Whether or not an investment portfolio is working for the investor typically rests with its level of complexity. Some of the worst portfolios I've seen have been so mind-numbingly complex that the investors had no idea what strategy, if any, they were following to achieve such horrible performance. My investing ideology has always been that simple portfolios are better, and I'm not alone in that belief.
Dow Jones' MarketWatch lists and tracks eight simple, so-called Lazy Portfolios. In fact, the simplest, and one of the top performing over the long run, is the Second Grader's Starter portfolio, which refers to my son, Kevin, who was a second grader when we designed it 11 years ago.
This three-fund portfolio consists of:
These three funds were selected because they are low-cost and diversified. With the two stock funds, you own virtually every publicly held company on earth. Buying additional stock funds virtually assures you less diversification, since you will likely own more of some industries and companies than the entire global stock market represents.
And with the Total Bond Market Index Fund, you will own an approximation of every investment-grade (high-quality) taxable bond issued by the U.S. government and U.S. corporations.
How has the portfolio performed? According to MarketWatch, it earned an average of 10 percent annually over the past five years. Over the past 10 years it earned an average of 5.1 percent annually, even though that period includes the 2008-09 market plunge. Both periods are through Oct. 26, 2016.
Brilliance in simplicity
There is even more brilliance in such simplicity, in that this portfolio is very tax-efficient. When you own some funds, they can pass through huge taxable gains even when you don't sell, because of the trading of securities inside the fund by its portfolio manager. I call it the mutual fund tax trap. With the index funds, you are in control of when you recognize gains, as little if any gains will be passed through if you don't sell the funds.
Further, research indicates that we do far less performance chasing (buying high after a surge) when we buy the entire market, through index funds, than when we buy narrow or smaller parts of the market.
Now, in case you think that brilliance must be complicated, consider these two statements, attributed to a couple of smart people:
Albert Einstein: "If you can't explain it simply, you don't understand it well enough."
Sir Isaac Newton: "Truth is ever to be found in simplicity, and not in the multiplicity and confusion of things."
You certainly don't want to be 90 percent in stocks, as my son was when he was 8 years old. So pick an allocation between stocks and bonds that you feel is right for your age, your goals and your tolerance for risk — and stick with it. Even with broadly diversified funds, there is still the risk of panicking when stocks tank and not resisting the impulse to sell. Avoid the buy high/sell low pitfall.
In beating the drum for simplicity, I tell people that if they can't explain their investment strategy to an 8-year-old, they have a bad strategy. And bad strategies make for bad portfolios — and poor investment results.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.