In a recent New York Times interview, financial guru Suze Orman said she has $25 million in liquid net worth. Of this, she related that she has $1 million in the stock market. The rest is apparently in zero-coupon municipal bonds, triple-A-rated and insured.
That's a very safe position. But will it yield the best return? Orman plans to receive a return of approximately 4% per year with a tax advantage bringing it up to 6% to 7% per year at best. If Orman does bring home 7% post tax on a million dollars over the next 20 years, and those with more diversified portfolios bring in a modest 8% post tax per year, what would that 1% difference mean, assuming management fees and turn over are the same? (See Chart A.)
Based on her approach, Orman will have $3.87 million. The more diversified investor would have $4.66 million, a difference of $800,000 in the favor of diversification. Of course, this assumes that the past is some indication of the future.
If an $800,000 return to the diversified investor does not sound impressive enough, what would happen if Orman reinvested four fifths of her entire liquid portfolio of $25 million? If Orman took $20 million of the $25 million and invested it in stocks rather than municipal bonds, she still would have $5 million in bonds for a rainy day. (See Chart B.)
At the end of 20 years at a 7% return, Orman would have $77,394,000. The diversified investor, on the other hand, would have $20 million growing at 8% over 20 years resulting in a return of $93,219,000. The difference in the diversified investor's favor is almost $16 million. Asset allocation is responsible for more than 90% of a portfolio's return, according to modern portfolio theory. This was the model proposed by Markowitz, Miller, and Sharpe, winners of a 1990 Nobel Prize.
Asset allocation is the process of dividing a portfolio among major asset categories such as bonds, stocks, and cash. Its purpose is to reduce risk for a specified return by diversifying the portfolio.
Although Ms. Orman may choose to invest against the principles of scientific financial wisdom, most investors may want to pay attention to the men who won the noble prize in 1990. Otherwise, we could limit opportunities for putting money in our own pocket.
Shirley M. Mueller, MD, is founder and president of MyMoneyMD, LLC. She educates, both one-on-one and publicly, on how to effectively self-invest using a simple and effective three-step approach. She has given many lectures about this subject, most recently at Indiana/Purdue University. For more information, visit MyMoneyMD.com.