The simplest solution is usually the best. Unfortunately, investment strategies tend to gravitate to complicated, rather than elegant, solutions. Many have sought to reverse this trend by stripping away the excess and suggesting a simple investing model, one involving only three or four components – instead of dozens, or hundreds, of moving parts.
Rick Ferri is one such advisor. He favors low-cost portfolios that offer broad market exposure utilizing no more investments than you can count on one hand.
The Three-fund Portfolio, plus one
“The Core 4 strategy is an extension of the “Three-fund Portfolio” that is popular with index investors,” Ferri tells NerdWallet. “The three-fund portfolio consists of a domestic-stock "total market" index fund, an international stock "total market" index fund and a bond "total market" index.”
Ferri uses Vanguard exchange-traded funds as an example. The Total Bond Market ETF (BND) fills the fixed income spot with a suggested 40% allocation, the Total Stock Market ETF (VTI) is used for U.S. stocks (a 36% allocation), and the Total International Stock ETF (VXUS) serves for international holdings (18%). The Core 4 strategy then adds one more wrinkle, the Vanguard REIT ETF (VNQ) for real estate exposure, with a 6% allocation. All four holdings are rebalanced to their original investment annually.
“The allocation to stocks and bonds is based on each investor's need to take risk and ability to handle risk,” Ferri adds. “Lower risk means more bonds than stocks, and it also means lower expected returns.”
But beware of taxes
But he also notes that taxes play a role in the strategy, especially if you are in a high tax bracket.
“I would suggest a municipal bond fund in place of a taxable bond fund if the Core 4 strategy is used in a taxable account,” he says. “Also, since REITS are not tax-efficient, it’s probably better to skip that fund and add a Treasury inflation-protected securities fund (TIPS) in its place.”
Core 4 performance
True to most low-cost index investing, the Core 4 strategy has done its job well. Tracking the five-year performance of the strategy, November 30, 2008 through November 30, 2013, shows that it has a 16.85% average annual return, with annual rebalancing. That compares with an S&P 500 return for the same period of 17.6%.
What’s really interesting is that, in spite of the diversification, the strategy actually seems to increase risk, rather than reducing it, when compared to the S&P 500.
To explain, we have to geek-out for just a moment:
Standard deviation is a generally accepted manner of measuring an investment’s risk, expressed as an annualized percentage. It simply means how widely a fund's returns have deviated from its average over a selected time period.
The lower the percentage the less deviation. Low-risk investments, like money market funds, have low standard deviations, while riskier investments typically have higher-percentage standard deviations. The percentage is calculated by using the fund's monthly returns over a selected time period and then annualized.
The Core 4 has a standard deviation of 16.88%, compared to the S&P 500’s 15.81%. That means we’re taking just a bit more risk for a bit less return. We could have simply purchased the Vanguard total market ETF alone, which returned an average annual return of 18.68% for the five-year period -- with a standard deviation of 16.33%.
The REIT and international investments are providing a good deal more risk without significantly contributing to the return. Of course, as is always said in such matters: past performance is no indication of future return.
Ever the optimist, Ferri says: “In an up market, standard deviation is good thing!”
Well, we’re always happy to walk on the sunny side of the street, but markets do go down every now and then.
The bottom line on the Core 4
It’s always a good idea to hold a diversified portfolio, and in this regard the Core 4 strategy fits the bill. But the goal of holding such a mix of investments is to reduce risk -- and in that respect the Core 4 may leave a little something to be desired. Perhaps by eliminating the 6% allocation to real estate and putting that back into the domestic stock ETF you could reduce a bit of the volatility.
What does Rick Ferri think of excluding the REITS? He’s not a fan.
“I’m a believer in weighing a portfolio to what the economy is composed rather than what the stock market is composed of because economic earnings are less volatile than stock market earnings,” Ferri says. “Commercial real estate is about 13% of our economy and only 3% of the stock market. This is because most commercial real estate is held privately. Putting 10% of the equity portion of a portfolio into REITs pushes a portfolio away from the stock market allocation and closer to an economic allocation.”
Regardless of how you massage your personal investment mix, the Core 4 portfolio is a good example of cost-efficient index investing. There are many more. When chosen carefully, a handful of funds can provide a pocketful of profits.
Neda Jafarzadeh is a financial analyst for NerdWallet, a site that helps investors find the right brokerage account and mutual funds for their investments.
Image courtesy of Shutterstock.