Don't Be Too Simple

by: The Barnacle

Summary

Indexing as a part of a portfolio strategy is very popular.

While I am not a fan of indexing, I do understand that people want that to save money on fees.

Having said that, it is important to understand that one still needs a properly diversified portfolio to meet their income needs for retirement.

(Source: Free Digital Photos)

Introduction

I recently read Carl Richards’ book, “The One-Page Financial Plan,” as part of my summer reading. It was an easy read, and one I wish I had read when I was still in the business. As a short synopsis, Richards proposes developing a simplified plan for reaching one’s goals. In a nutshell, it looks like:

  • Write down your goals
  • Develop your plan
  • Adjust your plan or goals as needed

He emphasizes the simplicity of this process by using cocktail napkins for his graphics to drive home the point of making sure we don’t overcomplicate the process.

When it comes to investing, Richards proposes a basic approach to allocation:

  • 18% - Vanguard Total International Stock Index Fund (MUT: VGTSX)
  • 42% - Vanguard Total Stock Market Index Fund (MUT: VTSMX)
  • 40% - Vanguard Total Bond Market Index Fund (MUT: VBMFX)

While this approach satisfies the traditional 60/40 approach one hears about so often, I feel that it falls short of meeting one’s financial goals. Why? It is not diversified enough.

The Problem with Vanguard

I understand why investors like indexed mutual funds and ETFs. Their simplicity and low costs are and should be appealing to investors. Me personally, I am not a fan, but that is my choice. Having said that, there is a hidden problem in Richards’ recommended portfolio. It is too over weighted in large-cap stocks.

First, 76% the stock mutual funds’ allocations are invested in large-cap stocks. Meanwhile, only 17.8% of the two funds are invested in medium sized companies. That means over 40% of the portfolio is invested in big companies. If one has read my earlier piece on mid-cap investing, that does not work for me. Why does this make a difference? Here is an illustration to make a point.

Let’s assume one had a $1 million portfolio on January 1, 2000, and they decided to invest the entire sum of money in the S&P 500. After that, they with draw an initial $40,000 per year with an annual increase of 3% for inflation. If they had done such a thing, they would have run out of money before the end of 2016. Obviously, a disastrous result that no retiree wants to face.

(Source: Morningstar)

Of course, one should never suggest investing all of one’s retirement money in the S&P 500. As one should see, and remember, two major market crashes can have a devastating effect on one’s retirement goals. Now compare this to a retiree who invested their entire savings in the S&P Midcap 400 index.

(Source: Morningstar)

As one can see, not only did our investor have more than enough money to provide for rising income needs, their portfolio tripled to $2.953 million. This illustration alone should provide enough evidence that one should include more midcap stocks in their allocations than what is normally recommended or used in indexed funds.

The Effects of Proper Allocation

With this information in mind, let’s see how different allocations effect portfolio values as distributions occur. Here is the illustration for the One-Page Financial Plan Portfolio

(Source: Morningstar)

With $892,111 left in the portfolio, there is plenty of money left in portfolio to cover the needed $68,000 for our retiree. It is an approach that can work over a volatile 18-year period such as the markets faced this century. However, I would like to propose a different approach, and it will look like this.

(Source: The Barnacle)

As one can see, there are six distinctive boats for these investments, and all of them are indexed. Our $1 million portfolio will now be invested using this approach, and rebalanced annually, just as all portfolios should be.

(Source: Morningstar)

The results from this portfolio are a lot more pleasing. First, our retiree can meet their income needs quite comfortably. Even after 2008, the portfolio value was $993,555; almost equal to their initial principal. 17 ½ years later, the portfolio is valued at $1.58 million, so there is room for growth to go along with the theoretical margin of safety.

My Take

For full disclosure, here is how each asset class performed since January 2000 through June 2018. Remember, this assumes monthly withdrawals starting at a 4% annual rate with an annual 3% increase for inflation.

Asset Class

Annualized Growth

June 2018 Value

Barclay Capital US Aggregate Bond Index

5.40%

$1,083,668

S&P 500 Index

-1.99%

$ 0

S&P MidCap 400

9.38%

$2,953,700

S&P SmallCap 600

9.97%

$3,364,609

S&P Global Ex US LargeMid Index

2.91%

$ 457,128

S&P Global Ex US Small Index

7.00%

$1,678,041

One needs to remember, if they are going to withdraw 4% of their initial investment, and increase those withdrawals 3% every year, they will need to grow their investment 4.3% to maintain their initial principal. Because the S&P 500 had four years of corrections greater than 10% in 2000, 2001, 2002, and 2008, it became impossible to protect the principal from that kind of damage.

There is too much conversation about the S&P 500 when it comes to equity investing. I fully understand that the large-cap index makes up 70% of the overall market, however, it underperformed every class listed above. It is time to stop allowing this index to be the center ship of our raft of boats. The data is overwhelming; one should allocate more money toward mid-caps and small-caps in their investing strategy.

Disclosures

Here are some disclosures. Please pay attention to the last one.

  • Past performance is not an indicator of future performance.
  • This post is illustrative and educational and is not a specific offer of products or services.
  • Information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein.
  • Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed.
  • All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change.
  • Investments in individual sectors or companies may be more volatile than investments that diversify across many industry sectors and companies.
  • Certain sectors of the market may expose an investor to more risk than others.
  • Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses.

Good luck out there.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.