Building the Perfect Portfolio

I wrote previously about The Perfect Portfolio. Spoiler Alert: I contend in the article that there is no such thing as the perfect portfolio.   This is because we can’t foresee the future for investment returns, and we all have different investment needs. Even so, I believe that an investor can build a portfolio that is nearly perfect for them.

How would someone go about achieving such a challenging objective? To answer that question, I like to use a little game or thought experiment that builds a portfolio one step at a time. To begin, assume that you could only have one investment for the rest of your life, what would it be?

Before I go on, I must lay out a few rules since all games must have rules.   First, the investment you choose must be a discrete security or asset class not a mixture like a balanced fund or a fund-of-funds. That would be cheating. You can have any investment you want but you must keep it for the rest of your life. What would you choose?

First, I would choose a mutual fund or exchange traded fund (ETF) rather than an individual security for the diversification advantage. Individual companies carry more risk than diversified funds without a commensurately higher return.   It doesn’t make sense to take on more risk without getting something for it. Of course, an individual stock might do much better than a diversified portfolio, but my purpose is to invest not to gamble. Secondly, I would want an index fund rather than a managed fund. Whereas managed funds might perform about the same before expenses, they almost always underperform after expenses are considered. Lastly, I would want a US based investment because ours is the largest and most dynamic economy in the world.

To fit these criteria, I would select a total US market index fund or ETF. Such a fund would provide both income and growth potential. Income would be generated from dividends and growth would come from the share price appreciation of the underlying securities.   It would be as broad-based and balanced as possible because it would cover the entire US market of publicly traded stocks – essentially representing the economy. I can’t imagine a single better investment to own than a total US market index fund.

Assuming that you agree with my logic, let’s continue the game. What if I was to offer you the opportunity to select a second investment for your portfolio. Keep in mind that adding another investment means that you must take dollars away from the total market index fund. You should only add something if there is a net incremental benefit. There are many types of investments from which to choose, so what would you add, if any, to get an expected marginal benefit?

I would add bonds to the portfolio even though it would mean less in stocks and slower growth. Bonds are a completely different asset class because they behave differently than stocks in many ways. Whereas stocks represent equity ownership, owning bonds is lending your money. Lending typically affords a safe and predictable return but cannot match the return from equities. By adding bonds to a stock portfolio, I’m sacrificing some long-term return in exchange for less volatility or risk.   This is not a trade-off to take lightly because over long periods of time stocks produce exponentially better results through the magic of compounding. In fact, I want as little as possible in bonds so I can sleep well at night and ride out the inevitable stock market roller coaster. Most investors should have both stocks and bonds in their portfolio because there is a low correlation between the two asset classes which provides a strong diversification benefit.

Specifically, I want high quality bonds since the whole purpose of adding them is to lower the risk. And, I’m going to prefer US bonds over those of other countries. In addition, I want broad exposure to the asset class. Therefore, the clear choice for my second fund is a US bond index fund which by its nature will be dominated by US Treasury bonds.

If we are still in sync with this building blocks approach, together we have developed a two-fund portfolio. We could stop here and have an excellent portfolio – far better than most investors. I’m confident that even Warren Buffet and the late Jack Bogle – two of the greatest investors of all time – would have endorsed such a two-fund portfolio. Each might have suggested a slight variation, but they are both on record saying that a low-cost portfolio of US stocks and bonds is all anyone needs.  

While I agree that just two index funds would get you pretty close to perfect, I still think an investor can generate some marginal benefit by adding at least one other fund.   I think you could get 80% to 90% of the way to where you want to be, but why not try to get even closer? What if you could add one more fund to the portfolio, what would it be?

I would add a broad-based international stock index fund.   There are more stocks outside the US than there are here, and many are high quality companies.   Economic theory suggests that non-US stocks in the aggregate should perform about the same as US stocks over the long-term even though international stocks have underperformed in recent years.   Statistical data shows a significant reduction in volatility from adding internationals stocks to an existing portfolio of domestic stocks. If you can produce a smoother ride without sacrificing return, why not?  

Simplicity might be a valid reason stay with just two funds – and I’m sure it was Buffet’s and Bogle’s thinking - but I think the marginal benefit would be worth the added complexity as international index funds are readily available at a low cost. Therefore, if I’m allowed to add a third fund to my portfolio of US stocks and US bonds, I’m going to add an international stock index fund.

At this point in the game, you have created what has become known in the investment world as the “Three-Fund Portfolio”.   This basic three-fund index portfolio which covers the most important asset categories is probably going to meet all of your needs and get you about 95% of the way toward the perfect portfolio.  Any additions are likely to have a very small incremental impact.

Even so, in the spirit of the game, let’s say you could add another fund or more to the portfolio. Keep in mind, though, that you should not add another investment unless you are confident it will produce a marginal benefit greater than the loss from taking away from the other funds. That is, is there another asset class that would increase the expected return, reduce the expected risk, or have some combination of the two? There could be in certain situations, but again, the impact is likely to be small.   Let’s take a look at some candidates.

I often recommend that clients add an inflation protected US bond fund to the portfolio, but mainly for people at or near retirement. This is because older investors typically have a significant amount in bonds, and bonds expose long-term investors to two primary threats. One is called credit risk which is the chance that the borrower will not make good on its promise to repay the loan as planned. US inflation protected bonds are backed by the full faith and credit of the US government which eliminates credit risk. The other danger is that inflation will erode the value of future payments, but this is negated with Treasury Inflation Protected Securities known as TIPS.   With normal expected inflation, TIPS and regular treasury bonds should perform about the same, but TIPS would do better in high inflationary periods thereby providing a hedge against unexpectedly high inflation.   I’m never completely sure that adding a TIPS fund will ultimately lead to better results, but in building a portfolio, I think adding a TIPS fund to the 3-fund portfolio makes a lot of sense for some investors.

I’ll sometimes suggest a fifth fund for certain clients, which is an international bond index fund. Again, this would be for someone with a large amount in bonds as a way to further diversify the portfolio. International bonds represent a very large part of the global securities markets, so they are a natural asset class to consider. Even so, the diversification effect is not nearly as great as with international stocks because bonds by their nature are very stable.

There are other asset classes that could also be added to provide either higher returns or greater diversification, such as real estate, commodities or cryptocurrencies.   These could benefit certain investors but would not be a net positive for most. For example, some people like to own gold as in investment – and it does have some advantages - but gold can be volatile and the long-term expected return is low. This is not a good combination and therefore not appropriate for most investors.

In addition to adding asset classes, some investors try to improve a portfolio by engaging in active trading activities.   For example, hedge funds employ a myriad of strategies to generate a desired return. As such, they are not really a separate asset class but are just manipulating other securities using various strategies. If they seek or actually earn higher returns, you can be sure that they have higher risk. An investor should certainly seek a higher return if they are truly willing to take higher risk, but hedge funds are not the answer because of their excessive costs.   You should expect a higher return than the overall market if you emphasize certain areas such as small companies or technology stocks. By adding such stocks, you are in effect reducing the amount in lower risk stocks. This is a valid strategy for someone willing to make that trade-off. But you could achieve similar results using a three-fund portfolio and reducing the bond allocation and increasing the stocks.

Note that we have not discussed how much of the portfolio would go into each of the funds. This is called asset allocation and is very important in order to match the desired investment objectives and risk profile. This discussion will have to wait for a future article. My purpose here is to demonstrate that most investors would be best served with a three-fund portfolio of low-cost funds. Some might gain small incremental advantages by adding one, two or even three more funds. Beyond that, it is hard to say with confidence that any additions would improve the portfolio.

Of course, this exercise assumes that you are starting with a clean sheet of paper whereas we know it’s not always this easy. People often have legacy assets to contend with and many types of accounts, which can make the job more daunting.   But if you play the game of starting from scratch and only adding one investment at a time you will quickly see an outstanding portfolio start to form – and little room for improvement by adding funds.   We know that it will not be perfect - but it will be nearly perfect for you.