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4 Things To Understand About Your Portfolio’s Margin Of Safety

By Ronald Delegge Does your portfolio have a margin of safety? I ask that question because the total U.S. stock market (NYSEARCA: SCHB ) has been rocky over the past few weeks and now has a year-to-date (YTD) loss of -1.23%. And since most investors underperform the stock market and the index ETFs tied to it, it’s fair to assume many people have much worse performance. The concept “margin of safety” was originally developed in the 1930s by Benjamin Graham and David Dodd, the founders of modern day value investing. Unlike today’s faceless generation of “roboadvisors” that have never experienced a bear market, let alone survived one, Graham and Dodd lived through the Great Depression so they understood the importance of investing with safety. Although their idea was applied to selecting individual stocks at undervalued prices, Dodd and Graham’s principles about safety are applicable to anyone with a portfolio of investments that owns not just stocks (NYSEARCA: VT ), but bonds (NYSEARCA: JNK ), real estate (NYSEARCA: VNQ ), and even commodities (NYSEARCA: GSG ). Here are four things all individual investors need to understand about their portfolio’s margin of safety: Installing a margin of safety within your portfolio should always happen before a negative event In my online course, “Build, Grow, and Protect Your Money: A Step-by-Step Guide,” I teach how the prudent investor does not wait for a market crash or another adverse global event to build a margin of safety within their investment portfolio. Rather, your portfolio’s margin of safety – just like an insurance policy – is purchased ahead of the accident or crisis in order to protect your capital. Investing money without a margin of safety, whether done deliberately or out of plain ignorance, is negligent. Building an architecturally sound investment portfolio doesn’t happen by chance All structurally strong and healthy portfolios have three crucial parts: 1) the portfolio’s core, 2) the portfolio’s non-core, and 3) the portfolio’s “margin of safety.” (See image below) Each of these containers within your portfolio will complement each other by deliberating holding non-overlapping assets. “I’m a long-term investor” or “the stock market always bounces back” is not prudent risk management Some people have deceived themselves into believing their IRA, 401(k), or other investments require no margin of safety. This group of individuals generally believes they are too wealthy, too experienced, and too smart to have a margin of safety inside their portfolio. It’s a paradox too, because this same group that invests without a margin of safety (or insurance), has insurance (or margin of safety) on their automobiles, homes, and lives. Somewhere along the line, this group of people lacks the same prudent sense to protect their financial assets. Investing in gold and bonds is not appropriate for your portfolio’s margin of safety Many people along with certain financial advisors make the rookie mistake of believing that assets like bonds (NYSEARCA: BND ) or gold (NYSEARCA: GLD ) can be used for a portfolio’s margin of safety. Why is this approach fundamentally wrong? Because both bonds and precious metals – just like stocks and real estate – are subject to daily fluctuations and can lose market value. For example, anybody that bought gold at its height in mid-2011 is now down over 42% and should know from first hand experience that gold is an inappropriate tool for margin of safety money. In conclusion, implementing your portfolio’s margin of safety should happen when market conditions are favorable, not when it’s raining cannonballs. And if you’re caught in the unfortunate situation where you failed to implement a margin of safety during good times and market conditions have deteriorated, the next most logical moment to implement your margin of safety is immediately. Disclosure: None Original Post

Expense Ratios Matter: Why The iShares Russell 3000 Index ETF Underperforms

Summary IWV has delivered very similar returns to those of VTI and SCHB in previous periods. The holdings are fairly similar throughout the ETFs, except IWV offers a higher expense ratio. Over the long term, it will be difficult for IWV to beat VTI or SCHB due to the slightly higher expense ratios. The iShares Russell 3000 Index ETF (NYSEARCA: IWV ) is a great barometer for the performance of the U.S. market. The fund offers investors excellent diversification and should be a solid long-term investment. There is only one problem with IWV; it has been surpassed by Vanguard and Charles Schwab offering extremely similar funds with lower expense ratios. That’s too bad for IWV, since the ETF’s expense ratio of .20% is still much better than the average. Looking at returns since the Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) was introduced and reinvesting all dividends, IWV has struggled to keep up. The Schwab U.S. Broad Market ETF and the Vanguard Total Stock Market ETF (NYSEARCA: VTI ) have steadily outperformed by a small amount. Over about five and a half years, IWV is up 120%, but SCHB is up 122.5% and VTI is up 123%. I put together a chart comparing the expense ratios of the ETFs. Even though .20% isn’t high for an ETF, it is high compared to the best options in the space. The .15% per year would be .825% over the span of 5 years. Unfortunately, IWV has trailed by more than the expense ratio. However, it has explained a significant portion of the difference in these extremely similar ETFs. The following chart turns the total returns into a CAGR (compound annual growth rate), which makes it easier to compare the difference in returns on an annual basis with the annual expense ratios. IWV was underperforming SCHB by about .22% annually and VTI by .27% annually. When you consider a difference in expense ratios of about .15%, it is more than half of the difference. They can’t deviate too far The returns of the Vanguard Total Stock Market ETF, the Schwab U.S. Broad Market ETF, and the iShares Russell 3000 Index ETF are going to be highly correlated for the foreseeable future, because the ETFs have very similar portfolios. Since the underlying securities are very similar, the ETFs should remain very similar, except for the long-term drag caused by the expense ratio. Holdings The charts below show the top 10 holdings for each ETF. (click to enlarge) (click to enlarge) (click to enlarge) When you look at the holdings, there is a lot of similarity between IWV and SCHB. VTI has more differences in the portfolio, but the holdings are still extremely similar. All three have the same top ten companies and when they are in different orders the difference in the allocations is still extremely small. Will IWV go up? I would certainly expect IWV to increase in value over the years. The correlation is going to be phenomenally high with ETF’s like VTI that I have selected as core holdings for my portfolio. However, if I had the option to short IWV with no maintenance costs on the position outside any dividends and could put the cash from the short into VTI or SCHB, I would happily make the trade and leverage it in an attempt to benefit from the difference in expense ratios. If your brokerage only allowed investing in ETFs and neither VTI nor SCHB was available, IWV would be a viable option. However, if I were in a situation like that, I’d be looking for any way to change the brokerage. The strangest conclusion I’ve found myself writing I expect IWV to see substantial growth over the years as a diversified investment in the U.S. economy, but I also expect it to consistently underperform SCHB and VTI. For purposes of tagging my expectations for positive returns compared to cash, I’d have to put down a “buy” rating. However, under all conceivable circumstances, I would rather buy SCHB or VTI. If markets were really efficient and there were no costs on trading (frictionless markets), I’d be shorting IWV to go long SCHB and expecting the position to be market-neutral (beta of 0) and to produce alpha around .15-.16% per year based on the total dollar value of the positions. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.