SINLetter Articles - The Ultimate Buy-and-Hold Strategy

In this article, one of the most important in our library at FundAdvice.com, Paul Merriman describes his basic recommendations to investors and the reasons for them. He introduces a series of simple but powerful concepts that can put investors far ahead of the crowd.

I founded Merriman Capital Management in 1983. We had just finished an almost 20 year period that had led to huge market losses for most investors. In fact from 1966 to 1982, the S&P 500 had actually returned less than inflation. As we were not trying to be all things to all people we initially offered only market timing strategies to give investors an opportunity to participate in the equity market, but without the high risk of buying and holding.

In 1992, as our firm decided to manage more of our clients’ money, we decided to seek a Buy-and-Hold strategy worth recommending to our clients. We found a strategy that is so good we decided to call it “The Ultimate Buy-and-Hold Strategy”. In this article I’ll explain why I think what we found is worthy of that name.

We don’t use the word “ultimate” lightly. We would apply it only to something that’s the best we know. We think the term fits here. There’s no question that this strategy has worked very well. I think almost every buy-and-hold investor can use it either to increase returns or reduce risk – or both.

The Ultimate Buy-and-Hold Strategy is suitable for do-it-yourself investors as well as those who want to hire professional money managers. It will work with small portfolios as well as large ones. It’s easy to understand and easy to apply using low-cost, tax-efficient no-load index funds.

By the way, I want to make it clear that we did not invent this strategy. It evolved from the work of many people over a long period, including some winners and nominees of the Nobel Prize in economics.

A “perfect” investment strategy would be cheap, easy to implement, would have no risk and would make you fabulously rich in about a week. Tax-free, of course. We haven’t found that combination, and we don’t expect to. But the Ultimate Buy-and-Hold Strategy comes as close as we have yet found.

The Ultimate Buy-and-Hold Strategy produces higher returns than the investments most people make. It does so at lower risk, with minimal transaction costs. It’s mechanical, so it does not depend on finding the right guru to make the right predictions about an individual company, the market or the economy. You will never again have to rely on “The 10 Funds You Should Buy Now” articles in the popular financial publications.

Even though this strategy is based on the finest academic research available, it’s simple enough that investors can understand it if they can grasp a handful of simple concepts.

If you think you already know what that means and you’re tempted to skip the rest of this article, I hope you’ll think twice. The evidence I’m about to show you is compelling, and I hope you’ll let me present it.

If there is a “catch” to this strategy, it’s availability. You can’t buy it in a single mutual fund. You can put it together approximately using Vanguard’s low-cost index funds. But the “ultimate” way to implement the Ultimate Buy-and-Hold Strategy is to hire a money manager (including but certainly not limited to Merriman Capital Management) who has access to the institutional funds offered by Dimensional Fund Advisors. (More about those funds later.)

This strategy is based on more than 50 years of research into the question: What really makes a difference to investment results? (Some of the answers may surprise you.) The people behind this research include Merton H. Miller, a 1990 Nobel laureate; Rex A. Sinquefield, who started the very first index mutual fund; Roger G. Ibbotson, a Yale finance professor whose market charts going back to 1926 are a fixture in the offices of most money managers; Kenneth R. French, a professor of finance at the MIT Sloan School of Management; and Eugene Fama, a professor of finance at the University of Chicago.

Their expertise has been pooled in a company Rex Sinquefield started in 1981, Dimensional Fund Advisors, to give institutional investors a practical way to take advantage of their research. Today Dimensional Fund Advisors, or Dimensional, manages $50 billion of investments for major pension funds and large corporations as well as its mutual funds, available to individual investors through a select group of investment advisors.

Before I get into the meat of this strategy, I want to issue a few warnings. The Ultimate Buy-and-Hold Strategy is not suitable for every investing need. It has had good returns on a long-term basis, but it won’t necessarily shine in any single week, month, quarter or year.

Like most worthwhile ways to invest money, this strategy requires investors to make a commitment. If you are the kind of investor who dabbles in a strategy to check it out for a quarter or two, don’t even bother with the Ultimate Buy-and-Hold Strategy. You would simply be relying on luck for such short-term results.

Often investors ask me questions like: “How did this do last year? How is it doing so far this year?” Or they tell me they think they (or I) should be in some particular type of asset over the next few months or the next year. These people aren’t likely to succeed with the Ultimate Buy-and-Hold Strategy because their focus is on the short term, not the long term.

I want to make this crystal clear: The Ultimate Buy-and-Hold Strategy is not based on anything that happened last year or last quarter. It’s not based on anything that is expected to happen next quarter or next year. It makes absolutely no attempt to predict what investments will be “hot” in the near future. If that is what you want, you won’t find it here.

The most important building block of the Ultimate Buy-and-Hold Strategy is also the most startling to some investors: Your choice of asset classes has far more impact on your results than any other investment decision you can make. Let me say this another way, because it flies in the face of a lot of conventional wisdom. Your choice of the right kind of assets is far more important than exactly when you buy and sell those assets. And it’s much more important than security selection, your ability to pick the very “best” stocks, bonds or mutual funds.

Here is the heart of the matter: An academic study of 91 large pension plans over 10 years found that it was possible to account for 94 percent of a plan’s returns just by knowing how the plan allocated its assets. Basic allocations are among bonds, stocks and cash. Within each one of those big classifications are various types of bonds, stocks and cash-like investment vehicles.

The researchers found that security selection accounted for 4 percent of a pension fund’s results and that the timing of investments accounted for only 2 percent. Ironically, most investors seem to spend at least 90 percent of their time concentrating on security selection and timing, the things that together make only 6 percent of the difference.

So how does an investor choose the right asset classes? I’m going to show you exactly how to do that, illustrating it in a series of pie charts. We’ll start with Portfolio 1, a very basic portfolio. Assume that the whole pie represents all the money you have invested. This one has only two slices, one for bonds (labeled the Lehman Govt./Corp. Index) and one for equities (labeled the Standard & Poor’s 500 Index).

This portfolio’s 60/40 split between equities and bonds is the way pension funds, insurance companies and other large institutional investors traditionally allocate their assets. The equities provide growth while the bonds provide stability and income.

We don’t believe 60 percent equity and 40 percent bonds is the right balance for all investors. Many young investors don’t need bonds at all in their portfolios. On the other hand, many older investors may want 70 percent of their portfolios in bonds. But the 60/40 ratio of Portfolio 1 is the industry standard, and that’s what we will use as a benchmark in this article.

For 31 years, from January 1973 through December 2003, this portfolio produced a compound annual return of 10.5 percent. That’s not bad at all, especially considering this period included major bear markets. I believe many investors could achieve their long-term goals with that return.

Therefore, a long-term return of 10.5 percent becomes the benchmark against which we will measure the Ultimate Buy-and-Hold Strategy. We’ll unveil this strategy in more pie charts, splitting the pie into thinner and thinner slices. Each slice will represent an important asset class that I believe you should own.

Another measure we will use for comparison is standard deviation. This is a statistical way to measure risk; to understand the Ultimate Buy-and-Hold Strategy, you need to know that a lower standard deviation is better, indicating a portfolio that is more predictable and less volatile. (For a more detailed discussion of standard deviation, see Appendix 3) The standard deviation of Portfolio 1 was 12.3, so we’ll use that as the benchmark.

Hundreds of thousands of investors would be better off with Portfolio 1 than they are with their current investments, which offer too little diversification and too much risk. If they did nothing more than adopt this simple mix of assets, which is easily duplicated using no-load index funds, these investors would be more likely to achieve their long-term investment goals than they are now.

So it’s important to realize that we are starting from a relatively high standard. At this point we can say that to achieve anything worthy of being called the Ultimate Buy-and-Hold Strategy, we must find a way to improve on two figures: We want a portfolio that can be expected to produce a return higher than 10.5 percent, with a standard deviation lower than 12.3.

You can jump ahead in this article to the section where we lay out exactly how to implement this strategy. But that’s a shortcut that might be counterproductive. Whether you are a do-it-yourself investor or a client of a money manager, you are much more likely to be successful with this strategy if you have a solid understanding of why each piece of it is important.

Most of the Ultimate Buy-and-Hold Strategy is concerned with allocating the equity piece of the pie. That’s where most of our focus is in this article. But this is a good place to say a few things about bonds.

Most people include bonds in a portfolio to provide stability, which can be measured by standard deviation, and to produce current income, which of course is part of a portfolio’s total return. The more bonds you include in a portfolio, the less growth you are likely to have – and the more stability you are likely to have.

Whether your portfolio is heavy or light on bonds, it matters what kind of bonds you own. In general, longer bond maturities go together with higher yields and higher volatility. You can see this relationship in Figure 1. The bottom line, which measures risk, crosses the top line, which measures return, at maturities of about five years. The message is clear: Bonds with maturities greater than five years are not consistently more rewarding, but they are consistently more risky.

Figure 1 shows that the longest maturity you needed in order to achieve high bond returns was five years. And it shows you that in this 40-year period, one-year Treasury bills gave investors nearly 95 percent of the return of five-year Treasury notes, with much less volatility.

We believe the best combination of bond funds for stabilizing an equity portfolio – and that is why we include bonds in the Ultimate Buy-and-Hold Strategy – is a 50/50 split of bonds with maturities up to two years and those with maturities up to five years. You can find a close approximation of this mix in the typical short-term bond fund.

In Portfolio 1, the average maturity of the bonds is eight to 13 years. That gives the portfolio considerably more volatility than is warranted for the return of those bonds. In building the Ultimate Buy-and-Hold Strategy, the first step is to change the bond slice of the portfolio pie to short-term bonds.

The result, based again on 1973 through 2003, is Portfolio 2. This combination has a total return of 10.3 percent, a relatively small decline from Portfolio 1, along with a standard deviation of 11.1—significantly lower than the benchmark. That gives the portfolio much more stability at almost the same return.

The standard pension fund’s equity portfolio consists mostly of the stocks of the 500 largest U.S. companies. These include many familiar names like General Electric, Microsoft, Pfizer, Wal-Mart, Citigroup, Cisco, Wells Fargo and Dell. Each of these was once a small company going through rapid growth that paid off for early investors. Microsoft is a classic case from the late 20^thcentury.

Because small companies can grow much faster than huge ones, the first and most fundamental way to diversify a stock portfolio is to get some of your money into the stocks of small companies.

To accomplish this, the next step in building the Ultimate Buy-and-Hold Strategy is to split the equity slice of the pie into two, mixing equal parts of large-cap stocks (represented by the S&P 500 Index) and small-cap stocks. To represent small-cap stocks, we use the returns of the Dimensional Fund Advisors U.S. Micro Cap Fund, which invests in the smallest 20 percent of U.S. companies.

As you can see in Portfolio 3, we now have a pie with three slices. This combination, from 1973 through 2003, had a compound return of 11.8 percent, a significant improvement over the 10.5 percent of the reference portfolio. The standard deviation, however, has risen to 12.5, indicating a small increase in volatility over the benchmark portfolio.

Typical growth investors look for companies with rising sales and profits as well as market dominance. Such companies are among the largest stocks in The S&P 500 Index.

Value managers, on the other hand, look for companies that for one reason or another are temporarily out of favor. Sometimes this status results from fads and sometimes from fundamental factors like declining demand in a certain industry. These stocks are seen as bargains that will return to their supposedly “normal” levels when the market perceives their prospects more positively. Prominent examples (taken from the largest holdings of the Vanguard Value Index Fund in 2004) are JP Morgan Chase, Hewlett-Packard, Bristol-Myers Squibb and Disney.

The Ultimate Buy-and-Hold Strategy uses a different approach, a purely mechanical one, to identify value companies. It starts by identifying the largest 50 percent of stocks on the New York Stock Exchange and all other public companies of similar size. These companies are then sorted by the ratio of their price per share to book value per share. The top 30 percent of this list, those with the highest price to book ratios, are classified as growth companies. The bottom 30 percent are classified as value companies.

Though the most popular stocks are growth stocks, much research shows that historically, unpopular (value) stocks outperform popular (growth) stocks. This is true of both large-cap stocks and small-cap stocks. From 1964 through 2003, large U.S. growth stocks had annualized returns of 9.7 percent; large U.S. value stocks, by contrast, had annualized returns of 13.6 percent. Among small-cap stocks over the same period, growth stocks returned 9.3 percent and value stocks returned 16.5 percent.

Therefore, in Portfolio 4, the next step in building the Ultimate Buy-and-Hold Strategy, we split the equity side of the pie into four pieces instead of two, adding U.S. large value stocks and U.S. small value stocks. This boosts the portfolio’s annualized return almost a full percentage point, to 12.7 percent, while reducing the standard deviation to 12.1.

To recap, by using shorter-maturity bonds and by including small-cap stocks and value stocks, we have improved the return of the traditional institutional portfolio from 10.5 percent to 12.7 percent, a very significant improvement. In the process, volatility is somewhat higher, but the increase is quite reasonable. Some investors will be quite content to stop at this point, having boosted their returns by about 21 percent and their final portfolio value to $4,077,649, an improvement of $1,853,012 over Portfolio 1.

The final step is to build Portfolio 5 by including international stocks as well as U.S. stocks. U.S. and foreign stocks both go up and down, but they often do so at different times. That makes them “non-correlated” assets. The idea is simple: Put together two assets, each of which has a long-term upward trend but each of which typically has short-term movements different from the other. Often, the different short-term movements cancel each other out to some extent, giving the combination a smoother long-term upward curve than either one by itself.

We’ve already discussed the virtues of balancing large-cap stocks with small-cap ones and of owning both value stocks and growth stocks. This diversification is equally important among international stocks as it is in U.S. stocks.

Portfolio 5 adds several new slices of the pie, reflecting the diversification of international large-cap growth and value, international small-cap growth and value and a small slice of emerging markets stocks, which over long time periods represent a significant opportunity.

The data used to construct Portfolio 5 isn’t quite as consistent as that used in the previous steps, because information we need simply isn’t available back to 1973. (See Appendix 1 for details.) That means the reported returns and volatility of Portfolio 5 don’t completely reflect all the diversification in this portfolio. I believe that if we had compete data going back to 1973, this combination would have an even greater advantage than we have shown.

To recap what we’ve seen so far: The Ultimate Buy-and-Hold Strategy increases your return while it reduces your risk. It’s not complicated and it’s based on solid research, not hocus-pocus. Notice that $100,000 invested in 1973 would have grown to almost $4.4 million with the Ultimate Buy-and-Hold Strategy, 97 percent more than the $2.2 million of Portfolio 1.

At this point, you may want higher returns or lower volatility. How do you get it? Simple! Just vary the amount of the portfolio that’s in fixed-income investments. Figure 2 shows summary statistics for several variations, from all-bonds to all-equity. Chances are good that one of these combinations will be the right one for you.

In each case, the fixed-income portion is all in short-term bonds, and the equity portion is sliced proportionately to match the allocations in Portfolio 5, which we just described. They are detailed in Appendix 2.

In Figure 2, you’ll see that returns and volatility (measured by standard deviation) go up and down together, just as you would expect. Extremely risk-averse investors will find the all-bond variation quite attractive for its very low volatility. But many people will find the 50/50 variation, with its annualized return of 12.3 percent and standard deviation of only 10.1, to be an ideal combination of growth and stability. And indeed we have found that the 50/50 DFA portfolio has been very popular with our clients. Aggressive investors who can handle the significantly higher volatility may find the all-equity return particularly appealing.

Compared with our benchmark, Portfolio 1, the 50/50 combination provides a 17.1 percent increase in compound return (from 10.5 percent to 12.3 percent) and a reduction of 17.9 percent in volatility as measured by standard deviation. That’s exactly the combination we set out to find: higher returns at lower risk.

The returns shown here from 1973 through 2003 are higher than historic norms. Even though this period includes the dramatic bear markets of 1973, 1974, 1987 and 2000-2002, the period under study does not include the 1929 market crash and its long aftermath. This period also is unusual because bond yields benefited from a long period of falling interest rates in the 1980s and early 1990s.

Therefore it may be unrealistic to expect returns of this level over the coming decades. For future projections over very long periods, we tell our clients to expect 1 to 2 percent less per year from equities and 2 to 3 percent less from fixed-income investments. (Incidentally, the same warning should apply to the record of every other investment strategy during the past 31 years. )

Still, the Ultimate Buy-and-Hold Strategy seems to me to be the best way that buy-and-hold investors can take advantage of the robust growth in the world economy that I am confident will continue.

Every variation of this strategy is based on the finest research available , without having to make forecasts or guesses about the performance of markets or sectors or stocks or managers. If you are a buy-and-hold investor with a time frame of five years or more, you don’t need to look any farther. You have found the ultimate strategy.

Now the obvious question becomes how to implement it yourself. You won’t find all this in any single mutual fund. However, there are readily available index funds that come close to matching all the components of this strategy. So let’s move on to the details of how you can make this strategy work for you.

Choice 2: You can hire an investment advisor to manage this strategy for you, using mutual funds created specifically for this strategy by Dimensional Fund Advisors. These funds are available only through investment advisors. But they are good enough that I think this is a better choice than the do-it-yourself route. By the end of this article, you will see why.

Using seven Vanguard no-load funds, you can create a portfolio that goes much of the distance to match the Ultimate Buy-and-Hold Strategy. (See Figure 3.) This is the cheapest way to invest in this strategy. You pay no sales commission or investment advisory fee, and Vanguard is legendary for low expenses and wide diversification. If you take this option, everything will be under your control and you can easily rebalance among funds, as we recommend.

The glaring deficiency of this mix of funds is that it has no international small-cap exposure. For that, investors must go beyond Vanguard.

Each of the non-tax-managed Vanguard funds we recommend has a $3,000 minimum. You will need at least $30,000 to set up the equity allocation we recommend. Within an IRA, Vanguard’s minimum for these funds is $1,000, so you could set up that allocation for as little as $10,000. Vanguard’s minimum for its tax-managed funds is $10,000; the minimum required for our recommended allocation using those funds is much higher.

Here’s what we recommend: First, determine what percentage of your portfolio should be in bond funds. Invest that entire amount in Vanguard’s Short-Term Investment Grade Bond Fund (VFSTX). All the rest of the money goes into seven equity funds, as shown in Figure 3. (Percentages add up to 100 because they refer to the total of equity investments.)

These funds are our choices for tax-sheltered accounts such as IRAs and 401(k)s. In a taxable account, you should use Vanguard’s tax-managed funds if you have enough money, as shown in Figure 9.

Charles Schwab’s OneSource account gives you access to a wider selection of funds, some of which have lower requirements for a minimum initial investment. Fidelity also has funds that can be used to approximate the Ultimate Buy-and-Hold Strategy. However, in both cases, most of the funds you’ll want to use are actively managed, not index funds. That means they have higher expenses than Vanguard’s index funds, and the asset classes in which they invest may vary.

Despite the appeal of doing it yourself, I believe you will get better results from hiring a professional investment advisor to implement the Ultimate Buy-and-Hold Strategy. Vanguard, Schwab and Fidelity funds have major drawbacks.

The whole idea of the Ultimate Buy-and-Hold Strategy is to properly load your portfolio with small-cap stocks and value stocks. The better you do that, the better your results should be. But you can’t get the best loading with Vanguard funds.

First example: Vanguard’s U.S. small-cap fund has an average market capitalization of $1.1 billion. The corresponding DFA fund invests in much smaller companies, with a median market capitalization of $279 million. If you want small (and you do in the Ultimate Buy and Hold Strategy) you get a lot more of it with the DFA fund.

Second example: Vanguard’s U.S. large-cap value fund has a portfolio with a price-to-book ratio of 2.4. (That is meaningful only in comparison to something else. The lower this number, the heavier the value orientation of a fund. For comparison’s sake, the price-to-book ratio of Vanguard’s S&P 500 Index fund is 3.1.) The ratio of the corresponding DFA fund is 0.9. If you want value (and you do), you get a lot more of it with the DFA fund.

As noted, Vanguard also fails to offer any open funds with international small-cap exposure.

In short, at Vanguard you get only an approximation of the asset allocations recommended by the academic research. This is not a minor detail, as you will recall, because the research said 94 percent of the returns of a pension fund portfolio could be accounted for by its asset classes.

You can come closer to the right mix of asset classes at Schwab. But the higher expenses of the Schwab funds will rob you of some of the return. You’ll pay more and still not get the real thing.

Finally, you will be likely to pay higher taxes on funds from Vanguard, Fidelity and Schwab than on DFA funds. This is largely because of portfolio turnover that creates capital gains liability to shareholders.

This might seem trivial, but it can make a very significant difference at tax time, when you have to either come up with additional money (the equivalent of investing more) or sell some of your funds in order to pay the taxes. In either case, your long-term returns are eroded by your tax liability. (This is not a consideration if these funds are owned within tax-sheltered accounts like IRAs.)

We have seen how the right mix of assets can make a big improvement in a traditional retirement portfolio. The only way you can truly duplicate the Ultimate Buy-and-Hold Strategy is to use an advisor and invest in DFA’s funds. (For a more thorough discussion of the DFA funds’ advantages, see the June 2001 issue of this newsletter.)

It will cost you money to use an advisor. You’ll pay management fees that range from 0.25 percent to 2 percent a year. In addition, advisors who offer these funds normally require a minimum account size of $100,000 or more. But for investors who can get past those hurdles, we think DFA funds over time should provide the extra edge that will fully implement the best buy-and-hold strategy I’ve ever found.

For investors with less than $100,000 or those who simply don’t want to hire an investment advisor, Vanguard’s low-cost index funds are the best choice.

Some things in life are beyond your control, including the weather and the stock market. Savvy long-term investors refuse to work themselves into a froth about short-term fluctuations. Instead, they focus on what they can control. That means expenses, taxes and most important, asset characteristics.

For a serious buy-and-hold investor, the final “moment of truth” is this question: Am I willing to pay an advisor in order to get access to the best asset classes?

For many years I have preached the gospel of low-cost investing, and I don’t want you to pay a penny more for your investments than you have to. But neither do I want you to be penny-wise and pound foolish.

Having exactly the right assets can add one to two percentage points of return per year to the typical investor’s portfolio. Over a period of years, that extra return can make a huge difference. To a retiree, it can be the difference between running out of money or having enough to leave a healthy inheritance. To somebody accumulating retirement savings, it can be the difference between having a comfortable retirement and just getting by. This extra return could be the difference between being able to retire at age 61 or having to wait until age 65 or later.

Many investors are averse to paying for an advisor’s services. We understand that. However, our analysis suggests that DFA equity funds have at least a 2 percent advantage over comparable Vanguard funds. If you pay an investment advisor 1 percent, this could leave you with a net gain of at least 1 percentage point over Vanguard.

In addition, professional guidance can be very valuable in determining your risk tolerance and your own asset allocation as well as in helping you maintain the discipline of being a successful investor.

Therefore, for serious long-term buy-and-hold investors, we believe that the combination of DFA funds and the services of a manager can be the best investment you’ll ever make.

That’s not a description I would ever use casually, but I believe it’s true. As we have seen, for buy-and-hold investors, the most important factor that determines success is proper asset allocation. There are lots of places you can invest money and get an adequate return. But if you are parking money in one spot for a long time, you should find a great spot for it, not just a spot that’s good enough.

Great asset allocation should, over a long time period, add a few percentage points to your return while reducing the inevitable volatility of investing in equities.

You might be surprised to learn how much difference a few percentage points of return can make. Imagine a working couple who fund a pair of Roth IRAs at $6,000 a year for 30 years. By eliminating commissions, shaving ongoing expenses and in particular by investing in the right assets, it’s not unrealistic to think this couple could increase its long-term compound return from 10 percent to 12 percent without taking more risk.

Over 30 years, this couple would have invested a total of $180,000. At the end of that time, a 10 percent annualized return would make their two IRAs worth about $1,086,000. If they boosted that return to 12 percent, the IRAs would be worth about $1,622,000.

The difference, $536,000, is three times their entire outlay of $180,000. That extra $536,000 is the result of paying attention to details like expenses and proper diversification.

We have been managing money for clients since 1983, and the best way we have ever found to build a buy-and-hold portfolio is using no-load asset-class index funds offered by Dimensional Fund Advisors. These funds were specifically created to help investors pinpoint the most productive types of assets, as identified in academic research.

DFA funds have a couple of drawbacks. First, they are only available to individuals through investment advisors, whose management fees can range from 0.25 percent to 2 percent annually. Second, advisors who offer these funds normally require a minimum account size of $100,000 or more. But for investors who can get past those hurdles, we think DFA funds over time should provide the extra edge that will make them great investments instead of merely good ones.

For investors with less than $100,000 or those who don’t want to hire an investment advisor, Vanguard’s low-cost index funds are the obvious alternative, and I’ll discuss them later in this article.

We have written extensively in the past about how to create just the right mix of assets in an equity portfolio. We’ve recommended buy-and-hold portfolios using DFA funds and Vanguard funds. You’ll see the funds listed in Figure 8, followed by Table 1, which shows annual performance starting in 1999, along with cumulative performance (assuming annual rebalancing) through 2002.

That of course is a very short time period, much shorter than the ones we usually call on to make our points. But the 1999-2002 period is particularly useful because it is fresh in the minds of most of today’s investors. It happened to them or to people they knew, and therefore it’s much more “real” than a dusty statistic about something that happened 60 or 70 years ago.

The superior performance of DFA funds is not a result of having better managers picking better stocks. Stock picking plays only a very minor role in the Vanguard and DFA funds that we recommend. These are index or passively managed funds. Their edge comes not from stock selection but from precise asset allocation that gives investors more of what they need and less of what they don’t need.

I can show this with a couple of examples, and I’ll start with a comparison of Vanguard’s large-cap U.S. value fund, the Vanguard Value Index, with DFA’s comparable fund, DFA U.S. Large Company Value. Statistics show that the DFA fund simply has a much stronger concentration of value.

Imagine that value vs. growth is represented by a straight line across the page, with “pure” value at the far left end of the line and “pure” growth at the far right end of the line. If we measure a mutual fund’s orientation to value or growth (which I’ll show you in a moment how to do it), we can assign a spot along the line to the fund. Most funds would fall somewhere between the extremes of growth and value.

Most experts on asset classification look at value vs. growth in two ways. First, they look at price/earnings ratios to represent value (low ratios) and growth (high ratios). Second, and widely regarded as the best measure of value, is the price/book value ratio. This ratio, which we’ll call the P/B ratio for short, indicates how much investors are willing to pay in relation to the company’s book value, which means the cash and all the other assets on its books, minus all liabilities. A low ratio indicates value, a high ratio indicates growth.

For instance, imagine a company facing enormous challenges, heavy debt, faltering management and perhaps other serious problems. In such a case, investors might price the stock so low that it approached the fire-sale value of the assets in case the company was liquidated. That would be an extreme or highly discounted value stock.

If the share price were equal to the book value, making the P/B ratio 1.0, investors would in effect be saying the company is worth exactly as much as the total of its balance sheet assets such as cash, trucks, buildings, land, machinery and inventory. The stock price would place no value at all on the company’s ability to use those assets to generate profits.

That’s an extreme definition, reflecting the most deeply discounted value company. Most stocks in the portfolios of value funds are not in dire straights, just relatively out of favor for various reasons.

One of the largest value companies in the DFA U.S. Large Cap Value Fund is Burlington Northern Santa Fe, with a P/B ratio of only 1.1. (For reference, the Standard & Poor's 500 Index has an average P/B ratio of 4.3.) Other companies among the fund’s top holdings in 2002 include General Motors, International Paper, Union Pacific, Sears Roebuck and KeyCorp.

On the other hand, imagine a company with rapidly growing profits and apparently a fine future. Investors would typically bid the price of that stock up on the hopes for future earnings, and the value of the company’s buildings and inventory, etc. would be only incidental.

That defines a classic growth company, and a prime example is General Electric, with a five year average P/B ratio of 8.3. General Electric is among the largest holdings of most large-cap growth funds, and it’s the No. 1 holding in the DFA U.S. Large Company Fund in 2002. Also among that fund’s top 10 holdings are such familiar names as Pfizer, Cisco, Microsoft and Intel.

What this means to an investor is simple: When you’re trying to capture the benefit of investing in value companies, you will get more of that benefit from funds with portfolios of stocks that fall farther to the left side of the imaginary line, companies with lower P/B ratios.

The Vanguard Value Index Fund’s portfolio has an average P/B ratio of 2.1, indicating it’s clearly on the side of value companies. But DFA’s U.S. Large Cap Value Fund has an average P/B ratio of only 1.3, indicating it’s much closer to the value end of the scale.

Here’s why that matters: Among U.S. stocks, for the past 76 years, and for the past 33 years, value companies have outperformed growth companies and small companies have outperformed large ones.

Those numbers hold the key to explaining why the DFA large cap value fund’s performance is superior when value funds are outperforming growth funds, as they have recently: The DFA fund shines because it invests in more deeply discounted value companies. For investors, the lesson is clear: the lower the price/book ratio of a value fund, the greater the historical advantage of that fund.

My second example is small-cap funds. And again, to get the benefits from investing in small companies, you should invest in really small companies, not just ones at the lower end of the mid-cap category.

For the past few years, small-cap stocks have been outperforming large-cap ones. From the start of 1999 thru 2002, the Standard & Poor's 500 Index fell 24.5 percent while the Russell 2000 Index rose fell 4.2 percent. (The Russell 2000 index tracks the smallest two-thirds of the largest 3,000 U.S. stocks.)

Again you can imagine a horizontal line representing the spectrum from tiny companies with total market capitalizations (total shares outstanding multiplied by share price) under $50 million to giants like General Electric, which has a market capitalization over $236 billion. Although there are no hard-and-fast definitions, small-cap stocks are generally regarded as those with market caps of not more than $1 billion.

The stocks in the portfolio of the Vanguard Small Cap Index Fund have a median market capitalization of $568 million. (“median” means half the stocks are higher than that and half are lower.) The DFA U.S. Micro Cap Fund (formerly the Small Company 9-10 Fund) has a portfolio with a median market capitalization of $212 million. This fund invests only in the smallest 20 percent of all stocks. The DFA fund clearly gives investors more of the benefits from investing in small companies.

The difference between $568 million and $212 million is the key to the difference in performance between these two funds. When small companies outperform large ones, stocks of “smaller small” companies are more profitable than those of “larger small” companies.

Investors will get much more of that effect from the DFA small cap fund than from the similar Vanguard one. In 1999, the Vanguard fund was up 23.1 percent while the DFA fund was up 29.8 percent. In 2001, the Vanguard fund was up 3.1 percent while the DFA fund was up 22.8 percent. In 2002, the Vanguard fund lost 20.0 percent while the DFA fund lost 13.3 percent.

The effect also works in reverse. When small-cap stocks are lagging, the DFA fund’s returns will be hit harder. In 1998, Vanguard Small Cap Index was down 2.6 percent while DFA U.S. Micro Cap fell 7.3 percent. In 2000, when the Vanguard fund was down 2.7 percent, its DFA counterpart was off 3.6 percent.

For the four years, 1998 through 2002, $10,000 invested in the Vanguard fund would have shrunk to $9,622; that much invested in the DFA fund would have grown to $12,349.

The DFA premium comes at a price: underperformance when small-cap stocks are lagging large-cap stocks. Should that deter you from investing in DFA’s micro-cap fund? I don’t think so, and here’s why: We believe that over the long term, investors should – and usually do – get premium returns for taking carefully controlled risks. Investing in a broadly diversified portfolio of very small companies represents a carefully controlled risk that does give investors a premium return.

If you invested only in the DFA U.S. Micro Cap Fund, your risk would indeed be high. But when you include this fund as part of a diverse portfolio and rebalance that portfolio annually, this fund contributes in a powerful way to the expected premium return from the portfolio. The rebalancing does the trick.

In Table 3, below, you’ll see the year-by-year results of rebalancing the DFA Large Company Fund and the DFA Micro Cap Fund from 1991 through 2002. The combination, which came from rebalancing each year, produced an annualized return higher than the average of each fund’s return individually.

To recap a few important points: We can’t know the future; but we can do our best to learn from the past. The past 76 years tells me that value funds have an advantage over growth funds and that small-cap funds have an advantage over large-cap ones. Investors can capture that advantage by investing in funds that target the differences. And those investors can increase their advantage by annual rebalancing.

We advise investors to focus on what they can control. That means expenses, taxes and most important, asset characteristics. The really big decision investors face is what kind of assets they want in their portfolios. That, more than anything else, determines their returns.

DFA funds give investors more accuracy in nailing down the right assets than any other investment. They give you combinations of assets you can’t get anywhere else. DFA puts more “small” in its small-cap funds and more value in its value funds. Vanguard has one additional international small-cap fund; DFA has two. DFA's international small cap funds are smaller and represent better value than Vanguard.

Our studies indicate the final “moment of truth” for serious buy-and-hold investors is this question: Am I willing to pay an advisor in order to get access to the best product? For many years I have preached the gospel of low-cost investing, and I don’t want you to pay a penny more for your investments than you have to. But neither do I want you to be penny-wise and pound foolish.

Having exactly the right assets can add at least two percentage points of return per year to the typical investor’s portfolio. Over a period of years, two extra percentage points of return can make a huge difference. To a retiree, it can be the difference between running out of money or having enough to leave a healthy estate. To somebody accumulating retirement savings, it can be the difference between having a comfortable retirement and just getting by. Those two percentage points could be the difference between being able to retire at age 61 or having to wait until age 65.

Our analysis suggests that DFA funds can add 1 percent or more to the annual return of a our Vanguard portfolio, after taking out assumed annual management fees of 1 percent and less as the account size grows. We believe this advantage, a net result of 1 percent or more per year, results from DFA’s concentration on small-cap stocks and value stocks.

Many investors are reluctant to pay for a manager’s services. But professional guidance can be very valuable. If you pay 1 percent of your assets in order to boost them by 2 percent, that could be the best investment you’ll make.

Not everybody will want to invest through an advisor or be able to meet the minimum requirements – our minimum requirement is $100,000. For those people, we recommend the Vanguard equity funds. Even that is too much for some people. For taxable accounts Vanguard requires $3,000 per fund to open accounts in most of the funds we recommend.

In addition, many investors just don’t see much point in having lots of separate funds to keep track of and worry about when it seems that they can get it all under one roof.

We are sometimes asked if there’s any reason not to simply buy the Vanguard Total Stock Market Index Fund (which owns U.S. stocks) and the Vanguard Total International Stock Fund. After all, those cover all the bases, don’t they?

Our answer is that yes, they do cover all the bases. But not very well. Just as a good cook chooses spices carefully for a soup, a good investor chooses assets carefully for a portfolio. If a cook simply put a little bit of every spice in the cupboard into the soup, the result would be interesting, to say the least. But a great cook will leave out some spices and carefully use others.

A great portfolio will do the same, pinpointing the assets that the portfolio’s creator believes will give the best overall result. We believe that over time, the carefully chosen portfolio we recommend, especially when it is rebalanced annually, will have an advantage of 2 to 3 percentage points of return over the total stock market funds that include everything.

We’re never sure whether our arguments are convincing enough to dissuade people who want to keep everything simple. So we decided to put our idea to the test.

We created what we call the Utterly Simple Portfolio, a 50/50 mix of Vanguard Total Stock Market Index Fund and Vanguard Total International Stock Fund. We tracked that portfolio for 1999 through 2002, a period that contained both a raging bull market and a prolonged, tough bear market. We held this Utterly Simple Portfolio up against our recommended Vanguard funds, and the results are shown in Table 4. We’ll let the numbers speak for themselves.

To quantify this, we computed the average price/book ratio (to measure value vs. growth) and the average median market capitalization (to measure size) of the four U.S. equity funds in our Vanguard buy-and-hold Model Portfolio. The U.S. equity part of that portfolio would mirror those averages, with a median market cap of $16.7 billion and a price/book ratio of 2.7.

The Vanguard Total Stock Market Fund, by contrast, has a median market cap of $26.0 billion, indicating it invests in slightly larger companies, and a price/book ratio of 4.1, indicating its portfolio is much more oriented toward growth than toward value.

On the international side, the difference is equally striking. The weighted averages of the four Vanguard funds in our Model Portfolio are a market cap of $12.8 billion and a price/book ratio of 2.4. But the Vanguard Total International Stock Market Fund has a median market cap of $34.4 billion and a price/book ratio of 2.6.

What these numbers mean is plain: Vanguard’s “total market” funds are oriented toward large-cap stocks and growth stocks. This is why those funds outperformed slightly in 1999 – and why they fell far behind in 2000, 2001 and 2002.

Of course there will be periods when large companies and growth companies outperform. The way to take advantage of those times is to include growth funds and large-cap funds in your portfolio. But all the historical information we have shows that simplicity comes at a price over the long run. We don’t think it’s a price worth paying.

The DFA and Vanguard funds we recommend are already very tax efficient. In addition, both DFA and Vanguard have funds specifically managed to minimize taxes.

Not every important asset class is represented by a tax-managed fund, but several are. If we were designing a worldwide buy-and-hold portfolio for somebody for whom taxes were a primary concern, we’d use our same basic portfolio, substituting tax-managed funds where they are available. For instance, we’d substitute Vanguard’s Tax-Managed Growth & Income Fund for the Vanguard 500 Index. The funds’ portfolios and returns are extremely similar, and the tax-managed one leaves investors with slightly more of that return.

Here are Vanguard’s other tax-managed funds: Tax Managed Balanced, Tax Managed Capital Appreciation, Tax Managed Small Cap and Tax Managed International. In addition, DFA has five tax-managed funds: Tax Managed U.S. Equity, Tax Managed U.S. Marketwide Value, Tax Managed U.S. Small Cap, Tax Managed U.S. Small Cap Value and Tax Managed International Value.

DFA’s tax-managed funds have a distinct bias toward value, for a good reason: That’s where tax efficiency matters more to investors. Why? Because value investing involves buying stocks that are depressed. When the companies behind those stocks get their acts together, or when investors in general just start favoring those stocks, the prices go up. After a while an “ugly duckling” value stock can start to look like a growth stock, and a value fund may sell it, ideally at a nice profit. Those profits can turn into unpleasant capital gains distributions for taxable investors. But when such funds are managed to minimize taxes, that can make a big difference to investors.

You can come closer to the right mix of asset classes at Schwab than you can at Vanguard. But the higher expenses of the Schwab funds will rob you of some of the return. You’ll pay more and still not get the real thing.

But you will be likely to pay higher taxes on funds from Fidelity and Schwab than on DFA funds. This is largely because of portfolio turnover that creates capital gains liability to shareholders.

Standard deviation is a statistical measurement that lets you compare the volatility of entirely different classes of things; for our purposes we use it to compare investment portfolios. Standard deviation always applies to a series of numbers. It is the range up and down from the average of the individual numbers in the series within which two-thirds of those individual numbers will fall. You can think of it as a band of probability. The lower the standard deviation, the narrower the band and the lower the volatility of the numbers in the series.

For example, imagine a series of numbers, the average of which is 40. If the series has a standard deviation of 10, that means two-thirds of the numbers in the series will fall within 10 of the average, in this case between 30 and 50. If the standard deviation were 18, then two-thirds of the numbers in the series would fall between 22 (40 minus 18) and 58 (40 plus 18). The second series would be much more volatile than the first, even though their averages were identical. Therefore, the lower the standard deviation, the more predictable the series.

The Vanguard Developed Markets Index was not available in 1999 and 2000 so we used the Vanguard European Stock Index (50%) and the Vanguard Pacific Stock Index (50%) to represent this fund. Our original publication of the Ultimate Buy and Hold Strategy used these two funds.

Returns described in this article, unless otherwise stated, do not take into consideration the effect of taxes or management fees. Those returns are in some cases hypothetical, meaning they were not based on actual trades. Such data is potentially misleading, and there is no indication that such results would have been achieved. Future returns will be different from those shown here.