Portfolio Recommendation Beats S&P 500 by 9.4%

The following is a guest post from Marotta Wealth Management. For those of you interested, I have a similar, though not exact, investing strategy to the one he details below.

Exactly a year ago I encouraged you to avoid another lost decade in the markets. I recommended a specific balanced portfolio that today is beating the S&P 500 by 9.4%.

At the end of September, the S&P 500 was down 6.9% after one of the most volatile 12 months in the market's history. Even over the past 10 years it lost money with an annualized return of -0.15%. So although buy-and-hold investors are relieved the markets have recovered much of their losses from lows in early March, all is not dividends and capital gains.

To add to their distress, many buy-and-hold investors did not even receive the market return. They purchased closet index funds with overly inflated expense ratios. Excessive fees sapped value from their investments while the underlying strategy proved fruitless.

Many active investors fared far worse. In their scramble to avoid bloodshed, they sold near the lows. They didn't get back into the markets until the recovery passed the point at which they had exited. Timing the markets this past year was nearly impossible. The drop was precipitous, but the recovery was equally steep. Those who rebalanced at the low took money out of safe investments and bought into equities just when the outlook was the bleakest. These fortunate contrarians boosted their returns significantly.

So did those people who simply diversified into the blended portfolio I recommended a year ago. That portfolio experienced a 2.48% gain over the past year in contrast to the S&P 500's 6.91% loss. It beat the S&P 500 by an impressive 9.39%.

We generally do not recommend S&P 500 index funds. The S&P 500 is a capitalization-weighted index. It tends to buy more of a stock when it goes up and hold less of a stock when it becomes more reasonably priced.

If the S&P were a financial advisor it would say, "Let's buy mostly large-cap growth stocks in the industry that did well last year with a high price per earnings ratio." The result would be a very aggressive and volatile portfolio that does better at the end of a bull market than at the beginning. And it does miserably at preserving capital during a bear market--exactly what happened over the last decade.

So if you are invested primarily in funds that mimic the S&P 500, a lost decade should be no surprise. If we use market history to run hundreds of Monte Carlo simulations on a portfolio invested in an S&P 500 index fund, projections indicate returns at or below zero about 6% to 7% of the time. This scenario is an astonishingly accurate snapshot of trends in the past 100 years in which six 10-year periods showed no gains. These periods were the 10 years ending in 1914, 1921, 1932, 1938, 1974 and 1977.

If you were invested in the Vanguard 500 Index, your 10-year average return through the end of last month was -0.23%. The official rate of inflation during the past decade averaged 3.0%, but in reality it was probably at least 5%. If you were invested in an S&P 500 fund, your decade-long progress toward your retirement goals has stalled significantly.

But if you were a savvy investor, you did not lose this past decade. If you committed to a balanced portfolio, you experienced both higher returns and lower volatility.

Even a balanced portfolio of just six different common funds could have boosted your 10-year average return to 6.21%. And it would have lowered your volatility from a standard deviation of 16.25% to only 14.83%, a 6.36% better annual return with 1.42% less volatility.

The portfolio I recommended didn't cherry-pick investments that have done the best recently. Rather it chose widely used funds from each major asset class.

My comparison portfolio allocates 20% to fixed income in the Vanguard Total Bond Index (VBMFX). Of the remainder, it designates 31% to U.S. stocks with 21% in the Vanguard 500 Index (VFINX) and 10% in the Vanguard Small Cap Index (NAESX). Another 31% goes to foreign stocks with 21% in Vanguard Total International Stock (VGTSX) and 10% in the Vanguard Emerging Market Index (VEIEX). The final 18% is invested in hard asset stocks in the T. Rowe Price New Era Fund (PRNEX).

The funds just described have been popular for over 10 years. They have not made their gains from active trading. And they have low expense ratios. These are not necessarily the ideal funds to select today. Nor is this the flawless asset allocation. These are simply reasonable funds in each asset class.

Both in theory and practice, a balanced portfolio has proven to be a far superior way to meet your financial goals. In Monte Carlo simulations, balanced portfolios earn money over a decade, even the bottom 5% of random returns. The exact portfolio construction is less critical than including asset categories with a low correlation to the S&P 500. A well-balanced portfolio should result in good returns with lower volatility. Returns will still vary widely because the markets are inherently capricious, but the worst cases should be considerably better.

Of the six holdings listed here, the best return over the past 12 months was the Vanguard Emerging Market Index (VEIEX), up 17.38%. This holding dropped the most a year ago but recovered even faster.

Downward pressure on the U.S. dollar has continued in recent months. So we are still strongly advocating portfolios that hold a significant percentage of assets denominated in other currencies. These assets include foreign and emerging stocks, foreign bonds and hard asset stocks.

Holding on to an undiversified portfolio will, on average, keep on providing inferior returns with higher volatility. Don't continue to wait in vain for a poorly balanced portfolio to satisfy your investment requirements. You can't afford to miss another year or another decade.

Comments

[MC]

A diversified portfolio is always better, I agree.

And of course, hindsight is the best!

[Paul Williams @ Provident Planning]

That seemed like a very long-winded way of saying a portfolio with stocks and bonds will have more stable returns than a portfolio of only stocks...

[FMF]

Paul --

Yes, I think you summarized it quite nicely. ;-)

[Rick]

Well, actually the article was saying that rather than buying the S&P500 index, it's better to invest in a diverse set of asset classes. Many people might be comfortable simply investing in the S&P 500, because that's an index, right?, and index funds are good. But the S&P 500 represents the largest companies, and it's capitalization-weighted, which makes it even worse.

So buy a diverse set of mutual funds.

[Mark]

Actually, the article was saying rather than buying a diverse set of mutual funds, split the stock component 50/50 between the US and the rest of the world.

How many people in the US are really willing to do that?

I personally think the bond component should also include foreign bonds.

[aaron]

Nice. What about those of us that are just starting out and cant get into Vanguard? Are there equivalents of the funds at say Schwab? I know they just lowered their minimums to $100 and dropped the expense ratios for several of their index funds. What say you?

[FMF]

Aaron --

I'm sure there are similar funds at Schwab. Call/email them and ask what their comparative funds are to those listed above.

[Virginiabob]

If you pick the years where the stock market is down, a diversified portfolio with lots of bonds performs well, but if you pick the years where the stock market is up 30%, stocks look good. Predicting this in advance is otherwise known as timing the market.

[Eugene Krabs]

Overall, it's a decent article. I guess I could nitpick about certain issues such as comparing short-term market performance versus long-term inflationary rate rather than an equivalent short term one, or the lack of thesis for the "downward pressure of the Dollar", which understandably, might have required a lot more writing. By the way, the following article from Kiplinger may be of some interest as a counter-point.

http://www.kiplinger.com/businessresource/forecast/archive/is-the-dollar-really-going-out-of-style-.html

But the crux of the issue is to make sure you have a balanced, diversified portfolio right? If so, I definitely agree with that. Short of valuations (if you're the likes of Peter Lynch or Warren Buffett), proper diversification is ideal path for most.

That being said, if you want static diversification, something like the Vanguard Wellsley fund can give you that, with a basic 60% stock /40% bond spread. One fund. One low cost. Simple.

However, I think diversification should also factor in target horizon (such as, when do you plan on retiring), because the asset allocation really should be rebalanced more and more conservatively as time goes by. A 20 year old may have the time to take a lot more risk than a 60 year old. Also, their accrued balance is likely to be very different as well. All of these things have to be accounted for when planning one's asset allocation.

Fortunately, Vanguard's Target Retirement fund (in a tax-deferred account) is a simple, passive strategy that takes all this into account, and offers it all in a single, low cost fund. To be clear, it's something called a Fund of Funds (FoFs), so it's an age-based arbitrary asset allocation that also includes Vanguard Total Bond Market, a Vanguard International Fund, and even Vanguard Emerging Market funds. So, it's very well-rounded. Rebalance is also automatically done for you (every 5 years).

Unless someone has something very specific in mind and has the knowledge to manually slice and dice, I typically recommend to just stick with Target Retirement. One could easily do a lot worse.

[Geoff]

Wow. You beat the market over 12 months? Call the news outlets....

[quant]

thanks, if you use Monte carlo simulation for that, have you included your transaction cost and slippage cost when you calculate return? if yes, that's great.

[kitty]

"Wow. You beat the market over 12 months? Call the news outlets...."

LOL. Yes, lots of people beat the market during last 12 months. I beat market for the past 22 months... My 401K ROI for the period starting with end of 2007 is -8.8% (as of yesterday). For the year, I am probably up. The rest of my assets did even better.

Amusingly, my ESPP stock beat both S&P and the portfolio above. It's actually up for the past 2 years. $127.19 as of this moment vs around $109 in December 2007 (when I sold a little) and just shy of brief 2008 high of $130 (but this was a brief spike only). Doesn't mean everyone should put money in my employer stock or any single stock that did well this year - it is still risky, even though it's hard to regret one's wrong decisions if they turn out for the better.

"Downward pressure on the U.S. dollar has continued in recent months. So we are still strongly advocating portfolios that hold a significant percentage of assets denominated in other currencies. These assets include foreign and emerging stocks, foreign bonds and hard asset stocks. "
What about US multi-nationals? They also profit from low dollar.

[billyjobob]

My mom use to have a saying....something about egg's and a basket..mmmmm

[kitty]

billyjobob - I agree it's not a good idea which is why I am gradually reducing my exposure. But this was not the point.

I just pointed out that that beating the market over the period of last 12 months doesn't mean the strategy is good. Yes you could beat the market because of good strategy but also because of luck. For me, keeping almost half of my 401K in bonds/stable value given my age and retirement plans was a good strategy and it paid off. At the same time keeping a large percentage of my investible assets in one stock (even of a well known, old, large, international IT corporation with lots of cash and that benefits greatly from low dollar) is a bad idea. Incidentally, it's not all eggs in one basket, more like 10% of eggs (if I include home equity) or 17% if I count just investible assets or about a third if I count only taxable accounts. But it is still way too much, which is why I am gradually reducing the exposure. Lots of it are capital gains... This is beside the point, though, the point is 12 months is too short a period to talk about strategy success.

[Daddy Paul]

This shows the power of asset allocation and rebalancing.