(This article first appeared in Real Estate Investor's Monthly.)

A reader recommended the book Unconventional Success to me. Great book!

The author, David F. Swensen, is the chief investment officer of Yale University. He most famous for achieving a 16.1% per year return for their endowment over two recent decades, which is quite remarkable.

The subtitle is “A Fundamental Approach to Personal Investment.” He covers stocks, bonds, and real estate. He assumes that you are a silent partner or passive investor who seeks to ride the market. This is different from owning and managing rental property, but the book is extremely well done and instructive for real estate investors nevertheless.

Active versus passive

The book mainly says that you should only invest passively and do it in a certain prescribed manner. That means, to buy low-cost index funds, e.g., Vanguard S&P 500 Index, and comparable broad, low-cost, foreign equity and U.S. bond funds.

No active

Swensen is unalterably opposed to active investing by laymen and persuasive about that. Active investing means trying to do better than the market rather that buying the entire market as with index funds. Very simply, Swensen says what every other thoughtful observer of the market says: You cannot beat the market. Only a handful of securities-industry super pros can and they do it with esoteric, ephemeral techniques.

Not only can you not do it, you cannot identify the guys who will do it in the future. So forget about it. He offers tons of data to prove it, as have many other books most notably the classic A Random Walk Down Wall Street.

Criminal ‘experts’

If prosecutors were interested, they could probably obtain criminal convictions of anyone who seeks to be paid for recommending stocks or operating or selling a mutual fund other than a low-cost index fund.

Basically, those guys say or imply that paying them directly or indirectly through commissions and such will result in your getting a better return than you would in the Vanguard S&P 500 Index or comparable foreign equity or U.S. bonds funds.

Easily provable

The statement is easily provable fraud. But they never get prosecuted for reasons beyond my comprehension—some sort of extreme extension of the “puffery” legal doctrine I guess. Swensen and I say that owning any stocks or mutual funds other than low-cost index funds is dumb—so much so that it is hard to imagine how anyone who makes those mistakes could survive a cross-examination about it in court by a knowledgeable attorney.

Three tools

Securities investors have three tools:

90% asset allocation

According to a persuasive study, 90% of the variations in investors’ returns stems from their asset allocation decisions, that is, what percent of their portfolio should be in each asset class. There are six pertinent asset classes according to Swensen:

No corporate or municipal bonds

Conspicuously absent from this list are bonds other than U.S. Treasuries and commodities like gold. The problem with non-U.S. treasury bonds is that they have a “heads I win tails you lose” provision: a call option that lets the bond issuer pay it off early if interest rates fall.

Commodities like gold produce no interest income or dividends and have no retained earnings like a public company.

Timing and stock picking

The other 10% of variations in returns stem from market timing (when to buy and when to sell) and security selection (which stocks to buy), both of which are impossible to do correctly on purpose. In other words, 100% of what action you can take to maximize your return is asset allocation.

Vanguard S&P 500 Index holds all the Standard & Poors 500 stocks and never buys or sells other than to rebalance, that is, maintain the same percentage of each stock as in the S&P 500 index itself. That becomes necessary as the various stock values go up and down.

How long will you live?

The correct asset allocation is mainly a function of the amount of time you expect to live. If you expect to live another 60 years, your portfolio should contain a higher percentage of stocks; 20 years, a higher percentage of money market funds and short-term or TIPS bonds.

The basic idea is that stocks can be expected to produce higher returns, but only over the long term. Both theory and history support that. Stocks could produce a lousy return over the long term in the future, but that has never happened in the U.S.


Your stock portfolio should consist only of index funds because no one can tell which stocks you should buy, therefore you must buy all of them. This approach has been proven best historically over the long-term.

In other words, if you had bought all the S&P index stocks since it began, you would have done better than any other theory of stock picking and you would have done better than if you had bought U.S. Treasury bonds.

Nobel Prize winner Harry Markowitz said diversification is one of the economic world’s rare “free lunches” because it reduces unsystematic (individual stock price variations) risk to zero, but leaves a relatively high return rate—historically—intact.


Without doubt, you are best off when you minimize costs like sales commissions, management fees, and loads. The lowest costs I know of are offered by USAA and Vanguard funds—around .19 to .20% of the assets under management. Others charge far, far more than that—in some cases, even for index funds where no decisions have to be made and few transactions should occur.

Income taxes

To maximize how much you have later in life when you want to spend the money, you also need to minimize the income taxes you pay on your investments along the way.

One way is to have your money in tax-deferred pension accounts. For assets in currently taxable accounts, minimize security sales that produce net taxable gains. You do that by avoiding selling at a gain unless you have another sale at a loss to offset the gain sale.

Low-cost index funds do their best to minimize sales of gain stocks to avoid making their owners pay taxes.


Deciding what percent of your assets to put into each asset class sounds easy. The hard part is rebalancing.

Over time, some of the assets you own will go up in value and others will go down. Those changes will mean you no longer have the percent you want in each asset class. That means you need to rebalance or restore the percent allocations that you originally decided on.

Sell winners and buy losers

By definition, rebalancing means selling winners and buying losers. For example, if your Vanguard S&P 500 Index went up in value and your Vanguard REIT Index fund went down, you need to sell some of the S&P 500 and buy more REIT fund. That, no doubt, sounds counterintuitive if not crazy.

This is one of many examples of how our caveman brain evolution did not prepare us for investing. Securities that recently went up are more likely to drop in the future and vice versa. Buying yesterday’s winners and selling yesterday’s losers generally will cause you to own more of tomorrow’s losers and fewer of tomorrow’s winners.

Rebalancers did better

Studies of what has actually happened in the past reveal that those who rebalanced in order to maintain their original asset-allocation percentages made more money over time than those who let the changes in values screw up their asset allocations.

Also, failure to rebalance changes the portfolio so it gets out of whack with what makes sense given your age. In the example I just gave, you would be moving to a younger person’s asset allocation with each day that stocks went up or bonds went down in value.

Rebalancing and taxes

Rebalancing, as I just said, necessitates selling winners. That triggers gains taxes which I just said to avoid. In some cases, you should tolerate a little bit of being out of balance if fixing it would trigger significant taxes.

Whenever possible, try to offset gain sales with loss sales or do your gain sales rebalancing inside your tax-deferred pension accounts [like your 401(k), IRA, or SEP].


Ownership of corporate stocks including REITs funds gives intermediate and long-term, but not short-term, protection against inflation. The last thing you want to own during unexpected inflation is intermediate or long-term U.S. bonds. To protect yourself against inflation in the fixed-income asset class, own money-market funds and short-term Treasury bonds or Treasury Inflation-Protected bonds (TIPs).

Class diversification

Swensen says that no asset class should have less than 5% of your assets and none more than 30%. That is for asset-class diversification as opposed to just stock diversification. Here is a generic young person’s asset allocation from Swensen:

Domestic equity30%
Foreign developed equity15%
Emerging market equity5%
U.S. Treasury bonds15%
U.S. TIPs15%

Foreign developed equity is corporate stock in developed foreign countries like United Kingdom. Emerging market equity is corporate stock in poorer countries like Mexico.

Foreign countries

I do not understand why Swensen wants you to put money in foreign developed stock. They have wars and sweeping government changes like the Bolshevik Revolution. There is also a currency risk that has to be hedged which is an extra pain in the neck and expense. Swensen says you can ignore that if your allocation is 25% or less. I do not see why.

He also says emerging markets stocks have always produced lousy returns and have much higher risk, yet he urges putting 5% of your money in them. He says their governments tend to interfere to prevent money from leaving the country, family owners tend to screw minority shareholders, and emerging country stock markets often go out of business. See ya.

U.S. bonds

U.S. bonds are good because of no default risk and no call provisions. Other types of bonds like corporate and munis have both. Also, when times get tough, U.S. Treasuries still have no default risk, and typically rise in value, but corporates’ and munis’ credit tend to get downgraded so they are not protection against hard times. U.S. bonds, including TIPS, also protect against deflation which occurred during the Depression.

Real estate

Real estate to Swensen is pretty much the Vanguard REIT index, period. Swensen says that properties with long-term fixed leases are not hedges against inflation. True, but since when would anyone write a long-term lease without without cost-of-living escalators. Swensen seems to indicate the practice is widespread. I would be amazed if it was—not since the 1970s.

Other assets

Swensen says other assets like your home should influence your allocation of passive financial assets. The same is true of your privately-held business, which in present company, would be your rental properties.

One issue that comes to mind is diversification of real estate risk. I have lamented that real estate investors typically only own a few properties, all of the same type and in the same region. Lousy diversification.

Real estate diversity

If, however, you also own an REIT index fund, you, in effect, own many parcels of real estate of diverse type in multiple locations around the U.S. That should reduce your exposure to the risks facing your locally owned and managed properties.

On the other hand, owning both REIT index fund and local rental properties may overweight your portfolio with too much short-term risk.

Extra allocation to real estate

But if you are employing a skill strategy in your local rental properties, and you truly have the required skill, there is relatively little risk—not at all like the various market risks when you are just a silent partner. Swensen says,

If investors truly possess a demonstrable edge in selecting superior investments [or operating a business profitably], then the arena to which investors bring special skills deserves a greater share of portfolio assets.

In other words, if your real estate investment skills are such that you can truly produce above-market returns consistently, it is not a mistake to allocate more than the generic portfolio percentage to the combination of REIT index fund and your personal rental properties.

Inefficient market

On the one hand, real estate investment unquestionably offers an inefficient market. That, in turn, holds out the possibility that smart investors can indeed achieve above-market returns. But the mere existence of an inefficient market does not necessarily mean every investor can or is capitalizing on the inefficiency.


Behavioral finance has found that most people are overconfident in everything they do. There is also the old saying that in a bull market, everyone thinks he’s a genius. Since 1970, U.S. real estate has generally been a bull market. So there is likely more overconfidence within real estate investment than in the securities markets.

True skill

If you really are adding value independent of market-wide price movements, or able to buy for at least 20% below market value, you should allocate more than the generic percentage to real estate. But I must add Swensen’s next sentence,

Unfortunately, genuine investment skill proves so rare a commodity among individual investors that the incidence of extraordinary-expertise-justified overexposure to an asset class approaches zero.

In other words, Swensen is extremely skeptical that any individual investor really knows what he is doing well enough to deviate from the generic portfolio (adjusted for your age).

I suggest the Swensen-type portfolio as a starting point. From there, you venture into active bargain purchase and/or value-adding real estate ventures. If truly accurate accounting of the results achieved by your skill, and not by market wide appreciation, indicates you can beat the passive returns, then increase your personal, active real estate business ventures. JTR