(PUB) Investing 2016

seven, 78%. Its after-tax returns of 1.2%, 1.6% and 8.4% might look miserly, but compared to Total Bond Market ’s after- tax returns of 1.2%, 2.5% and 3.2% over the same periods, Convertible Securities doesn’t look like such a bad income play after all. (Note that the tables on pages 12 and 13 only show Vanguard’s stock and balanced funds.) Now, to be perfectly clear, all tax efficiency numbers as well as after-tax returns need to be taken with a grain of salt, because they are time dependent. Remember, these are point-in-time cal- culations, not rolling returns. So, again, it’s not tax efficiency that matters; it’s after-tax returns, and even these need to be regarded with one eye on the time period being measured. I’ll show you why. Efficient Investing Before we get into the nitty-gritty of the data, let’s back up and talk about tax

additional hit shareholders took due to taxes probably stung pretty hard. Yet, had you looked at Energy in the earlier part of this decade, when oil prices were rising and the fund’s for- tunes were soaring, you’d have found that its tax efficiency ran better than 95%. Was that a good reason to buy the fund? As I said, tax efficiency, like so many performance measures based on single points in time or single time periods, is quite susceptible to dramatic change, and doesn’t make for a good fund-selection metric. Besides, low tax efficiency isn’t always a bad thing unless observed in a vacuum. Take Convertible Securities , a chronic underachiever in the tax-efficien- cy hunt. Many investors use the fund pre- cisely for its income-generating charac- teristics. And in our tax system, income gets taxed pretty heavily. Yes, the fund can also produce some capital gains, as well. Over the past three years, the fund’s tax efficiency has run 36%; over the past five, it’s run 43%; and over the past

Is low or negative tax efficiency anoth- er story, though? Funds like Precious Metals & Mining, Emerging Markets Select Stock, Emerging Markets Index, Energy Index and Energy have been pretty lousy for investors over the past several years, and taxes made performance even worse. Some funds’ small pre-tax gains turned into losses once the tax-man got his share. Total International Stock Index , for example, gained an annualized 0.7% over the past three years and 0.6% over the past five through March. After taxes on its dis- tributions, those positive (albeit small) returns turned into fractional losses. The same held true for World ex-U.S. Index and some other foreign index funds. Energy shareholders, who saw annu- alized losses before taxes of 6.7% and 5.6%, respectively, over the past three and five years through March 31, lost even more once the tax man got his share, with after-tax losses of 7.6% and 6.5%. Of course, falling oil prices played a big part in Energy’s losses, but the

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MAILBOX Equity Allocations

In the February Adviser , the article on rebalancing uses a 50/50 portfolio for comparison purposes. But your Model Portfolios seem very heavily weighted to equities. For example, the Conservative Growth Model appears to have only 14% in bonds. Can you explain how (or if) the Models compare to more tra- ditional ones, in which a conservative growth portfolio would probably contain closer to 50% bonds? —R. E., Huntington Beach, CA THANK YOU FOR YOUR QUESTION. Yes, it’s true that the Model Portfolios are more heavily weighted to equities than a 50/50 portfolio, with allocations of about 60% to 95% as of the end of March. This reflects my longstanding belief that the best way to build wealth over the long term is to have a large allocation to stocks, rather than bonds. That’s particularly true given the current low-interest-rate environment we find ourselves in today. As for the allocation in the Conservative Growth Model Portfolio , I guess it all depends on your definitions of “conservative” and “growth.” Since we could all have different interpretations of what “conservative” means, I would pay closer attention to the allocations you mentioned, as well as their long-term records for risk. Note that, for instance, the Conservative Growth Model Portfolio’ s relative volatility has run about 82% (0.82) of the stock market’s volatility since inception in January

1991. At the nadir of the financial crisis, the portfolio was down 44.5%, compared to Total Stock Market ’ s 51.0% decline. (Just to give another comparison, a 50/50 portfolio would have dropped 34.5%.) That means the model dropped about 87% as much as the stock market. The reason it fell more than its relative volatility of 0.82 would imply is that the model also held foreign stocks (about 18%) and bonds (about 14%). While the bond market fell just 5.8% at its worst, foreign markets dropped almost 59%. So the relative volatility number gives at least a good estimate of the risk that might be encountered in this model. The Income Model Portfolio’ s long-term risk number comes in around 60% (0.60), and sure enough, its maximum loss of 32.5% during the financial crisis was about 64% of the loss in the stock market. Believe it or not, some academics have argued that long-term inves- tors building retirement savings should invest 100% of their money in the stock market. While the math behind their arguments is strong, what the calculus doesn’t take into consideration is human behavior. It’s one thing to “know” that your retirement account allocated com- pletely to stocks is the “best” way to go, but it’s quite another to stom- ach the wrenching losses that you’ll inevitably suffer over the course of what may be several market cycles during your investment lifetime. The Greek aphorism “know thyself” has had many interpretations. I think it’s particularly apt when an investor applies it to their investment goals and the risks they are willing to endure.

The Independent Adviser for Vanguard Investors • May 2016 • 7

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