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2 Funds or 12?

by Tim Isbell, posted April 2014, minor revision in December 2015.

Also in late December 2015, I published a more robust version of much of the content on this web page: Portfolio Evaluation

I occasionally write about simple investing strategies that produce solid results over the long haul, primarily using stock and bond mutual funds (mostly index). The simplest is just two funds while the most complex uses 10-12.

Historically the real (inflation-adjusted) rate of return on stocks was nearly 7%/year; while the return on bonds was about 3.5%. Since these tend to be uncorrelated, they can combine into a fine portfolio.

This post uses a market proxy benchmark to analyze the payoff for the more complex portfolio. (Hint: it's less than you might think.) To learn more just keep reading.

Motif Investing

Motif Investing is an online broker that enables investors to custom-design a proxy fund that "turns an idea into investments." When you see an upcoming trend, you can sign up with Motif to construct a 30-stock proxy of companies that are positioned to benefit if the trend thrives.

Motif recently did this with the Affordable Care Act (also called ACA or Obamacare). They constructed an Obamacare-succeeds proxy whose companies are set to benefit if the ACA succeeds. Motif also created an Obamacare-fails proxy full of companies designed to benefit if the ACA fails. From June 28, 2012 (when the Supreme Court upheld the ACA) until February 14, 2014, the Obamacare-succeed proxy rose 46.9% while the Obamacare-fail proxy rose only 13.8%. During this time, the S&P 500 index rose 22.8%. And Motif reported that 45 times more money went into the Obamacare-succeed fund than into Obamacare-fail fund.

The conclusion: simultaneous with all the rhetoric predicting the doom of the ACA, investors bet heavily on the success of Obamacare. (Bloomberg Business Week article: The Markets Go Mad for Obamacare from February 20, 2014.)

A 2-fund proxy portfolio for stocks and bonds provides a benchmark

Let's apply this sort of market proxy thinking to our investments. For example, we can use the Vanguard Total Stock Market Fund Admiral Shares (VTSAX) as a proxy for the broad stock market because it contains a balanced mix of small, mid, and large cap U.S. stocks. Similarly, we can use the Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX) as a proxy for the broad bond market because it contains a balanced mix of U.S. government and corporate bonds.  

The simplest way to begin investing is to decide on an asset allocation percentage that fits our risk tolerance (see Asset Allocation Basics for how to do this). The next step is to implement it using just these 2 Vanguard funds as a proxy for our portfolio. Let's assume we are 35 years old, and when we analyze our risk tolerance we decide that we're comfortable with the volatility that comes with a 65/35% stock/bond split. So we put 65% in the stock fund, and the other 35% in the bond fund. The result is a very simple portfolio with extremely low operating costs, which incurs minimal taxation due to the low turnover of index funds! 

If five years ago (on April 1, 2009) we put money into these two proxy funds and left it entirely alone (until March 21, 2014) the non-inflation adjusted result was:

  • The VTSAX stock fund returned 22.07%/year (data is readily available from this link to the Vanguard website).
  • The VBTLX bond fund returned 4.71%/year. 

So a 65/35% allocation returned 0.65*22.07 + 0.35*4.71 = 15.99%/year. This is a spectacular return and about twice what we'd expect from historical data - because the last five years was, indeed, that unusual.

But this 15.99%/year proxy portfolio number does not factor in rebalancing, which had a larger impact on the return in the last five years than is typical. Every time we rebalanced in this span meant that we moved stocks to bonds, and then the stocks kept going up! So 15.99%/year overstates the return a bit.

Even so, the 2-fund proxy is a good, simple benchmark for an investment portfolio. If your portfolio didn't produce something close to this number (adjusted to your actual asset allocation) over the past five years, it's time to do something different.  

Making the 2-fund Proxy your actual portfolio

There's absolutely nothing wrong with making this proxy portfolio our actual portfolio, and rebalancing it every year so that it stays tuned to our risk tolerance.

But rebalancing is not the only thing that is different in a real portfolio. Another difference is that over the five years we probably added or withdrew some money, the timing of which raised or lowered the IRR (internal rate of return) a bit.

Still, this 2-fund portfolio provided an attractive return with volatility matching our risk tolerance. This is great news. It means that good returns are available to the person who does not want, does not have time, or just cannot manage a complex portfolio. And it means that if/when we get to a stage in life where we need to simplify our investing, we can easily do so.

The payoff for complexity

Now let's consider a more complex portfolio to see what benefits it provides over the simple 2-fund portfolio. Implementing the complex portfolio described on this website requires 10-12 funds deployed in a strategy such as in this chart. And it presumes that we periodically rebalance, which will require a moderately sophisticated spreadsheet such as this one.

So the question is, "How much more return does the complex portfolio provide for the extra work?"

The truth is, For the past five years not too much, but over the longer haul probably 1-2% per year. Note that "return" is not the only benefit from the complex portfolio. Here are several others:

  • The inclusion of international stocks. The past 5 years began in 2009, immediately after the Great Recession. This stretch saw an almost continual rise in the U.S (domestic) stock market, which is over-represented in the 2-fund proxy portfolio. International stocks were a drag on the complex portfolio over the last five years, but over the long-haul having some international stocks in the mix reduces our volatility. Adding internationals is easy: just add one fund: the Vanguard Total International Stock Index Fund Admiral (VTIAX).
  • Addition of a dividend/value stock tilt. Academic literature indicates that mixing in some value and dividend stocks lowers volatility and over a wide range of markets and can increase the return by 1-2%/year. This tilt didn't pay off in the past five years, but will over more full range of market conditions.
  • Inclusion of international bonds. The complex portfolio also adds some of these into the mix, though I wouldn't rush into these.
  • Extends tax management options. A complex portfolio provides more flexibility to manage taxes, including mixing in some tax-free municipal bonds. Also, the complex portfolio offers more flexibility to house strategically specific investments in tax-deferred retirement accounts as opposed to taxable investment accounts, which Vanguard says can be worth 0.75%/year return after taxes.
  • Makes the hobby more enjoyable. For some of us, personal investing at the level of a complex portfolio is an enjoyable hobby.

Getting actual IRR numbers for our portfolio (whether simple or complex)

Average Annual Return and Internal Rate of Return are very similar things (see Glossary). 

Return numbers for the individual proxy funds. Finding the 1, 3, and 5-year Average Annual Return numbers for each of fund in the proxy is easy: just read them from the Vanguard website up to the most recent quarter-end. They include reinvested dividends but not expenses. Finding the Compound Annual Growth Rate is more challenging. 

Return numbers for your actual portfolio. It is difficult to manually calculate the return of even the simplest 2-fund portfolio because we must include dividends, rebalancing, and additions or withdrawals along the way.

If all the investments are in one institution, even if they spread across various accounts, the company's website usually provides actual Internal Rate of Return data for 1, 3 and 5 years that factor in all these items. This data is available for any subset of the funds in the portfolio, making it easy to find the actual IRR for just the stock part of our portfolio and for just the bond part. So we can easily compare our actual stock return with the proxy stock fund return. And we can just as easily compare our actual bond return with the proxy bond fund return.

If we have money spread across several institutions, we can use Quicken to integrate all our data in one place. Quicken provides IRRs for your overall portfolio as well as any subset - and for any timeframe. In my experience, the Quicken IRR numbers closely track those from the Vanguard website. 

Taking action

It's fair to assume that over a long period of time there is a 1% to 3%/year payoff benefit for managing a complex portfolio such as described on this site. So if it's 1.5%/year and your portfolio is $100,000, the payoff for the work is $1,500/year. That's not much, but it will pay for a nice vacation. For a million dollar portfolio, the same work is worth $15,000. Only you can decide if the work is worth it for you.

As I see it, there are three options:

  1. Manage your own 1 to 4 fund portfolio. It's easy, and the return beats what money managers can provide over any 5-year span, after fees. First determine the right asset allocation for your risk tolerance, then implement it with the Vanguard funds suggested on this web page (or similar funds from another investment company). Then rebalance once a year. (Added in December 2015: If you're looking for a great single-fund option, consider one of the Vanguard LifeStrategy Funds. It is the combination of 4 index funds, one each for domestic stocks, domestic bonds, international stocks, and international bonds. Vanguard offers 4 fund options for stock/bond splits of 20/80%, 40/60%, 60/40%, and 80/20%. If you want an asset allocation somewhere between these numbers, it's easy to accomplish this with just two funds. Expenses are under 0.20%. In my opinion, this is a very reasonable and viable option.) 
  2. Manage a more complex portfolio such as described in this website section. Over time, you can expect a 1-2%/year higher return and a slightly lower volatility than option 1. If you enjoy the process or need the benefits, choose the complex portfolio. Otherwise, select option 1. 
  3. Pay someone to manage your investments. After their cut, and you pay the higher expenses, fees and resulting taxes that go with active financial management, it will probably cost you about 3.5% per year of the total portfolio. Working with a manager will probably take as much time and work as option 1. So, (in my opinion) forget option 3! Instead, check out the investment advice on this website, and especially look at the Resources/Links page where you'll meet some great personal finance authors (especially see Daniel Solin). This will probably lead you back to option 1 or 2.
I titled this web page with a question: "2 Funds or 12?" So I'll close with the short answer:
  • Either is a quite good portfolio so long as you rebalance annually. The more complex portfolio takes more work, but lowers the volatility a bit and potentially adds 1-3% of return. 

All the best,

Edited with Grammarly

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