Many investors today believe that traditional index investing—buying and holding a broad basket of stocks and/or bonds to capture the general returns of the market minus a small expense—is the best way to go. Trying to outguess the market through active management (selection and timing) is a waste of time, so if you can’t beat it, join it.
Traditional indexing is a good approach, certainly better than active investing. All of the data confirms this. But I don’t recommend indexing to Servo clients; I don’t own index funds personally, and I don’t think indexing is the best way to invest. Why not?
Because Asset Class Investing is better.
What is Asset Class Investing? It's an approach that assumes different groups of stocks and bonds ("asset classes") have different (higher and lower) long-term returns. And by overweighting a portfolio allocation to these asset classes—for example, smaller and lower-priced “value” stocks—it’s possible to achieve better overall diversification and higher expected returns or similar returns with less risk than traditional indexing.
That’s a bold statement, but we now have 50 years of historical data to support the claim.
The graphic below covers the period from 1973 through 2022. It reports the returns and risk (“standard deviation”) for three Asset Class Investing Portfolios (the Dimensional Balanced Strategy Indexes) as well as the three most common traditional stock indexes—the S&P 500 Index, the CRSP 1-10 US “Total Market” Index, and the MSCI World Index.
The all-stock, Dimensional Equity Balanced Strategy Index had an annualized return of +12.7% over this period, much higher than the +10.3% for the S&P 500 Index and the US Total Market (CRSP 1-10) Index and over 3.5% per year more than the globally diversified MSCI World Index. But notice that it earned this return without greater risk—the Equity Balanced Strategy Index had almost identical standard deviation compared to the stock indexes. That’s much higher returns without higher risk.
The Dimensional 80/20 Balanced Strategy Index allocates 80% to the Equity Balanced Strategy Index and 20% to short-term, high-quality bonds. With less than 100% in stocks, you might expect the mix to underperform an all-stock index like the S&P 500. But it didn’t. The 80/20 Balanced Strategy Index outperformed the S&P 500 Index and the US Total Market (CRSP 1-10) Index by 1% per year and the MSCI World Index by over 2% per year while having about 20% less risk. Who said higher returns and lower risk weren’t possible?
Finally, the Dimensional 60/40 Balanced Strategy Index is similar to the 80/20 mix above but in the classic 60/40 split of stocks and bonds. With 40% in bonds, you might assume much lower returns than stock indexes. Again, no. The 60/40 Balanced Strategy Index had returns of +10.1% per year, almost as much as the +10.3% for the S&P 500 Index and US Total Market (CRSP 1-10) Index, and about 1% more than the MSCI World Index. To achieve “stock market-like returns” with 40% less risk was quite a feat. You can understand why this mix is popular with retirees looking for a robust combination of long-term growth and short-term income.
We now have data that spans 50 years for Asset Class Investing, and it’s clear that this is the best approach for your serious wealth. It’s not that index investing is inherently bad; indexing certainly makes more sense than investing in actively-managed funds or strategies. But indexing just isn’t good enough. Lower potential returns or greater risk isn’t a recipe anyone willingly accepts.
Depending on the mix, Asset Class Investing has had a higher long-term return than traditional index funds without more risk or stock-market returns with less risk than traditional index funds. As the last half century demonstrates, Asset Class Investing can help you achieve the best investment experience.
If you have questions or would like to talk about how Asset Class Investing can help you achieve greater financial success, schedule a few minutes to chat with me here.
Dimensional Balanced Strategy Index allocations provided by Dimensional Fund Advisors and are available upon request.
Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or additional expenses except where noted. This content is informational and should not be considered an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.