Investors: Don’t do dumb stuff when it gets hard

Given the choice between a simple solution and a complex one, which would you choose? When it comes to investing, many people seem bent on making their portfolios needlessly complicated.

My blog—canadiancouchpotato.com—includes a model portfolio with just three exchange-traded funds (ETFs): one covering Canadian stocks, another for foreign stocks and a third for bonds. This trio of funds includes more than 3,000 companies from around the world, plus hundreds of bonds of all maturities. It’s super-cheap with a fee of less than 0.20%. And during the last 10- and 20-year periods it would have returned about 6% to 7%. Yet so many investors have an unshakable urge to tinker with it.

I routinely get emails that go something like this: “I like your Couch Potato portfolio, but I would like to make some changes. What do you think about adding some gold, small-cap stocks, commodities, real estate, global bonds, sector ETFs, infrastructure and maybe some blue-chip stocks to the mix?” I’m exaggerating, but only a little. Even those who admit they have no experience are convinced their tweaks will improve the portfolio.

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Then there are those who don’t even start with the boring old Couch Potato model. They’d rather go with a related strategy that sounds more sophisticated: there’s the Permanent Portfolio (equal parts gold, stocks, bonds and cash), the Endowment Portfolio (which mimics the Yale and Harvard investment funds, with a focus on real estate), the All Seasons portfolio (favoured by Tony Robbins in his most recent bestseller, with lots of bonds and a dash of commodities), and a host of others. They all purport to have the ideal asset mix for maximum returns with limited risk. Why waste your time with the plain vanilla Couch Potato when you can make it better?

The answer to that question reveals itself in Mebane Faber’s insightful new book, Global Asset Allocation (the Kindle version is just a few bucks on Amazon). If you believe the secret to investing is finding the optimal portfolio mix, this book should dispel that notion. It turns out that as long as you get the big decisions correct—broad diversification, low cost and long-term discipline—the others barely matter.

Faber compared the historical returns and risk of a traditional balanced portfolio of 60% stocks and 40% bonds with seven well-publicized alternatives (including those mentioned above) from 1973 through 2013. These four decades ran the gamut of economic conditions, inflation and interest rates, and they included both charging bull markets and growling bears.

Each portfolio was constructed from up to 13 asset classes covering stocks, bonds, real estate and commodities: some combined just two or three of these asset classes, while others incorporated seven or eight. So, which portfolio came out the winner? All of them.

That’s right: not only would all of these portfolios have performed well over the last 41 years, but the differences between them were shockingly small. The inflation-adjusted annualized returns ranged from 4.12% for the worst portfolio to 5.67% for the best, a narrow range that Faber calls “astonishing.” They didn’t look equally good from year to year, though: each enjoyed some years basking in the sun and spent others cowering in the doghouse. Some had stretches where they were downright dreadful, at least compared to the alternatives. But if you had followed any of these diverse strategies over the entire four decades, you would have made out extremely well.

The key insight here is that you must always be broadly diversified. “The most important principle for all investors is that they have a plan and process for investing in any environment,” Faber writes. But the precise allocations don’t mean very much in the long run, so tinkering with a model like the Couch Potato is just a distraction. The simple three-fund portfolio I suggest is not perfect, but neither are the alternatives—and you don’t need to be perfect.

The second takeaway is that costs matter a lot. The difference between the best and worst performers in Faber’s survey differed by just 1.86% annually before costs. Imagine one investor who implemented the best-performing portfolio using mutual funds that cost 2.1%, and a second who built the worst performer but kept fees to 0.2% by using ETFs. After costs, the ETF investor would have come out ahead.

Finally, and most important, bad behaviour would have reduced any of these portfolios to rubble. No matter which portfolio you might have chosen, there would have been many times when you felt like you had made a mistake. You would have hated stocks in the 1970s, sworn off gold in the 1980s, and you might have abandoned bonds today. So you need to resist the temptation to abandon your strategy as soon as it lags the alternatives. As Faber writes: “First you need to get your emotions in check and have a plan. Then don’t do dumb stuff when it gets hard.”