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The Best Investment Strategy is Simple, But Hard to Do

You can get great returns if you stick with 3 mutual funds

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En español | I've long argued that investing is simple, and that you only need a portfolio of a few diversified, low-cost index funds. But simple doesn't always mean easy. I'll confess that my own portfolio sometimes violates the simplicity I advocate. Investing using the KISS principle (Keep It Simple, Stupid) is hard.

Fifteen years ago, I taught my son how to invest using just three index funds. (Index funds simply track a well-known index, such as the Standard & Poor's 500.) Called the Second Grader's Starter portfolio, it became one of the eight Dow Jones MarketWatch Lazy portfolios. It's currently occupying first place and besting other portfolios created by brilliant investors, including Yale University's David Swensen.

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Use 3 kinds of index funds for a simple portfolio:

  • A total U.S. stock index fund
  • A total international stock index fund
  • A total bond fund

You can weight these however you want, but a moderately risky portfolio could be 40 percent U.S. stocks, 20 percent international stocks and 40 percent bonds. Later in life, you many want less in the way of stocks. Either way, I recommend rebalancing to keep a relatively constant amount of risk. When you rebalance, you put your portfolio back to its intended allocation. For example, if, after a few years, the above portfolio were 70 percent U.S. stocks, 20 percent international stocks and 10 percent bonds, you'd move enough out of your stock funds to get your bond fund back to 40 percent of your portfolio.

With these funds, my son owned virtually every publicly held company on the planet, as well as an approximation of nearly every investment-grade taxable bond in the U.S. He got a high-performance portfolio. Nobel laureate William Sharpe, in his paper The Arithmetic of Active Management, proved that owning the entire market at the lowest cost must beat the majority of investors.

Owning even one other stock fund will actually decrease diversification, since it will be making specific bets on different types of companies. In fact, the portfolio can arguably be simpler with a two-fund portfolio where the U.S. and international stock funds are replaced by a total world stock index fund.

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Over the years, I've benchmarked hundreds of portfolios against similarly weighted three-fund portfolios and can count on one hand the number of portfolios I've seen that bested this benchmark. Most fall short by far more than expenses can explain.

If data dictates that simple trumps complex, why do we build more complex portfolios? Let's review the four reasons:

1. The human brain. Our brains are wired to find patterns and develop order out of randomness. Jason Zweig's book Your Money and Your Brain shows that our emotions, not our brains, are often in control. The desire to find the next hot stock to make a killing — and the release of dopamine you get from the chase — isn't all that different than an addiction to drugs. I have a gambling portfolio whose purpose is admittedly to satisfy my addiction to predictions of outperformance.

2. The financial services industry. People in the investment industry have an incentive to create complexity. The industry makes billions of dollars in advisory fees, and it would be pretty hard to charge much for simplicity.

3. The media. I love watching CNBC and other investment TV shows, as they are very entertaining. The logic from the gurus is incredibly compelling and really fires my neurons to both grow and protect my money. I want to know what the market is going to do and what to invest in. Unfortunately, there is overwhelming evidence it doesn't work. In fact, given the horrible economic events in 2020 and the U.S. stock market clocking in a 21 percent gain, I can't even explain the past.

Investing, if you're doing it right, just isn't very exciting. If I hosted a weekly TV show, Episode 1 would say, “Own the whole market at the lowest costs and rebalance.” The next 99 episodes would be the same — and nobody would watch it, including me.

As economist and Nobel laureate Paul Samuelson said, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas."

4. Taxes. None of the three total index funds existed when I started investing, and I suspect they didn't when you started. But in a taxable account, we'd likely have to recognize some pretty hefty taxes to sell the more expensive and less diversified holdings. There usually are no tax ramifications to selling and simplifying within our traditional and Roth IRAs, 401(k)s and other tax-advantaged accounts.

I think simple is nearly always better when it comes to investing (and most things in life), so my advice is to simplify as much as possible, keeping diversification high and expenses low. In addition to likely higher returns going forward, it also helps protect against the possibility of cognitive decline later in life. After all, the more complex a portfolio, the easier it is to make mistakes.

Get your excitement from life, not investing.

Allan Roth is a practicing financial planner who has taught finance and behavioral finance at three universities and has written for national publications including The Wall Street Journal. Despite his many credentials (CFP, CPA, MBA), he remains confident that he can still keep investing simple.

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