The power of simple portfolios

By Dan Bortolotti and Canadian Couch Potato on April 29, 2013
Estimated reading time: 3 minutes

Carl Richards, author of The Behavior Gap, wrote an insightful article in February called Why We Fear Simple Money Solutions. “People say they want things to be simpler—investing, life insurance, retirement planning, etc.,” he observed. “But when a simpler (and effective) option is proposed, they reject it as too simple.” I recently came face to face with this idea when working with a client of PWL Capital’s DIY Investor Service. Barbara had a portfolio of dozens of stocks and ETFs that followed no rhyme or reason. She admitted she enjoyed making trades and was inclined to buy simply buy stocks she had read about in the media. There were some blue-chip dividend payers, a couple of precious metal ETFs, plus a few random penny stocks thrown in for good measure. In other words, the portfolio was a complicated mess. To Barbara’s credit, she realized this sort of seat-of-the-pants strategy wasn’t working: with about half a million in her RRSP and retirement approaching quickly, she knew she needed a more disciplined plan. That’s why she came to us. After we reviewed Barbara’s spending patterns, pension income and other factors, my colleagues suggested a radically different approach. Not including the cash and GIC holdings, her new portfolio would be built from just five ETFs: one for bonds, one for real estate, and one each for Canadian, US, and international equities. The mix was in line with Barbara’s target rate of return and risk tolerance, and with the spreadsheet and instructions we provided it will be easy for her to rebalance with just a few trades per year.

Is that all there is?

We thought the new portfolio was ideal for Barbara, but when we presented it she was taken aback. Only five holdings for half a million dollars? She was clearly expecting something more “sophisticated.” You know, like those model portfolios that include a tactical position in the US health care sector, some emerging market bonds, and a 3.72% allocation to copper futures. That certainly would have looked more impressive than our simple five-ETF solution. Fortunately it didn’t take long for Barbara to understand the benefits of simplicity. She had already admitted she’d come to us with no strategy, no long-term plan, and no attention to risk. She had also made it clear she didn’t want to work with an advisor on an ongoing basis. So our job was not only to come up with a sound strategy, but to ensure she could manage on her own. By helping her implement a low-cost, broadly diversified portfolio with just five moving parts, we accomplished those tasks. And here’s the important point: though we streamlined Barbara’s portfolio from about 50 holdings to just five, we made it less risky. Investors who are used to building a portfolio stock by stock often struggle with this idea. They fail to appreciate that even 30 or 40 individual companies provides less diversification than even one broad-market index fund. The equity ETFs we recommended for Barbara include more than 10,000 stocks from around the world. Our investing brain seems hard-wired to resist straightforward solutions. As Richards writes, “By default, if it’s simple, say only two steps instead of ten, we think we’re missing out.” We need to get past the idea that complex portfolios increase our chances of investing success. In reality, the opposite is more likely to be true.