve already seen, this is not a bad state of affairs. (Page 136)

Dynamic Asset Allocation

You should not attempt dynamic asset allocation before mastering fixed asset allocation. (Page 137)

  • Overbalancing: rebalancing in a more vigorous form. (Page 138)
  • A simpler way of overbalancing is to increase your target allocation ever so slightly—perhaps by 0.1% for every percent that the asset falls in value, and vice versa. (Page 138)
  • Changes in allocations around in response to changes in economic or political conditions is a poor approach. Changes in allocation that are purely market-valuation driven are quite likely to increase return. (Page 138)

Behavioral Finance

It is the study of the logical inconsistencies and foibles that plague investors.

  • Overconfidence: the average investor must of necessity obtain the market return, minus expenses and transaction costs. The more complex the task, the more inappropriately overconfident we are. (Page 140)
  • Recency: we tend to overweight more recent data and underweight older data, even if it is more comprehensive. (Page 141)
  • Risk Aversion Myopia: overemphasis on the possibility of short-term loss. It explains the equity risk-premium puzzle — why stocks have been allowed to remain so cheap that their returns so greatly and consistently exceed that of other assets. The risk horizon of the average investor, according to an article by Shlomo Benzarti and Richard Thaler, was about one year. (Page 142)

Chapter 7 Summary

  1. Bad companies are usually good stocks, good companies are usually bad stocks. Value investing probably has the highest long-term returns.
  2. Currency hedging has important effects on short-term portfolio behavior, but little in the way of long-term impact.
  3. It is permissible to change your allocation slightly from time to time, as long as you do so in a direction opposite from valuation changes.

Chapter 8 Implementing Your Asset Allocation Strategy

Understanding the theory of asset allocation is easy; pulling it off is another matter.

Choosing Your Allocation

  1. Determine your basic allocation between stocks and bonds: “What is the biggest annual portfolio loss I am willing to tolerate in order to get the highest returns?” Your maximum stock allocation should be 10 times the number of years until you will have to spend the money. (Page 143)

    I can tolerate losing ___ % of my portfolio in the course of earning higher returns:Recommended percent of portfolio
  2. Determine how much complexity you can tolerate: Is keeping track of six different asset classes more than you can handle? Or are you an “asset-class junkie”? (Page 144)

    • The starter recipe:
      • U.S. large stocks (S&P 500)
      • U.S. small stocks (CRSP 9-10, Russell 2000, or Barra 600)
      • Foreign stocks (EAFE)
      • U.S. short-term bonds
    • Breaking them a bit further:
      • U.S. large stocks — market and value
      • U.S. small stocks — market, value, and REITs
      • Foreign stocks — Europe, Japan, Pacific Rim, emerging markets, and small cap
      • U.S. short-term bonds
  3. Determine how much tracking error you can tolerate: If you cannot resist to compare the returns on a frequent basis with that of the Dow or S&P 500, then perhaps you should consider an allocation heavy in large-cap U.S. stocks.

Planning for Taxes

There is an enormous obstacle called “taxes” and we need to be extremely careful if a significant part of our assets is taxable. (Page 145)

  • The S&P 500 is a relatively tax-efficient index.
  • The small-cap indexes are another story.
  • Both large and small cap value index funds are also not tax-efficient as they sometimes generate unwanted capital gains distributions.
  • REITs are even worse. Because most of their return is the result of dividends, they are taxable at your full marginal rate, and thus are very likely not appropriate for taxable accounts.
  • Bond: Depending on your state of residence, a municipal bond fund or Treasury ladder may be advantageous.

Indexing: Vanguard and DFA

The Vanguard stock funds recommended by author (as of 2001). All the links of the below listed funds are pointing to Vanguard’s Admiral Shares of the corresponding funds, if available. The Admiral Shares offer a lower cost option with higher minimum investment requirement: (Page 146-148)

  1. Vanguard 500 Index Fund (VFIAX): Tracks the S&P 500. A fine choice for the long haul, particularly in tax-sheltered accounts, it does have some modest drawbacks for the taxable investor. Also available as an ETF - Vanguard S&P 500 ETF (VOO).
  2. Vanguard Tax-Managed Growth and Income Fund: The tax-managed version of the 500 Index Fund. It seeks to minimize distributions by selling high-basis-cost shares first and selling other positions at a loss to offset gain sales. Note: The Vanguard Tax-Managed Growth and Income Fund has been reorganized into Vanguard 500 Index Fund in 2014.
  3. Vanguard Total Stock Market Index Fund (VTSAX): Tracks the Wilshire 5000 Index CRSP US Total Market Index (since 2013) and is particularly suitable for taxable investors. It can be thought of as constituting 75% large cap, 15% mid cap, and 10% small cap. Also available as an ETF - Vanguard Total Stock Market ETF (VTI).
  4. Vanguard Value Index Fund (VVIAX): Tracks the bottom 50% of market capitalization of the S&P 500 when sorted by price/book ratio. Because this strategy results in high turnover, it is not suitable for taxable accounts. Also available as an ETF - Vanguard Value ETF (VTV).
  5. Vanguard Small-Cap Index Fund (VSMAX): This fund tracks the Russell 2000 Index CRSP US Small Cap Index (since 2013). According to the prospectus, the fund’s portfolio turnover rate was 15% of the average value of its portfolio during the most recent fiscal year of 2020. As the author stated, it is suitable only for tax-sheltered accounts. Also available as an ETF - Vanguard Small-Cap ETF (VB).
  6. Vanguard Tax-Managed Small-Cap Fund (VTMSX): This fund uses the tax-managed strategy described above.
  7. Vanguard Small-Cap Value Index Fund (VSIAX): This fund is suitable for tax-sheltered accounts only because it is likely to have high turnover and distributions. Also available as an ETF - Vanguard Small-Cap Value ETF (VBR).
  8. Vanguard European and Pacific Stock Index Funds: This fund has been replaced by the following two which specific to each market:
    1. Vanguard European Stock Index Fund (VEUSX): Tracks the FTSE Developed Europe All Cap Index with a low turnover. Also available as an ETF - Vanguard FTSE Europe ETF (VGK).
    2. Vanguard Pacific Stock Index Fund (VPADX): Tracks the FTSE Developed Asia Pacific All Cap Index with a low turnover. Also available as an ETF - Vanguard FTSE Pacific ETF (VPL).
  9. Vanguard Emerging Markets Stock Index Fund (VEMAX): Tracks the FTSE Emerging Markets All Cap China A Inclusion Index. Beware of the higher management fees. Also available as en ETF - Vanguard FTSE Emerging Markets ETF (VWO).
  10. Vanguard Total International Stock Index Fund (VTIAX): Tracks the FTSE Global All Cap ex US Index. This is the one for those who prize portfolio simplicity. Also available as an ETF - Vanguard Total International Stock ETF (VXUS).
  11. Vanguard REIT Index Fund (VGSLX): Tracks the MSCI US Investable Market Real Estate 25/50 Index. Beware of the high management fees and high turnover. Also available as an ETF - Vanguard Real Estate ETF (VNQ).

At the date of the publish of this book, as the author said, there were a few “holes” in Vanguard’s indexed asset-class coverage, which are international small-cap and international value. That is no more the situation. Vanguard now has the below two funds available:

  1. Vanguard International Value Fund (VTRIX): Beware of the high management fees as well as the high turnover rate (38% of the average value of its portfolio during the most recent fiscal year of 2020). The fund is compared with the MSCI ACWI ex USA Index.
  2. Vanguard FTSE All-World ex-US Small-Cap Index Fund Admiral Shares (VFSAX): Tracks the FTSE Global Small Cap ex US Index. Also available as an ETF - Vanguard FTSE All-World ex-US Small-Cap ETF (VSS).


  • The advantage of exchange-traded funds (ETFs), such as SPDRS (now SPDR S&P 500) that is based on the S&P 500, do not generate appreciable capital gains and are thus slightly more tax-efficient than conventional S&P index funds. (Page 149)
  • On the other hand, the purchase and sale of an ETF incurs both commissions and spreads, and so is slightly more expensive to own. (Page 149)
  • ETFs reinvest dividends only quarterly, and thus will suffer a slight performance drag relative to a conventional fund, which continuously reinvests its dividends. (Page 149)
  • Make sure that the ETF you are looking at has not trailed its benchmark index by more than its expenses for a period of at least one or two years. As always, pay attention to expenses and turnover rate. (Page 151)


  • Depending on whether the account is tax-sheltered or not, be wise on picking taxable and non-taxable bonds. (Page 151)
  • Only choose funds on short-term and intermediate-term bonds. (Page 152)
  • Bond funds on federal, corporate, municipal are all available to choose from. (Page 152)

Treasury Ladders

(Page 152)

  • Treasury bonds can be bought at auction with no spread through most brokerage houses.
  • Purchasing five-year (and initially some two-year and one-year) notes at regular intervals will result in a steady stream of maturing securities.
  • The gap between Treasury and corporate yields can be considered the “price of safety.” When this gap is small, safety is cheap, and Treasuries should be purchased.

Determining Your Precise Allocation

Of critical importance to your allocation is the relative amount of tax-sheltered versus taxable assets. Put the most tax-efficient asset classes in your taxable accounts and the least tax-efficient asset classes (basically small and large value, and REITs) in your tax-sheltered accounts. (Page 153)

Executing the Plan

  • A wonderful technique of reaching a fully invested position is by dollar cost averaging (DCA). It involves investing the same amount regularly in a given fund or stock. (Page 155)
    • It takes great fortitude and discipline to carry out a successful DCA program, especially when buying at “point of maximum pessimism”.
    • The real risk of DCA is that your entire buy-in period may occur during a powerful bull market, which may be immediately followed by a prolonged drop in prices.
  • There is an even better method of gradually investing, known as value averaging (VA), described by Michael Edleson. (Page 155)
  • Here is a very simplified example for illustration. You want to have a 600 investment in 6 months. With that, you would like to have 100 at the beginning of the first month in your account, 200 at the beginning of the second month, etc. Due to fluctuation of value of your asset, you may need to invest more or less than CW100 in the next month. You may even need to withdraw some of the asset from your account instead of investing in it. The following chart and figure may give a clearer idea on VA.
    PeriodInitial valueInvest valueTotal value
Value Averaging: investing value of each period varies according to the difference between the value path and current asset level.
Value Averaging: investing value of each period varies according to the difference between the value path and current asset level.
  • Value Averaging is not perfect. If we are still in the VA phase and when asset level rises above the “value path” in taxable account, not much can be done. If the VA program has been completed, do not sell the shares because it would have serious tax consequences. The best we can do is to avoid reinvesting distributions (Page 156)

  • Once you have transferred all of your cash and bonds into your desired allocation, it becomes a simple matter to periodically rebalance the account back to the policy, or “target,” compositions. (Page 157)

Rebalancing in a Tax-Sheltered Account

  • Rebalancing can be done as often as you wish, since there are no tax consequences. (Page 157)
  • Author has seen optimal rebalancing periods ranging from monthly to as long as once every several years for similar portfolios. (Page 160)
  • As a general rule, long rebalancing intervals are preferred. This is because of the momentum phenomenon. (Page 160)
  • If you rebalance every year or two, you probably won’t go too far wrong. (Page 160)

Rebalancing Your Taxable Accounts

  • Do so as sparingly as possible. In fact, a good case can be made for never rebalancing. (Page 161)
  • If a particular taxable fund exceeds its policy target, at least avoid reinvesting these distributions. Instead, take the distribution in cash. (Page 161)
  • It is fine to add frequently to a taxable mutual fund, but I’d recommend selling at most once per year. (Page 161)

Does It Have to Be This Complex?

  • The traditional all-U.S. half-stock and half-bond portfolio is extremely simple and easy to rebalance. (Page 161)
  • Another compromise would be to split your stock component equally into six Vanguard index funds (Value, 500 Index, Small-Cap, European, Pacific, and Emerging Markets) for your stock component and use one of their short-term bond funds for the fixed-income component. (Page 161)

Keeping Abreast of Market Valuation

  • Dynamic asset allocation - increase your allocation of an asset only after it has gotten measurably cheaper and only after it has been hammered in price. Never increase your allocation to an asset because of economic or political events or because you have heard an analyst make a convincing case for doing so. (Page 163)
  • It is a good idea to become informed about market valuations, by look up the P/E, P/C (price/cash flow), P/B and dividend yield for the relevant index funds, maybe through Morningstar’s Principia mutual fund database or other Barra’s website. (Page 163)
  • P/B and dividend yield are the most stable measurements, with P/E and P/C being of less use. Dividend yield is the only measure that has any meaning across different stock asset classes. (Page 164)

Retirement—The Biggest Risk of All

  • Duration of security: the period of the investment of the security to break even. (Page 165)
  • There are lots of other definitions of duration, some dizzyingly complex, but “point of indifference” is the simplest and most intuitive. (Page 165)
  • Duration is also an excellent measure of the risk of an investment. The higher the duration, the bigger the risk. (Page 166)
  • The lower the yield, the higher the market price; the longer the duration, the greater the risk. (Page 167)

A Simple Example to Determine Retirement Risk

First some assumptions: (Page 168)

  • annual income need: $40,000;
  • investment returns is inflation-adjusted;
  • real (inflation-adjusted) return of a mixed stock and bond portfolio is at around 4%;
  • the portfolio’s real value can be maintained indefinitely.

Which translates to:

$$ \begin{align} \text{required savings} &= \text{income requirement / real investment return} \\ &= \$40,000/0.04 \\ &= \$1,000,000 \end{align} $$

The 4% return assumption refers to the market return, from which investment fees and other expenses have to be subtracted. Therefore, a 2% expenses means a doubling of your retirement savings requirement.

  • The problem of this kind of calculation is there is an embedded erroneous assumption: that our return is the same each and every year. In the real world, the order of the good and bad years matters a great deal. (Page 168)
  • If future real portfolio returns are going to be only 4%, then in a worst case scenario you may only be able to withdraw 2% of the starting amount of your nest egg each year. And this gets to the heart of how we perceive risk. On the contrary, a prolonged bull market at the beginning can enable a 6% or more withdrawal of your starting amount each year. (Page 170)
  • A healthy commitment to Treasury Inflation-Protected Securities (TIPS) in tax-sheltered account is probably nnot a bad idea. (Page 172)

Cousin Harry Asks Your Advice

In summary, the advises are: (Page 173)

  1. Risk and reward are inextricably entwined. Do not expect high returns from safe assets.
  2. Those who do not learn from history are condemned to repeat it. The surprised investor is a failed investor.
  3. Portfolios behave differently than their constituent parts. Excessive reliance on safe assets may actually increase portfolio risk.
  4. For a given degree of risk, there is a portfolio that will deliver the most return; this portfolio occupies the efficient frontier of portfolio compositions. It is impossible to seek a portfolio that sits on the efficient frontier. Rather, the goal of the intelligent asset allocator is to find a portfolio mix that will come reasonably close to the mark under a broad range of circumstances.
  5. Focus on the behavior of your portfolio, not on its constituent parts.
  6. Recognize the benefits of rebalancing. The correct response to a fall in asset price is to buy a bit more; the correct response to a rising price is to lighten up a bit.
  7. The markets are smarter than you are; they are also smarter than the experts. Nobody consistently predicts market direction. Very few money managers beat the market in the long run; those that have done so in the recent past are unlikely to do so in the future.
  8. Know how expensive the tomatoes are. Economic and political considerations are worthless as market predictors.
  9. Good companies are usually bad stocks; bad companies are usually good stocks. Favor a “value” approach in your stock and mutual fund choices; the P/B ratio is the best indicator of this.
  10. In the long run, it is very hard to beat a low-expense index mutual fund. Try to index as many of your investments as you can.
Leo Mak
Make the world a better place, piece by piece.
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