Simple Portfolios

The art of doing nothing

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More investors don’t copy our model because our model (Berkshire Hathaway) is too simple. Most people believe you can’t be an expert if it’s too simple — Charlie Munger

Steve Edmundson is a fascinating figure. He used to manage the Nevada Public Employees’ Retirement System singlehandedly for a decade¹. When WSJ evaluated the $35 billion fund’s performance in 2016, the fund had beaten the nation’s largest public pension², over a 1, 3, 5, and 10-year period.

Steve’s daily trading strategy was to do as little as possible, usually nothing.

His strategy was simple — keep the costs low and don’t try to beat the market. A typical fund having a similar $35 billion portfolio would roughly pay $120 million in annual fees. But Nevada ended up just paying $18 million.

When he joined the fund in 2005, roughly 60% of the fund was in indexes. When he became the chief investment officer in 2012, he fired 10 external managers and by 2015, all of the stock and bond holdings were in passively managed funds.

It’s not like Mr.Edmundson is not interested in the markets. In his own words, “I spend a lot of time researching things we ultimately don’t do.”

We almost always equate complexity to a better product — Think of the number of times you were impressed by a friend or colleague introducing an idea with a lot of complicated jargon and terminologies. You come away from the conversation more confused than you went in but you end up thinking that the person is an expert and you should trust him/her.

Since this type of selling complexity is exceedingly common in investing, we have decided to put together 4 simple portfolios that can form the foundation for successful long-term investing.

These are portfolios that you can build once and then set on autopilot for decades. Most of them require at most a few trades a year and that too only to rebalance the portfolio.

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1. 60/40 Portfolio

There is a reason this is the most popular portfolio on the planet. The idea is simple — you put 60% of your money in stocks and the other 40% in bonds. It’s the safe mundane way of investing without taking too much risk.

By investing in both stocks and bonds, you improve your diversification and reduce the volatility of your portfolio. It is usually considered the gold standard for portfolios as it’s simple to build, robust in most cases, and provides adequate diversification.

The simple 60/40 portfolio is able to generate a very comparable performance to the S&P 500 while having significantly lower volatility, drawdown, and a better Sharpe ratio!

Compare the performance of the 60/40 portfolio to that of the market during historical market stress periods: While the S&P 500 was put through the grinder, the 60/40 escaped with relatively low drawdowns.

Deep dive into the 60/40 portfolio.

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2. The Cockroach Portfolio

Anyone who has ever dealt with a Cockroach infestation knows how hard it is to deal with it. The Cockroach portfolio seeks to survive in all types of economic scenarios unlike most of our portfolios that are only designed to work well in periods of growth (stocks perform well) or during periods of deflation (bonds perform well).

• 25% allocation to stocks: When inflation is under control and the economy is growing, stocks tend to outperform every other instrument.

• 25% allocation to bonds: The last time the U.S. faced deflation was during The Great Depression in 1929. Investment-grade bonds from treasuries and blue-chip companies perform well during periods of deflation.

• 25% allocation to cash: For that recession that inevitably occurs, the best thing you can do is hold some cash in your portfolio. Cash also helps to dampen the drawdowns from the rest of the portfolio.

• 25% allocation to gold: In the unlikely scenario of stagflation (where economic growth is low but inflation is very high), gold is the perfect hedge.

The Cockroach Portfolio has performed as expected in the U.S., coming in just behind the 60|40 portfolio and the S&P 500 in terms of overall returns.

But, raw returns tell us only half the story. The cockroach portfolio had considerably lower drawdowns and market correlation when compared to the other two. Where it really shines through is when we are going through market stress periods.

This strategy is what we would call the Jon Snow approach to investing – it’s where you believe that you know nothing about what can happen in the future. When you deviate from equal weighting, you are implicitly saying that you know something about the future market. Say you put 40% into stocks – this shows that you expect stocks to outperform bonds/gold/cash at some point in the future. Avoiding these sorts of predictions is the idea behind the Cockroach Portfolio.

Deep dive into the Cockroach Portfolio.

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3. 3-Fund Portfolio

The beauty of the 3-fund portfolio lies in how simple it is to build – and it works even if your portfolio is $10K or $10M just as effectively. The most well-established 3-fund portfolio is built using:

• Vanguard Total Stock Market Index Fund (VTSAX)

• Vanguard Total International Stock Index Fund (VTIAX)

• Vanguard Total Bond Market Fund (VBTLX)

Just by using these 3 funds, you will have exposure to more than 12,000 stocks from all across the world and 10,000+ bonds while having an overall expense ratio < 0.1%. Now go back and look at your current portfolio and see if you are anywhere this diversified.

The key question here is how much to allocate to each fund – While there is no one right approach and the allocations are mostly dependent on your risk profile, the most popular distribution is 50% to the U.S. stock market, 30% to the international markets and 20% to the bond market.

To put the performance of the 3-fund portfolio into perspective, let’s take a look at the study conducted by Rick Ferri in 2013. The simple 3-fund portfolio beat ~83% of 5,000 randomly selected, comparable, actively-managed funds during a 16-year window.

Deep dive into the 3 fund portfolio.

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4. Ray Dalio’s All Weather Portfolio

American billionaire investor and hedge fund manager Ray Dalio had his humbling moment quite early in his life. Fresh out of college, Ray was working as a clerk on the New York Stock Exchange when President Richard Nixon announced that the U.S. was breaking out of the Bretton Woods system of fixed exchange rates that had tied the dollar’s value to gold.

Ray was confident that the markets would drop the next morning. Instead, the DJI rose by 4% and gold shot higher in what was later called the “Nixon Rally”. Reflecting back on the event, Ray said

That was a lesson for me. I developed a modus operandi to expect surprises. I learned not to let my experiences dominate my thinking; I could go beyond my experiences to see how the machine works.

Ray started working on creating a passive portfolio with a simple goal — It should do reasonably well 20 years from now without attempting to predict anything about the future. It would take Ray and his team 25 years of learning to perfect the all-weather strategy. But the portfolio they created was able to achieve the same return as the global stock market while having 1/3rd the risk.

The commonly accepted asset allocation strategy for creating the all-weather portfolio is 55% bonds, 30% stocks, and 15% commodities.

1. VANGUARD TOTAL STOCK MARKET ETF (VTI) — 30%

2. ISHARES 20+ YEAR TREASURY BOND ETF (TLT) — 40%

3. ISHARES 7-10 YEAR TREASURY BOND ETF (IEF) — 15%

4. INVESCO DB COMMODITY TRACKING (DBC) — 7.5%

5. SPDR GOLD SHARES (GLD) — 7.5%

Over the last 15 years, the All Weather portfolio has chugged along providing a respectable 12% CAGR. But what separates it from the crowd is its low volatility. At 8.2% volatility and a max drawdown of 21.4%, it provides much better downside protection than that of a traditional 100% equity portfolio or even the 60/40 portfolio.

While we are limited to data going back to 2007 (Due to the commodity exposure), it’s really interesting to see how the All Weather portfolio has performed during market turmoil. During the Global Financial Crisis, the traditional index investor was down 51% whereas if you had the All Weather portfolio, you would have been down by only 12%. What’s even more impressive is that when the entire market collapsed by 20% in one month during the Covid-19 crisis, the All Weather portfolio was down only 1%!

Deep dive into the all-weather portfolio

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The formula for successful do-it-yourself investing is simple: diversify broadly, keep your costs low, and stick to your plan over the long term. There is a reason the story of the Vanguard Group is titled Stay the Course. Once you adopt an investing plan, you should stick with it no matter what.

People say they want things to be simpler—investing, life insurance, retirement planning, etc. But when a simpler option is proposed, they reject it as too simple. — Carl Richards

1. It looks like they have added another person in 2021

2. The California Public Employees’ Retirement Fund

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Disclaimer: We are not financial advisors. Please do your own research before investing