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EDITOR'S NOTE: Since 2003, one of the most popular articles at FundAdvice.com has been "The perfect portfolio" by Jeff Merriman-Cohen, our chief executive officer. This article has now been updated to reflect investment results through 2008.
Great chefs know that it takes more than the right ingredients to make
an outstanding stew. If you put everything together in just the right
way, ordinary ingredients can turn into magic. In this article, Jeff
Merriman-Cohen shows how the same thing is true for investing.
The ideal portfolio may be different for every investor, but that doesn’t mean there are 150 million perfect variations.
Nevertheless, based on the Suggested Portfolios on our Web site and the strategies we manage for clients, there are probably thousands of combinations that could qualify, depending on any one person's needs.
How can an investor choose the right one?
In this article, I’ll walk through some of the steps I used when I was still meeting with clients (something that's ruled out by my current job) for the first time. I hope this will give you some good ideas on how to put together a combination that’s just right for you.
The most important initial conversation with any new client is about risk. It’s the most basic part of investing, the topic that most of the industry (and most investors) would be happy to avoid altogether.
Let me be blunt about this: Investors who don’t understand risk cannot understand the most important decisions and choices they must make.
Imagine that you are in a bank office applying for a loan. Soon you realize that at the next desk, Bill Gates is also applying for a loan. Which borrower is likely to be more attractive to the bank? Bill, of course.
The bank would always rather lend its money to him than lend it to you, because there is simply no question about his ability to pay the money back. He’s as close to a risk-free borrower as the bank could have.
But Bill Gates is not the sort of person who would hesitate to take advantage of his position. If he told the bank he wouldn’t pay more than 3 percent interest, and you were willing to pay 6 percent, what would the bank do?
In this case, the bank is in the same position as an investor. It can lend money to Bill Gates and earn 3 percent in a risk-free transaction. Or it can lend money to you and collect 6 percent in a transaction that has some risk.
The bank has to decide whether the extra return is worth the extra risk. This is exactly the challenge that smart investors face, over the whole spectrum of investment choices.
In a bond, there are two main risks: maturity and credit. Maturity refers to the fact that rising interest rates tend to depress the prices of longer term bonds more than shorter-term bonds. This makes long-term bonds riskier than short-term bonds.
Credit risk refers to the fact that repayment from a blue-chip company is more reliable than repayment from a company struggling to find enough customers to meet its obligations.
In a stock, there are many risks. But in the aggregate, smaller companies are more risky than bigger ones, and “value” companies are more risky than growth companies.
These risks are well known, and over long periods of time value stocks and small-company stocks have historically offered higher returns than growth stocks and large-company stocks.
Now I'd like you to look at Figure 1A, a graph called “Theoretical Balance of Risk and Return.”
This is pretty simple, but you’ll need to understand this graph in order to follow the rest of this discussion.
The top end of the dotted line in Figure 1A represents the risk and return level of the Standard & Poor's 500 Index from 1970 through 2008, while the bottom end represents the risk and return of five-year Treasury notes.
The area on the right side of this graph represents higher risks; the area on the left represents lower risks. Similarly, the area at the top represents higher returns, the bottom represents lower returns.
Once you understand this, you’ll see that the perfect investment strategy would wind up in the upper left corner of this graph, where risk is lowest and return is highest.
We’ll be looking at a series of graphs laid out this same way, always looking for combinations of assets that have more return (closer to the top) and less risk (closer to the left).
By looking at the ends of the dotted line in Figure 1A, you can easily see that, just as you would expect, T-notes had much less risk (on the left side of the graph) but also had lower return (lower on the graph) than the Standard & Poor's 500 Index.
The point in the middle of that line shows what you might expect from a 50/50 combination of T-notes and the S&P 500 Index. This represents the halfway point of both risk and return between T-notes and the index.
However, it doesn’t work out that way in real life. You’ll see that in Figure 1B below, which shows a solid line based on actual combinations of these two assets.
The solid line in Figure 1B is bent toward the left and toward the top of the graph. You can see that a 50/50 combination of the S&P 500 Index and T-notes produced more than the average of the two returns, at less than the average risk of these two assets.
In Figure 1C below, you’ll see where various combinations of these two assets land on the graph. Every intermediate combination is higher than – and to the left of – where it would fall on the straight dotted line we saw in Figures 1A and 1B.
You can think of the bend in the solid line as a benefit of diversification. As we will see, this phenomenon is not limited to these two particular assets. In fact, these three graphs illustrate a fundamental point that investors need to understand: Smart diversification lets you mix two assets together and achieve a higher return at less risk than the average of those two assets.
Before I show you more examples of this, I want you to look at a chart, which you’ll find in Figure 2 below, called “Which Investment Would You Prefer?” It shows a theoretical graph of return over time of two investments, each of which starts out at $100,000 and winds up worth $200,000.
Many people have a hard time choosing one of these, and for good reason. They are mirror images of each other, each with ups and downs. The choice between them isn’t critical, because they wind up in the same place. There's a variation of this in the graph called “Perfect Diversification,” Figure 3. The straight line right up the middle represents the progress of a 50/50 combination of the two investments from Figure 2.
These two assets have identical long-term rates of return. But in the short term, they are negatively correlated. In plain English, that means that each one does the opposite of the other.
Perfect diversification like this doesn’t exist in real life. But it’s a worthwhile goal. By itself, each asset eventually produces the same result, along with a good deal of angst along the way. Put together, they achieve the same result without the angst.
If you remember only one thing from this article, I hope it’s this: For diversification to work, it has to be more than holding different things. They have to be things that behave differently from each other. Figure 3 demonstrates this dramatically.
This is exactly why it doesn’t do investors much good to hold several funds that each behave much like the Standard & Poor's 500 Index. Doing so may feel comfortable. But as one of my colleagues sometimes says, three boxes of different brands of cornflakes may look different on the shelf; but in the end all that’s inside is cornflakes.
The “mostly cornflakes” problem is more prevalent than you might think. It turns out that institutions fall into the same traps as individuals. Lots of 401(k) plans have multiple options that overlap each other and are focused mostly on large-cap U.S. stock funds.
It’s not uncommon to find 401(k) plans that offer half a dozen such funds and perhaps a mid-cap stock fund, but nothing at all in the way of small-cap funds. International stock funds may or may not be offered, and that’s certainly a pity, as you are about to see.
Figure 4 below shows combinations of large-cap U.S. stocks and large-cap international stocks, represented by the Morgan Stanley Europe Australia Far East Index known as EAFE.
At first glance, this looks very different from Figure 1. But you’ll notice that the two ends of the solid curved line could be connected by a straight dotted line similar to that in Figures 1A and 1B. Again, the line in Figure 4 has a very pronounced bend toward the left. The 50/50 combination of these assets is much less risky and more productive than the midpoint of a straight line would be.
This graph should be particularly interesting to anybody who is regularly withdrawing money from a portfolio, because lower volatility (represented on the left side of the chart area) is a huge contributor to the ability of a portfolio to survive regular withdrawals.
You might note that in this 39-year period, a 50/50 combination of U.S. and international stocks had about the same return as the S&P 500 Index -- but at less risk.
Now I want to show you two more graphs constructed the same way: Figure 5, showing U.S. large-cap vs. U.S. small-cap stocks, and Figure 6, showing U.S. large-cap vs. U.S. large-cap value stocks.
The shapes of the curves are different. But each line has a distinct bend to the left, and a 50/50 combination produced less risk than would be achieved with a straight line. In each case, the line bends because the assets behave differently from each other.
Back to the subject of risk. Figure 7 is a 12-column table of numbers showing the underlying data behind Figure 1C, which you will recall is the balance of risk and return of T-notes vs. the S&P 500.
There is no perfect point on the risk/return curve. Finding the proper balance depends on each person’s needs and ability to tolerate risk. The table in Figure 7 is a good way to show exactly how much risk an investor would have taken over the past 39 calendar years with various combinations of T-notes and stocks.
The numbers at the bottom of each column in this table show four measures of risk for each portfolio combination. I suggest that you study those numbers and find a column that you think you could live with. In the bull market of 2005 and 2006, many people had an exaggerated view of how much risk they could stomach. But the bear market of 2008 taught investors that risk is not just a theoretical concept!
Today, many investors underestimate their ability to tolerate risk, perhaps overcompensating for the ravages of 2008. A few years ago, I found myself urging investors to assume less risk than they wanted to; now I find some investors so nervous that they want to take less risk than is appropriate for them.
Because this is the core of the most important decisions that investors must make, I would like to spend a little more time looking at Figure 7 and thinking about the topic of risk.
Let’s start with the assumption that you are comfortable with the very minimal risk of the all-fixed-income portfolio of T-notes, but that you are not satisfied with the 8.3 percent compound return. Let's also assume that you could be satisfied with the 9.5 percent return of the all-equity portfolio, but that you’re not comfortable with the risks.
The question is: Where do you fit in between?
To find the answer, look at the worst-12-months figures for various combinations and find a loss that you could accept. Let’s say your maximum acceptable one-year loss is 25 percent, meaning the combination of 60 percent equities and 40 percent fixed-income investments is appropriate for you.
Imagine that you choose this combination and one year later and I call you to say that you have lost 25 percent of your money. How do you think you would feel about that?
At this point, the topic of risk becomes a bit more real for somebody contemplating an investment. However, thinking of losses in percentage terms is still too theoretical for some people. So let's pose the question a different way.
As you think about how much you are willing to lose, I want you to think about the current value of your portfolio and apply the percentage loss figure to that amount. If you have a $1 million portfolio, for example, you may think you are quite comfortable with a 15 percent loss. But if I ask you whether or not you're willing to accept a loss of $150,000, I may get a very different reaction.
That reaction represents the difference between losing money on paper and losing money in reality. On paper, it’s no big deal. In real life, it can be a big deal. Many retirees and people near retirement remember very well when $30,000 represented an entire year’s pay. And when they think of losing $150,000, they may see it as the equivalent of losing five years of income.
If you have a time horizon of 20 years or more before you will need the money, in theory you should have no issues about risks over periods of one year or five years. What matters is what happens in 20 years when you need the money, not now. But that's theory. Emotionally, we react differently. Unless we see reassuring interim results, we can very easily lose confidence that we’re on the right road.
Here's why that's important: When we lose confidence, it's easy to make counterproductive decisions.
In theory, the route to the highest long-term returns is through an all-equity portfolio, at least if the past is any indication. But investing in nothing but equities is bound to subject you to occasional gut-wrenching volatility of the kind that can easily shake your confidence. And if you lose that confidence, you may bail out of the market at the worst time and perhaps never fully recover your losses.
I would rather have you invest successfully in an imperfect mix of assets than choose a theoretically more advantageous mix and then fail to carry it through.
Remember this when you are thinking about where you belong on the scale of security (mostly fixed income) vs. high returns (mostly or all equities).
Part of the role of a good financial advisor is to play the devil’s advocate, to be the person who questions your preconceived notions and your unexamined assumptions. Without that, your advisor is doing you a disservice.
The data we have, of course, is from the past. But investors can buy only the future, not the past. Although we know future returns won’t be the same as those of the past, we can be pretty sure certain patterns will continue.
Here are three very important correlations that I believe will continue to be true:
- Premium returns come from investing in stocks instead of T-notes or bonds.
- Premium returns come from investing in value stocks instead of growth stocks.
- Premium returns come from investing in small-cap stocks instead of large-cap stocks.
Those relationships have been true over long periods of time, and we have no reason to think they will change. But over shorter periods, they don’t always hold up. There will always be periods when T-bills and bonds outperform stocks and other periods when large companies outperform small ones. Likewise, at times growth companies will outperform value companies.
The most important questions for savvy investors are these: How big are these premiums and how reliable are they? The answers are shown in Figures 8 and 9.
Figure 8 shows the results of thousands of computer simulations designed to find out how likely investors were to receive the premiums from 1926 through 2008.
In this table, market premium is the return of the S&P 500 Index minus Treasury-bill returns. Size premium is small stock returns minus large stock returns. Value premium is high book-to-market returns minus low book-to-market returns. Reliability is the percentage of advantageous periods.
To illustrate what the numbers mean, let’s start at the upper left corner, measuring the market premium (the stock market vs. T-bills) for one-year periods. The figures are derived from measuring returns during every possible one-year period (for example March 1933 through February 1934) from 1926 through 2008.
The “reliability” figure indicates that in 68.1 percent of all those 12-month periods, stocks outperformed T-bills. On average, stocks had total returns 8.5 percentage points higher than those of T-bills. In the best of those one-year periods, stocks’ return was 162.6 percent better than that of T-notes.
The reliability number is the most important. It tells you that over this time, you had roughly two chances out of three of beating T-bills by investing in the S&P 500 Index. Measuring longer periods, the odds improved to about 77 percent in five-year periods, to nearly 95 percent in 15-year periods and to 100 percent in 20-year and 25-year periods.
The size premium and value premium parts of that table work the same way.
Once understood, this table becomes an excellent tool to help investors create reasonable expectations for short-term, medium-term and long-term investment results.
Figure 9 shows the reliability relationships for various time periods. In every case, you can see that the market and value premiums have been more reliable than the size premiums.
If you look carefully at the curves in Figures 4, 5 and 6, you can find a point on each curved line that is closest to the upper left-hand corner of the graph. That is the theoretically “ideal” allocation to get the best combination of high return at low risk. For example, in Figure 4, the ideal point appears to be about 60 percent S&P 500 Index and 40 percent EAFE.
This is the point where a lot of investors, including some mutual fund managers, get into trouble.
If the curves (and the results from which they are drawn) never changed, using the precisely optimum point on a graph like this might be a valid method of fine-tuning an asset allocation. But guess what: If the underlying results never changed and we could rely on the future to exactly mimic the past, investors would be fools to diversify. A rational investor would simply choose the top-performing asset.
Because the future won’t be a mirror image of the past, diversification is the most prudent approach. Likewise, the curves shown in these graphs won’t be the same in the coming years as they were in the past.
I am quite confident that the curves in Figures 4, 5 and 6 will continue to bend to the left, meaning that diversification will continue to add value. I’m also sure that the shapes of those curves will change. And if that is true, then the “ideal” point on each curve can’t be predicted accurately.
It is tempting to optimize an asset allocation based on past data. Many investors, including professionals, do this. It’s not hard to use tables and charts like these to show how well an investor could have done in the past by getting everything perfectly “right.”
Fundamentally, this is similar to looking back at the stock market of the last 10 or 20 years and showing exactly which stocks an investor should have owned to maximize a return.
This usually leads to mischief. For example, based on some measurement of the past, a manager can carefully allocate a portfolio with some precise percentage of its assets in value stocks. But after a few years when the curve of Figure 6 changes, what is that manager going to do?
To continue the hypothetical example, assume value stocks perform very well for several years. At that point the updated curve might indicate that the ideal past allocation would have been a higher percentage of value stocks.
To remain competitive, the manager may reallocate the portfolio accordingly.
Essentially, this can become just another form of chasing recent performance. And when you chase recent performance, you tend to buy high and sell low – exactly the opposite of what most investors believe they should be doing.
The way out of this trap is to diversify without trying to achieve perfection. (The "perfect portfolio," ironically, does not have to be perfect.)
Our approach begins with the assumption that an investor’s equity assets should be equally divided between U.S. and international, equally divided once again between value and a blend of value and growth, and equally divided once again between large and small.
With an equity portfolio that well diversified, an investor is not likely to miss out on any major market trends.
However, that diversification has another effect that investors must understand: It makes a portfolio behave differently from the broad market indexes.
We don’t make many absolute promises to clients about the returns they will receive, but here’s one I can make without any qualms: If you are properly diversified, your returns will be different from those of the S&P 500 Index.
You’ll see this in Figure 10, which compares year-by-year returns of a fully diversified equity portfolio with the returns of the index. (The difference figure is computed without regard to which return was higher.)
As you can see in that table, the calendar-year returns of the two portfolios were very similar (within two percentage points of each other) in only five of the 39 years from 1970 through 2008.
In 16 of those 39 years, the difference was more than 10 percentage points, and in five years it was more than 20 percentage points.
A big positive difference is easy to accept, when (as in 1977) a diversified portfolio is up 25.7 percent while the index loses 7.2 percent. But when diversification trails the index by 27.6 percentage points, as it did 20 years later in 1997, it can be tough to maintain your belief in all this diversification.
The differences in return can persist for years. A fully diversified equity portfolio underperformed the S&P 500 Index for four consecutive years in 1989 through 1992, then beat the index in 1993 and 1994, only to underperform in each of the following four years, 1995 through 1998. While the diversified portfolio was profitable in each of those four underperforming years, many investors would have lost patience with it.
Those who became frustrated and “defected” to the S&P 500 Index probably regretted doing so, as the diversified portfolio came back to outperform the index in every calendar year from 1999 through 2006.
Figure 11 shows the same comparisons for balanced portfolios. In the first column ("Basic"), the portfolio is divided equally between Treasury notes and the Standard & Poor's 500 Index; in the second column ("Diversified"), it’s divided equally between a globally diversified portfolio (excluding real estate investment trusts) and a fixed-income portfolio with an average maturity of 5.4 years.
As you might expect, the yearly differences were less extreme with the balanced portfolios. But there were still five years when the difference was in double digits.
Even with half your money in bond funds, you can gain return and reduce risk through proper diversification. This is a good example of the potential rewards that some investors forfeit because they want things to be as simple as possible.
If you want your money to work as hard as possible for you, you have to go beyond simplicity. Fortunately, diversification does not have to be daunting, and it doesn’t demand perfection.
In the end, investors need strategies with enough power on the upside to generate favorable returns, along with enough protection on the downside to keep them from bailing out in discouragement.
This is one of the hardest parts of investing. But it’s well worth whatever time and trouble it takes to do it right.
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Disclosures for Perfect Portfolio
Figure 1A, 1B, 1C, 7
S&P 500 Index Returns: From DFA Fund Advisors (DFA).
Five-Year US Treasury Notes: DFA
Figure 4
EAFE (Net dividends) from DFA.
Figure 5
U.S. Small Cap stocks - CRSP Decile 6-10 Index, through DFA.
Figure 6
U.S. Large-Cap Value Stocks - DFA U.S. Large Cap Value Portfolio starting April 1993, DFA US Large Cap Value Index with equivalent fee subtracted prior to April 1993.
Figure 8
Market premium: Difference in returns between S&P500 Index and One Month T-Bill returns, from DFA.
Value Premium: Value stocks = average of Large Cap Value and Small Cap Value. U.S. Large-Cap Value Stocks - DFA U.S. Large Cap Value Portfolio starting April 1993, DFA US Large Cap Value Index with equivalent fee subtracted prior to April 1993. Small Cap Value is DFA Small Cap Value from March 1993, DFA Small Cap Value Index adjusted for fees prior to March 1993. To this average return subtract the Fama/French US HML Research Factor, from DFA, to get a proxy for the average return of growth stocks.
Size Premium: Small Cap is DFA U.S. Micro Cap portfolio starting January 1983, DFA U.S. Microcap index adjusted for fees prior to 1983. Large Cap is DFA U.S. Large Company portfolio starting January 1991, S&P 500 Index adjusted for fees prior to January 1991.
Figure 10
DFA Equity:
DFA Equity is comprised of 50% each U.S. funds and international funds.
U.S. allocation is comprised of 25% each U.S. Large, U.S. Large Value, U.S. Small and U.S. Small Value.
International allocation is comprised of 50% each of International Large Cap and International Small Cap from January 1970 through December 1974; 25% each International Large Cap and International Large Value plus 50% International Small Cap from January 1975 through December 1986; 20% each in International Large Cap, International Large Value and Emerging Markets plus 40% in International Small Cap from January 1987 through December 1994; 20% each in International Large Cap, International Large Value, International Small Cap, International Small Cap Value and Emerging Markets from January 1995 forward.
U.S. Large - DFA U.S. Large Company portfolio starting January 1991, S&P 500 Index adjusted for fees prior to January 1991.
U.S. Large Value - DFA U.S. Large Cap Value Portfolio starting April 1993, DFA US Large Cap Value Index with equivalent fee subtracted prior to April 1993.
U.S. Small - U.S. Micro Cap portfolio starting January 1983, DFA U.S. Microcap index adjusted for fees prior to 1983.
U.S. Small Value - Small Cap Value is DFA Small Cap Value from March 1993, DFA Small Cap Value Index adjusted for fees prior to March 1993.
International Large Cap – DFA Large Cap International portfolio starting August 1991, EAFE (net dividends) adjusted for fees prior to August 1991.
International Large Value – DFA International Value portfolio starting March 1994, DFA international large value index adjusted for fees from January 1975 to February 1994.
International Small Cap – DFA International Small Company portfolio starting October 1996, DFA index of international small cap stocks adjusted for fees prior to October 1996.
International Small Cap Value – DFA International Small Cap Value portfolio starting January 1995, DFA International Small Cap Value Index adjusted for fees from July 1981 to December 1994.
Emerging Markets – DFA Emerging Markets Core portfolio starting May 2005. From January 1987 to April 2005, DFA Emerging Markets 50%, DFA Emerging Markets Value 25%, DFA Emerging Markets Small 25%.
Figure 11:
DFA Bonds:
From January 1970 through February 1997: 62.5% DFA Intermediate Government Bond fund; 37.5% Vanguard Short Term Treasury fund
From March 1997, 30% Vanguard Short Term Treasury, 50% DFA Intermediate Government Bond, 20% TIPs.
Vanguard Short Term Treasury fund
DFA Intermediate Government Bond fund
TIPs - Vanguard Inflation Protected Securities from March 1997 through June 2000, then DFA Inflation Protected Securities fund from July 2000.
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