Build a Lazy Portfolio – Dividend Power

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Build a Lazy Portfolio – Dividend Power


Last Updated on December 10, 2021 by Dividend Power

Build a Lazy Portfolio. The KISS principle applies to many things in life, and managing your retirement portfolio is one such thing. A retirement portfolio should be simple, permitting an investor to be lazy. Most investors do not want to continuously monitor their retirement portfolio and make changes. This activity would become a full-time job akin to day trading and introduce needless complexity. Instead, investors should periodically check their retirement portfolios. However, this is not a daily or weekly activity but a bi-annual or annual activity. It’s quite easy to check the asset allocation, rebalance and wait for the next six or 12 months to check again. 

But how does an investor get to this point, where a retirement account performs decently in up or down markets with less volatility and thus less worry. In this case, an investor follows a buy-and-hold investment strategy, and the portfolio is essentially on autopilot. Investors should consider a lazy portfolio that has stood the test of time.

Build a Lazy Portfolio

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What is a Lazy Portfolio?

A lazy portfolio is a basket of funds that take little effort to maintain. They are typically compromised of a handful of passive index funds, either mutual funds or exchange-traded funds (ETFs). Lazy portfolios commonly own stocks, bonds, real estate investment trusts (REITs), gold, and other assets. The basic lazy portfolios are comprised of two funds, three funds, or four funds, but some contain more. 

The fundamental difference between the portfolios is the number of funds and asset allocations. For example, an investor desiring a three-fund portfolio can choose the basic Bogleheads 3 Fund Portfolio, the Margarita Portfolio, or other variations.

An investor does not need to buy and sell often when managing a lazy portfolio. This fact points to one of the primary benefits, simplicity. An investor only needs to set the asset allocation and periodically rebalance it to return the lazy portfolio to the target asset allocation. 

Index Funds are the Building Blocks

By using index funds, an investor takes advantage of the pros of a lazy portfolio, including diversification, low expense ratios, and low portfolio turnover. 

Index funds are inherently diversified since they own a basket of stocks. For example, the Vanguard Total Stock Market ETF (VTI) or its mutual fund counterpart, the Vanguard Total Stock Market Index Fund (VTSMX), owns almost all the stocks in the CRSP US Total Market Index. The two funds own more than 4,100 stocks.

Passively managed index funds are low-cost. The expense ratios are usually less than 0.20%. This fact means that an investor captures almost the complete total return of the index fund without a significant cost drag. In addition, investors should know that expense ratios affect returns. Empirical research shows a correlation between expense ratios and total returns. Funds with higher expense ratios have lower excess returns. It is worth quoting John Bogle, the father of passive index investing and founder of Vanguard about fund expense ratios at this point

First, in investing, realize that you get what you don’t pay for. Whatever future returns the markets are generous enough to deliver, few investors will succeed in capturing 100% of those returns simply because of the high costs of investing—all those commissions, management fees, investment expenses, yes, even taxes—so pare them to the bone.

Lastly, passive index funds usually have a low turnover ratio. Turnover ratio is the percentage of a fund’s holdings that are replaced in the past year. Funds with a high turnover ratio engage in more trading, resulting in higher costs and taxes. On the other hand, a low turnover ratio means that the fund probably follows a buy-and-hold strategy and thus does not have significant trading costs. It also means that the fund does not have capital gains distributions and associated taxes. For instance, the Vanguard Total Stock Market ETF has an expense ratio of 0.03%, while the Vanguard Total Stock Market Index Fund has an expense ratio of 0.14%. On the other hand, actively managed mutual funds had on average a 1.08% ER in 2019.

Rebalancing is Part of the Strategy

A lazy portfolio strategy required periodic rebalancing. However, some investors question whether rebalancing is necessary at all? John Bogle did not think you needed to rebalance. The reason is that stocks outperform bonds and cash over time. If stocks are the higher returning asset and an investor periodically rebalances into lower-performing assets, total returns will be lower. It is again worth quoting Bogle about rebalancing here:

I am in a small minority on the idea of rebalancing. I don’t think you need to do it. The data bear me out because the higher-yielding asset is going to be stocks over the long term. That’s the way the capital markets work, not in every 10-year period, or even for that matter, every 25-year period. But the higher-returning asset you’re getting rid of goes into a lower-returning asset, so it dampens your returns, and the differences turn out to be if you look at 25-year periods, very, very small. And sometimes, rebalancing improves your returns. Sometimes it makes them worse.

However, rebalancing is an inherent part of the lazy portfolio strategy. It reduces risk by maintaining the target asset allocation and volatility in many cases. For example, stocks tend to have higher volatility than bonds and cash. If market action causes the percentage of stocks to go up relative to other asset classes, portfolio volatility will also rise. Rebalancing will bring your lazy portfolio back to the target asset allocation.

The longer an investor waits to rebalance the greater the possible deviation from target asset allocation due to market action. A recent article on Morningstar illustrated this point. For example, a 60% stock / 40% bond portfolio that has not been rebalanced in five years is no about 73% stocks / 27% bonds. This result is expected since stocks have outperformed bonds in the past five years.

Two Rebalancing Strategies

There are two strategies for rebalancing that are relatively simple to follow. The first strategy is time-based. To hit the target asset allocation, an investor would rebalance holdings at a periodic interval, such as once per year. The second strategy is variance-based. For example, an investor can rebalance when the asset allocation deviates from the target percentages by a fixed amount, e.g., 5%.

In either case, an investor would sell overweight holdings and use the proceeds to buy underweight holdings. This process is simple in a tax-advantaged retirement accounts, such as a 401(k) or Individual Retirement Account (IRA). Selling an overweight asset and buying an underweight asset has no tax implications.

Alternatively, an investor can direct new money to underweight holdings until the target asset allocation is achieved. This process is suitable for both tax-advantaged and is preferred for taxable accounts. Remember, buying and selling assets in a taxable account will result in realized capital-gains or losses.

Risks of a Lazy Portfolio

All investing strategies have risks, and lazy portfolios are no exception. The primary risk is that an investor’s lazy portfolio does not perform as expected. This risk is a real risk since one investor’s best choice of a lazy portfolio may not be the favorite of the next investor. All investing strategies underperform at some time and often for long periods. An investor who becomes disenchanted with his or her lazy portfolio and asset allocation may start tinkering, resulting in even worse returns.

How to Build a Lazy Portfolio

Today, investors do not need to build a lazy portfolio from scratch since there are many to choose from. Instead, investors and mutual fund companies have created an assortment of lazy portfolios. Most but not all the portfolio choices are conservative. 

The simplest way for an investor to create a lazy portfolio is to pick one of the existing ones. Most mutual fund companies offer index funds, and it is just a matter of setting the asset allocation. Subsequently, invest a certain amount each month and rebalance once per year.

Which is the Best Lazy Portfolio?

Investors invariably ask which is the best lazy portfolio? The answer to that question is that it depends. For example, the best for one investor may be a lazy portfolio with high expected returns, while the best for another investor can be one with low volatility. In addition, investors must take into account several considerations, including current age, planned retirement age, risk tolerance, diversification, expenses, number of desired funds, and other criteria.

The following list is some of the most popular lazy portfolios.

1. Bogleheads 3 Fund Portfolio

One of the oldest and most popular lazy portfolios is the Bogleheads 3 Fund portfolio. This portfolio was created by one of the original Bogleheads, Taylor Larimore. The portfolio comprises three total market index funds: a US stock market fund, an international stock market fund, and the US taxable investment-grade bond market fund. The primary idea is that an investor should own the three most important asset classes.

The table below shows an example of the Bogleheads 3 Fund Portfolio assuming an overall 60% stock / 40% bond asset allocation. The stock allocation is split between US and international stocks. Historically, the funds have been selected from Vanguard’s many passive index funds. However, today, investors can choose index funds from any large asset manager. 

Weighting Asset Class
40% Total Stock Market Index Fund
20% Total International Stock Market Index Fund
40% Total Bond Market Index Fund

For example, the fund choices would be the Vanguard Total Stock Market Index Fund (VTSMX), the Vanguard Total International Stock Market Index Fund (VGTSX), and the Vanguard Total Bond Market Index Fund (VBMFX). 

An investor preferring Fidelity, the fund choices would be the Fidelity Total Market Index Fund (FSKAX), the Fidelity Total International Index Fund (FTIHX), and the Fidelity US Bond Index Fund (FXNAX). 

Finally, for an investor preferring Schwab, the fund choices would be the Schwab Total Stock Market Index Fund (SWTSX), the Schwab International Index Fund (SWISX), and the Schwab US Aggregate Bond Index Fund (SWAGX).

Changing the Bond Fund

There are different versions of the Bogleheads 3 Fund Portfolio that differ in asset allocation or choice of a bond fund. For instance, investors desiring higher yields can substitute an investment-grade corporate bond fund, such as the Vanguard Intermediate-Term Investment-Grade Fund (VFICX), for the Total Bond Market Index Fund.

Weighting Asset Class
40% Total Stock Market Index Fund
20% Total International Stock Market Index Fund
40% Intermediate-Term Investment-Grade Fund

Margarita Portfolio

Similarly, the Margarita Portfolio advocated by Scott Burns substitutes a Treasury Inflation-Protected Securities (TIPS) fund, e.g., Vanguard Inflation-Protected Securities Fund (VIPSX), for the Total Bond Market Index Fund. This switch provides an investor inflation protection—the asset allocation changes to an approximately equal weighting between the three funds.

Weighting Asset Class
34% Total Stock Market Index Fund
33% Total International Stock Market Index Fund
33% Treasury Inflation-Protected Securities (TIPS)

Using an S&P 500 Index Fund

Some investors prefer to use an S&P 500 Index Fund instead of a Total Stock Market Index Fund. However, there is very little difference in CAGR, volatility, or maximum drawdown between the two funds since large-cap stocks in the S&P 500 index also have a significant presence in the total stock market index.

Weighting Asset Class
40% S&P 500 Index Fund
20% Total International Stock Market Index Fund
40% Total Bond Market Index Fund

More Stock Exposure

Another version of the Bogleheads 3 Fund Portfolio changes the asset allocation increasing exposure to US and international stocks while reducing exposure to US bonds. This version of the Bogleheads 3 Fund Portfolio allocates 80% to equities and 20% to bonds. However, the changes make the lazy portfolio more volatile.

Weighting Asset Class
50% Total Stock Market Index Fund
30% Total International Stock Market Index Fund
20% Total Bond Market Index Fund

Ultimately, most three fund lazy portfolios are simply versions of the primary 40% / 20%/ 40% Bogleheads 3 Fund Portfolio with changes in fund choice, asset allocation, or both.

Performance

The Bogleheads 3 Fund Portfolio is backtested from July 2000 to November 2021 using Vanguard fund regular class shares. The Admiral class shares did not exist for some funds back to 2000, but the backtest results should be similar. This analysis compares three versions of the 3 Fund Portfolio with the Vanguard Balanced Index Fund (VBINX) as the benchmark. This balanced fund consists of approximately 60% equity and the remaining bonds with a small amount of cash.

In the analysis, we invest $10,000 and assume the portfolios are rebalanced annually. We focus on the compound annual growth rate (CAGR), standard deviation, and maximum drawdown numbers. 

Example 1

In the first analysis, we include three versions of the Bogleheads 3 Fund Portfolio in this comparison. Portfolio 1 is the baseline; in portfolio 2, we change the bond fund to an intermediate-term investment-grade one. Finally, in portfolio 3 (Margarita), we switch the bond fund to a TIPS fund and modify the asset allocation.

Source: Portfolio Visualizer
Source: Portfolio Visualizer

Substituting an intermediate-term investment grade for the total bond index fund in portfolio 2 improves CAGR at the expense of higher volatility (as measured by standard deviation). Additionally, portfolio 2 has a more significant maximum drawdown than portfolio 1. This change occurs because corporate bonds are more volatile than US Treasuries or agency Mortgage-Backed Securities (MBS). There is no change in the Sharpe ratio, meaning risk-adjusted returns are the same.

Switching the bond fund to a TIPS fund and increasing exposure to international stocks in portfolio 3 (Margarita) increases volatility with the highest maximum drawdown and a lower Sharpe Ratio. This difference occurs because international stocks funds have been more volatile than US stock funds in the past 20-years.

However, the benchmark performs the best with the second-lowest volatility and smallest maximum drawdown since an international fund is not included. The benchmark also has the highest Sharpe ratio. The benchmark also performs the best during bear markets with lower drawdowns.

Source: Portfolio Visualizer
Example 2

In the second analysis, we include two more versions of the Bogleheads 3 Fund Portfolio in this comparison. Portfolio 1 is the baseline; in portfolio 2, we change the asset allocation to increase the weightings of the US and international stocks while reducing bonds (80% equity / 20%  bond), and in portfolio 3, we change the total stock market fund to an S&P 500 Index fund.

Source: Portfolio Visualizer
Source: Portfolio Visualizer

Changing the asset allocation in portfolio 2 to a higher weighting for the Total Stock Market Index Fund and the Total International Stock Index Fund and a lower weighting for the Total Bong Market Index Fund does not significantly improve returns. However, volatility increases and the Sharpe Ratio comes down, meaning that risk rises, compared to portfolio 1 and the benchmark. However, this result is expected since stocks are more volatile than bonds. Another negative is that the maximum drawdown is significantly greater. Furthermore, the performance during bear markets is generally worse than portfolio 1 and the benchmark.

Substituting an S&P 500 Index fund for the Total Stock Market Index Fund results in slightly worse returns but lower volatility compared to portfolio 1. There is no change in the Sharpe Ratio and a slight difference in the maximum drawdown or bear market performance. This result is expected because of the presence of almost the same mega-cap and large-cap stocks in both indices.

Interestingly, the best-performing lazy portfolio is again the benchmark. The Vanguard Balanced Index fund has the highest returns and the second-lowest volatility. The risk-adjusted returns are also the highest. Additionally, the maximum drawdown is the lowest, and the performance during bear markets is good. Arguably, an investor can just choose the benchmark fund as their lazy portfolio.

Source: Portfolio Visualizer

2. Coffeehouse Investor Portfolio

Another popular lazy portfolio is Bill Schulteis’ Coffeehouse Investor Portfolio. Bill Shulteis was an early advocate of using passive index funds to build a retirement portfolio. He wrote a book called “The Coffeehouse Investor’s Ground Rules: Save, Invest and Plan for a Life of Wealth and Happiness,” published about 23 years ago in 1998. 

This Coffeehouse Investor Portfolio became popular during the dot-com crash due to its better performance than the S&P 500 and a balanced portfolio of 60% stocks / 40% bonds. The main reason for this outperformance was more emphasis on small-cap stocks and REITs and less on large-cap and international stocks.

The portfolio consists of seven index funds, a greater number than in most lazy portfolios. The Coffeehouse Investor Portfolio achieves this by dividing the equity component of the 60% equity / 40% bond into 10% increments. In addition, this lazy portfolio has a lower weighting of international stocks and adds REITs to the mix.

Weighting Asset Class
10% US Large Cap Equities
10% US Large Cap Value
10% US Small Cap
10% US Small Cap Growth
10% International Equities (ex-US)
10% REITs
40% US Total Bond

The advantage of this portfolio is it has performed well during most bear markets, especially the dot-com crash, due to the value tilt, small-cap weightings, and the presence of REITs. However, the Coffeehouse Investor Portfolio is not foolproof. For example, REITs caused headwinds on total returns during both the sub-prime mortgage crisis and the COVID-19 pandemic bear market.

Performance

The Coffeehouse Investor Portfolio is back tested using Vanguard fund regular class shares from July 2000 to November 2021. The Admiral class shares did not exist for some funds, but the backtest results should be similar. This analysis compares the Coffeehouse Investor Portfolio with the 40% / 20% / 40% Boglehead 3 Fund Portfolio and the Vanguard Balanced Index Fund (VBINX) as the benchmark. This balanced fund consists of approximately 60% equity, and the remainder is in bonds with a small amount of cash.

In the analysis, we invest $10,000 and assume the portfolios are rebalanced annually. We focus on the compound annual growth rate (CAGR), standard deviation, and maximum drawdown numbers. 

In this analysis, portfolio 1 is the Coffeehouse Investor Portfolio and portfolio 2 is the 40% / 20% / 40% Boglehead 3 Fund Portfolio.

Source: Portfolio Visualizer
Source: Portfolio Visualizer

In the comparison, the Coffeehouse Investor Portfolio is the hands-down winner for returns. This point is caused by the lower weighting of international stocks, which have performed relatively poorly compared to US stocks in the backtest period. In addition, the volatility and maximum drawdown are slightly greater than the Bogleheads 3 Fund Portfolio. This fact occurs due to the addition of small-cap stocks and REITs. However, the Sharpe Ratio is much higher, indicating that the risk-adjusted returns are better. Moreover, the Coffeehouse Investor Portfolio performs better than the benchmark on a risk-adjusted basis.

The Coffeehouse Investor Portfolio has a mixed performance during bear markets. It performed exceptionally well during the dot-com crash due to the inclusion of small-cap stocks and REITs. However, REITs hurt this lazy portfolio’s performance during the sub-prime mortgage crisis and the COVID-19 pandemic. This result is not surprising due to REITs cutting, suspending, or omitting dividends causing a sharp drop in stock prices.

Source: Portfolio Visualizer

3. Permanent Portfolio

Another popular lazy portfolio is Harry Browne’s Permanent Portfolio. This choice is a simple lazy portfolio with four equally weighted asset classes. There is a mutual fund company by the same name as the portfolio. The promoter of the Permanent Portfolio is Harry Browne of the Permanent Portfolio Family of Funds. The mutual fund was first created in 1982. Harry Browne later expanded on the Permanent Portfolio concept in his 1999 book “Fail-Safe Investing.” The mutual fund still exists but is more complex than the original concept. It now includes bonds, gold and silver, growth stocks, cash in Swiss francs, and energy, mining, and real estate stocks.

The Permanent Portfolio is different than most other four fund portfolios. It includes a more significant weighting of cash and gold than most investors may like. The reason is that the Permanent Portfolio is designed as an all-weather portfolio to perform well in up and down markets. It is for this reason that this lazy portfolio includes cash and gold. In addition, the portfolio is designed to mitigate volatility and significant drawdowns during bear markets.

Weighting Asset Class
25% US Stocks
25% US Treasury Long-Term Bonds
25% Cash
25% Gold

This lazy portfolio’s relative performance is the best during times of economic duress. Investors tend to move to cash and gold while exiting stocks, high-yield bonds, and other riskier asset classes. Cash and gold are often viewed as a safe haven.

The Permanent Portfolio did not perform as well as stocks and bonds during the 1990s due to the decline in gold prices. However, the portfolio’s merit was demonstrated during the dot-com crash and through the sub-prime mortgage crisis. More recently, the Permanent Portfolio has not performed as well on a relative basis due to the decade-long bull market in stocks.

Performance

The Permanent Portfolio is back tested from December 2004 to November 2021 using ETFs, making it easier to invest in gold. Additionally, the standard gold ETF, SPDR Gold Shares (GLD), history only goes back to late-2004. We use iShares Treasury Bond ETFs since they have a long history. Several short-term T-bill ETFs now exist, but they have a short history.

This analysis compares the Permanent Portfolio with the 40% / 20% / 40% Boglehead 3 Fund Portfolio and the Vanguard Balanced Index Fund (VBINX) as the benchmark. This balanced fund consists of approximately 60% equity and the remainder in bonds with a small amount of cash.

In the analysis, we invest $10,000 and assume the portfolios are rebalanced annually. We focus on the compound annual growth rate (CAGR), standard deviation, and maximum drawdown numbers.

Source: Portfolio Visualizer
Source: Portfolio Visualizer

In this evaluation, the Permanent Portfolio has better returns than the Bogleheads 3 Fund Portfolio but is not as good as the benchmark. However, the Permanent Portfolio is less volatile and has significantly smaller maximum drawdowns. Hence, the Sharpe Ratio is much higher. The return graph shows that the Permanent Portfolio performed well on a relative basis from the sub-prime mortgage crisis until about 2018. This difference was due to the gold tilt, which performed well during this time. Since 2018, the bull market in stocks has caused the lazy portfolio to lag.

The bottom line is that the Permanent Portfolio smoothed out volatility and drawdowns over time. Although the returns are not as good as the benchmark, it beats the benchmark on a risk-adjusted basis.

The Permanent Portfolio performs well during bear markets as it was designed to do. This lazy portfolio performed exceptionally well during the sub-prime mortgage crisis and the COVID-19 pandemic. The difference between the Permanent Portfolio, the Bogleheads 3 Fund Portfolio, and the benchmark during bear markets is apparent.

Source: Portfolio Visualizer

The Permanent Portfolio is an option for investors seeking to minimize volatility and bear market drawdowns. However, most retirement plans do not offer a gold fund making it challenging to replicate. An investor could buy a share of the eponymous mutual fund, but the expense ratio is high at 0.83%, making it unattractive.

Final Thoughts on Build a Lazy Portfolio

For retirement portfolios, passive index investing has become the norm. This point is demonstrated by the high net flows of money to the two index fund leaders, privately-held Vanguard Group and BlackRock (BLK). Lazy portfolios take the concept of index investing even further by removing complexity and simplifying the investing choices and process. There exist a multitude of lazy portfolios. An investor only needs to select one, periodically invest, and rebalance annually. A lazy portfolio is a good choice for those saving for retirement. However, it is essential to understand that not all lazy portfolios are equal or perform equally. This growing list of lazy portfolios is a good place for investors to understand the pros, cons, and differences.

Disclosure: Long some of the funds discussed and BLK

Thanks for reading Build a Lazy Portfolio!

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