dreamer101,

Hope you don't mind me asking you a question.

Assuming an investor has USD100k to spare (i.e. capital preservation is not a priority), should he not focus on buying index funds of mainly companies that are relatively small and have high book to market value and not buy bonds at all nor the wider equity market?

I say this because -

1) Historically speaking, the risk premium of shares (over risk free treasury bills) is circa 7% whilst the risk premium for bonds is only 1.4%.

If the said investor can stomach the volatility of investing 100% equities, why bother with bonds? Is the risk adjusted return for a 80/20 (80 being equity and 20 being bonds) portfolio better than a 100 equity only portfolio?

Assuming I don't panic sell my 100 equity portfolio in a stock market crash, would my long term risk adjusted return be lower than a 80/20 portfolio? If yes, have this been proven before?

2) Fama and French in their 1995 article - "Size and Book to Market Factors in Earnings and return" have found that shares of smaller companies and those with high book to value ratio have provided above average return compared to the wider market.

Applying their findings (if still true today, which one can doubt since they is no free lunch in the financial markets), would one again not be better off by investing in index funds focusing on these companies and not the wider equity market?


Knowing a little could be dangerous when investing (talking about myself here haha), hence I would like to have your learned opinion on the above.

As you can probably guess, I have not invested in an index fund yet but rather in certain individual UK small caps.
I suspect in the long term index investing would probably turn out to be a wiser choice!

Thanks

Point 4 is quite insightful.

I suppose it is worth quite a lot being able to sell down your holdings of bonds to fund purchases in equities during a stock market crash. However, this can be achieved also by selling down your equities and keeping significant amount in cash as the market goes up to unrealistic levels.

Easier said than done I suppose (it is unclear how do we identify market peak) whereas the stock-bond allocation method will make it automatic!

This post has been edited by SalvationArmy: Sep 1 2014, 12:39 AM

So yeah, when I'm tired of doing my own investing (I get far too much joy from it at the moment), I shall be selling all my shares and buying Vanguard ETFs.

The other thing is, at lower levels of capital, you probably save more on transaction costs (compared against forgone interest income from bonds) when keeping equities+cash as opposed to equities+bonds.