Simple Money Portfolio

The Simple DIY Portfolio that has Beaten the Pros

The financial industry would prefer you to believe that you can’t be a successful investor without it. That’s good for business but it’s not exactly true.

In fact, it may be truer to suggest that a layperson with a reasonable grasp of middle school math—combined with the rarer traits of discipline, grit and humility—is capable of building a portfolio that could beat the majority of professional stock pickers over the long-term.

Please note I’m not suggesting that most individual investors are likely to beat the pros. Indeed, statistics suggest just the opposite, as individual investors regularly underperform the very investments—mutual funds, run by professionals—that they own.

But the vast majority of professional money managers actively attempting to beat their respective benchmarks also have demonstrated a persistent propensity to underperform. In other words, they don’t “beat the market.”

Therefore, the individual willing and able to effectively capture market returns should indeed beat the pros. It is surprisingly simple, but it is not easy.

So, just “buy the market,” then? Perhaps, but first a little background and a disclaimer.

A Compressed History of “the Market”

Since 1927, the annualized rate of return of the US stock market has been approximately 10% per year. If you invested $10,000 in the US stock market in 1927 and “let it ride,” you’d have roughly $54 million to show for it today, 89 years later. Not bad.

But oh, how it would’ve been a bumpy ride.

Distinct Asset Classes

You’d have lost 90%—yes, nine-zero—of your investment following the 1929 crash (as measured by the Dow Jones Industrial Average), and it wouldn’t have been until 1943 that you’d get back to where you started prior to the Great Depression.

From 1949 through 1966, the market experienced consistent growth, but from the mid-sixties through 1981, the market traversed 15 years of relative mediocrity. In 1982, however, a bull market began that, despite numerous short-term scares, wouldn’t be reversed until the turn of the century.

Sixteen years later, we’re looking back on another decade-plus stretch of market returns that have largely inspired the response, “Meh.” Do the phrases “tech bubble” or “financial crisis” ring any bells?

Do You Have What It Takes?

Let’s leave the realm of hypothetical percentages for a moment and put you in the position of many who experienced the real-life pain of market ups and downs. We’ll determine if you have what it takes to endure the white-knuckle roller coaster ride of the market.

You decided to retire at the end of 2007. You sold your house and downsized, netting an additional $250,000 to add to your $750,000 retirement nest egg, bringing your total retirement savings to $1 million. The income from your nest egg will supplement your Social Security retirement benefit and a small pension.

The market had always treated you pretty well, and you’d recovered nicely from the bursting of the tech bubble in the early 2000s. You were confident enough in the market that you left all of your money in a handful of brand-name mutual funds that owned mostly large company stocks.

the downside of downsideYou were certain that you’d be able to ride out any downside.

Then came 2008.

In a single year, you saw the head and shoulders of your million-dollar nest egg lopped off—losing $370,000. But the slide didn’t stop there. With optimism brewing over the holidays, you waited to see what happened in the beginning of 2009.

What happened was that you lost even more. But you were also taking the old standard of 5% per year income stream out of your original portfolio to live on in retirement, so by the end of March 2009, you had only about half of your $1 million nest egg left.

What did you do next?

The Behavior Gap

You sold, of course, right as the market began its recovery and “refunded” your losses. The emotional Elephant took over and tossed the rational Rider (referenced in Chapter 3 of Simple Money).

There’s no shame in this. It felt like the rational thing to do, especially because, at that time, even the world’s top economic and investment minds acknowledged that the crisis could have deepened to Depression-like levels.

But you acted on the basis of the limited information at hand and the emotional turmoil within. Carl Richards, author of The One-Page Financial Plan and New York Times contributor (and a generally great guy), coined a term for this persistent investment error: the “behavior gap.”

Behavior GapIt’s the gap between the return that investments produce and the return that investors in those investments actually earn. They are the same only if an investor holds the investment the entire period in question.

As you might suspect, many investors earn less than the very mutual funds in which they invest because they don’t remain invested, getting in and out at the behest of their emotions.

We have a tendency to wait until everyone, including our barber and barista, is blabbing about how much money they’ve made in the market before we finally decide to get in. That inevitably seems to occur near the market’s top.

Then, like our friend who retired at the perfectly wrong time, investors historically wait until the market has sufficiently bruised and bloodied them before giving up and getting out.

In short, the research has proven that the average investor has an uncanny propensity to buy high and sell low, the opposite of the profitable investing maxim. As Benjamin Graham, the father of value investing and Warren Buffett’s mentor, said, “The investor’s chief problem—and even his worst enemy—is likely to be himself.”

The Real Point of Investing

The real point of investing is not actually to make money but to have a better life and facilitate a form of contentment called Enough (a concept referenced in Chapter 1 of Simple Money).

The primary objective of investing in stocks, however, is to make money. The primary objective of investing in bonds and cash, then, is to help you stay invested in stocks when it inevitably becomes difficult to do so.

The net effect should be that investing adds value to your life, in accordance with your priorities (Chapter 2) and in pursuit of your goals (Chapter 3).

Evidence-based investing forces us to submit all our opinions and educated guesses to actual peer-reviewed scrutiny. The evidence shows, after all, that it is extremely difficult to “beat the market.” There is a significant body of research, however, that indicates certain asset classes—slices of the full market spectrum, or “factors”—have performed better than others.

For example, you already likely know that stocks have historically made more money than bonds. What you may not know is that small-company stocks have outperformed large-company stocks, and value stocks historically have outperformed growth stocks.

Unfortunately, the asset classes that have historically produced outsized returns have also required more intestinal fortitude, at times, in order to reap a reward. Their highs may be higher, but their lows can also be lower. What’s more, they tend to perform poorly in the scariest of times.

But if you’re not scared yet, let’s build the Simple Money Portfolio, first in theory–then in practice.

The Simple Money Portfolio–in Theory

The S&P 500, the benchmark of benchmarks, tracks the 500 largest publicly traded U.S. companies. It’s “the market,” although not an investment in and of itself, and it’s the bogey that most stock fund managers are chasing. Since 1927, the index has earned an annualized return of 10% with an annualized standard deviation of 20%.

The annualized return gives you an idea of how much you’d have earned per year over that stretch. But it wasn’t as smooth a ride as any of us would prefer, as evidenced by the second figure.

The annualized standard deviation is a more intimidating statistic, but you don’t need to fully understand it in order to grasp its importance. In short, it’s a measurement of volatility or risk, the degree to which an investment would have deviated from its average return over a given timeframe.

An investor certainly could buy an index mutual fund or exchange-traded fund designed to mimic the S&P 500 and call it a day. Doing so, however, would likely expose that investor to more risk—and interestingly, less return—than might otherwise be optimal. Let’s use the S&P 500 as a starting point, and then build a DIY portfolio from there in three steps.

1927-2016 Annualized Return Annual Standard Deviation
S&P 500 10% 20%

Step 1: Add fixed income to lower portfolio volatility.

The market was good to the patient investor between 1927 and 2016. $10,000 invested at the beginning of that period would have grown to nearly $54 million. But most could not have weathered the volatility associated with that investment along the way.

The worst single year was down 43%, and the worst three-year stretch resulted in a 61% decline.  The antidote to stock volatility is fixed income, or bonds.

We invest in stocks to make money, but we invest in bonds to keep us invested in stocks when volatility threatens to derail us from our long-term financial plan.

Yes, a well-diversified, all-stock portfolio should certainly earn more than a balanced portfolio over your lifetime. But if you abandon your portfolio due to high volatility in the worst of times, it’s all for naught.

And since the primary purpose of investing in bonds is to stabilize a portfolio and keep us invested in stocks, consider purchasing only the stable-est of the stable, such as U.S Treasuries or FDIC-insured CDs. For our purposes, we’ll take 40% of our previous allocation to large-cap stocks and invest it in five-year U.S. Treasuries. Here’s what happens:

Portfolio 1:

60% – S&P 500 Index

40% – 5-Year Treasuries

1927-2016 Annualized Return Annual Standard Deviation
S&P 500 10% 20%
Portfolio 1 8.6% 12.1%

What’s most interesting to me about the change in the numbers from the S&P 500-only investment to the results we see from Portfolio 1 is that our measurement of risk drops a relative 39.5%, proportionately far more than our return, which falls a relative 14%.

But what if large U.S. company stocks weren’t the only equities in which we invested? How might the complexion of this portfolio change further?

Step 2: Add small company stocks, to increase return.

Small company stocks historically have provided higher returns than large company stocks. That probably doesn’t come as a surprise, right? Smaller companies are hungrier, nimbler and have more room to grow. But it also probably doesn’t come as a surprise that they are riskier and less predictable.

Let’s see what the portfolio looks like if we take half of the allocation we’ve dedicated to large companies and devote it to small companies. In order to do so, we’re relying on the research of two Nobel prize-winning economists, Eugene Fama and Kenneth French.

Portfolio 2

30% – S&P 500 Index

30% – Fama/French US Small Cap Index           

40% – 5 Year Treasuries

1927-2016 Annualized Return Annual Standard Deviation
S&P 500 10% 20%
Portfolio 1 8.6% 12.1%
Portfolio 2 9.5% 14.5%


Step 3: Add undervalued company stocks, to further increase returns.

Fama and French are credited with the “three-factor model” of investing. Instead of relying on hunches and predictions, they ran the numbers and found statistical evidence that stocks return more than bonds, small companies return more than larger companies and, furthermore, that undervalued—or value—companies return more than growth companies.

This sounds counterintuitive, because the word “growth” feels more dynamic. Value companies, however, are firms whose stock price has been beaten down relative to the company’s earnings or “book value,” ironically giving them more room to grow than growth stocks.

These “distressed” companies, of course, also come with a catch—increased risk and higher volatility. Still, by adding this third “factor” to our portfolio, we arrive at a destination that has for the past 88 years posted the same rate of return as the all-stock S&P 500—and that with 20.5% less relative volatility.

Portfolio 3

15% – S&P 500 Index

15% – Fama/French US Large Value                   

15% – Fama/French US Small Cap Index

15% – Fama/French US Small Value                   

40% – 5 Year Treasuries

1927-2016 Annualized Return Annual Standard Deviation
S&P 500 10% 20%
Portfolio 1 8.6% 12.1%
Portfolio 2 9.5% 14.5%
Portfolio 3 10% 15.9%

The “three factors” I’ve mentioned aren’t the only ones to be considered in portfolio construction, but they are the most influential. An additional consideration is the introduction of international stocks.

Besides seeming like a generally good idea to consider the economic output of the other 95% of the Earth’s seven billion inhabitants and about half the world’s market capitalization of stocks, international stocks also diversify the economic and geopolitical risks of investing in only the U.S.

The Simple Money Portfolio–In Practice

This brings us to the Simple Money Portfolio (so named because it is the central focus of the investing guidance in my comprehensive personal finance book, Simple Money).

One of the challenges of the above analysis is that it’s hard to access (although it is possible) readily available mutual funds that replicate the Fama/French indices.  However, we have translated it into low-cost index funds that virtually anyone can purchase in practice:

Here’s a text breakdown:

Allocation Asset Class Fund Name Symbol
7.5% US Large Cap Vanguard 500 Index Admiral VFIAX
7.5% US Large Value iShares Russell 1000 Value ETF IWD
7.5% US Small Cap iShares Russell 2000 ETF IWM
7.5% US Small Value iShares Russell 2000 Value ETF IWN
15% International Value iShares MSCI EAFE Value ETF EFV
15% International Small Cap iShares MSCI EAFE Small ETF SCZ
40% US Treasuries iShares Barclays 3-7 Year Treasury Bond ETF IEI

Historical Performance

Are you curious to see what the hypothetical performance of this portfolio has been over recent history?  We’re able to track these particular slices of the market back to 1979.  Here is how the portfolio would have performed each of those individual years, as well as the past 5, 10, 15, 20 and 38 years:

Year Annual Return
1979 11.7%
1980 16.9%
1981 5.3%
1982 18.4%
1983 19.3%
1984 8.0%
1985 35.3%
1986 30.6%
1987 8.7%
1988 18.3%
1989 15.5%
1990 -6.8%
1991 20.3%
1992 4.5%
1993 20.7%
1994 0.5%
1995 19.9%
1996 9.3%
1997 13.0%
1998 12.4%
1999 10.6%
2000 3.8%
2001 -3.0%
2002 -4.8%
2003 24.9%
2004 12.7%
2005 6.2%
2006 15.8%
2007 6.1%
2008 -18.1%
2009 16.0%
2010 10.6%
2011 -0.7%
2012 11.0%
2013 15.8%
2014 2.4%
2015 -1.3%
2016 7.8%

 

Term Annualized Return
5 Years 6.3%
10 Years 4.6%
15 Years 6.7%
20 Years 6.7%

“Since Inception” (38 Years)

10%

How, you should ask, can a simple, index-based portfolio outperform so many professional investors while taking less risk?

  • It diversifies the stock-based investments across a broad range of asset classes that historically have rewarded investors with higher returns than the broader market (small cap stocks and value stocks).
  • It lowers overall risk by investing 40% of the portfolio in fixed-income instruments, like bonds.
  • It limits the negative impact of riskier fixed-income implements by only investing in the most conservative bonds (or bond equivalents) available.
  • It diversifies half of the stock exposure beyond the U.S. and Canada into the international landscape. This exposes the portfolio to many opportunities beyond our borders.

Modifications

This is a decidedly moderate portfolio, one that for many investors may appear too cautious with 40% allocated to decidedly conservative fixed income. There is a reason for this:

Behavioral science has taught us that losing hurts more than winning helps.

In fact, we tend to feel the pain of a decline twice as hard as the joy we experience when everything is on the rise. In essence, we’re more conservative than we think, and therefore would do well to err on the side of conservatism in portfolio construction.

(Please note, for example, that the stock-based allocations in this portfolio have been, in and of themselves, more volatile than the U.S. large cap market alone.)

But it may be entirely appropriate to adjust your allocation to better suit your ability, willingness and need to take risk. This can be easily done by calibrating the stock-to-bond ratio to reflect a more aggressive or conservative posture while maintaining the relative ratios between the equity asset classes, the subject of our next chapter.

Some investors may also be concerned about having 50% of their stock exposure allocated to international companies. I understand this concern, in part because I share it.

I don’t understand languages, cultures, economies and markets around the world in the same way that I do in my home country—but I recognize this as a personal bias, not necessarily reflective of the data. Nonetheless, if you feel overexposed internationally, reduce the internationally oriented stock ratio from 50% to 40% or even 25%, but I encourage you not to eliminate it entirely.

Ongoing Maintenance

Is this a set-it-and-forget-it portfolio? No, I don’t want you to be an active trader of your investments, but I do advocate for active ownership.

That means rebalancing periodically, bringing your portfolio back to its intended allocation as certain slices of the pie inevitably shrink and swell. This should, over time, actually reduce overall portfolio volatility.

While rebalancing doesn’t always feel safe—taking from the parts of your portfolio that have done well and giving to those that have underperformed—the practice is entirely logical and helps ensure that you are consistently buying relatively low and selling relatively high.

Most 401(k)s and other employer-sponsored retirement plans make this an easy, automated process that you can elect when you put your portfolio in place.

Implementation

It may take some work to translate what you’ve read above to your individual situation. Your 401(k) likely only has so many options, so I recommend you try to match up the indices I’ve referenced with the most applicable index fund you can find in your plan.

If index funds aren’t available to you, look for an equivalent fund that has the lowest expense ratio possible.  (Funds typically charge higher expenses because they are more active–even though, as we’ve discussed, their activity typically results in underperformance.)

If you’re investing outside of an employer-sponsored retirement plan, The Simple Money Portfolio is designed to give you the exact mutual funds and exchange traded funds to purchase, a task that is made simplest and the least expensive by utilizing a low-cost brokerage option, like Schwab, Fidelity or TD Ameritrade.

A Word of Caution

I urge you not to take this on unless you have the discipline and grit to build and maintain the portfolio, and the humility to submit yourself to the evidence. The evidence suggests that most investors do not, or would prefer to apply their effort to endeavors more to their liking.

I believe, however, that education could inspire the confidence to apply investing discipline, and that erring on the side of a higher allocation to fixed income helps investors to stay the course.

But what about humility? This is where the financial industry fails. The industry has discipline and grit—but its lack of humility has been its undoing.

Even though the vast majority of stock pickers don’t beat the market, every stock picker, by definition, thinks he or she can. This is precisely the reason that a dedicated DIY investor can actually beat the majority of pros.

What about having a financial advisor?

Does this mean that there’s no place, or need, for a financial advisor? Hardly. Many, if not most, investors simply feel more comfortable with the guidance of a dedicated professional whose life’s work is to marinate in this stuff.

And even though you may have the discipline and the humility to establish a great DIY portfolio, many fewer investors have the grit to survive the most tumultuous market times.

Additionally, a true financial advisor is not solely an investment advisor. This is an important distinction, because a good advisor will help you place your investment strategy within the context of your cash flow, insurance, tax, education, retirement and estate planning.

The Certified Financial Planner™ Board has been one of the industry’s foremost advocates in promoting holistic, comprehensive financial planning, and the CFP® credential, while not sufficient, is a good sign that your advisor has the training to view your money within the context of your life. 

(Here’s more on “How to Make the Most of Working with a Financial Advisor.”)

But the best financial advisor will ensure that all of this financial planning is built on the foundation of your personal priorities and goals. This is imperative because personal finance is more personal than it is finance.

In the end, behavior management is more important than financial management. And that’s one critical reason why this financial advisor makes sure to have his own financial advisor.

Disclosure:

Historical return data supplied by Dimensional Fund Advisors. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. Total return includes reinvestment of dividends. Annualized from quarterly data. All portfolios rebalanced quarterly.

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