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The World’s Simplest Portfolio? – Take Two

May 09, 2011 4:12 AM ETVTI, BND2 Comments
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Seeking Alpha Analyst Since 2011

Mr. Mueller has more than 15 years of extensive experience in trading and investment management. He worked on the floor of the Pacific Coast Options Exchange (now the NYSE/ARCA Options Exchange), as a professional trader off-floor of the exchange, as a futures and commodities broker, and as a financial planner and portfolio manager.
I am not the first to coin the term or idea. I read about Charles Ellis’s idea of a two fund (stock and bond) portfolio last year. I was fascinated with its simplicity and very low expense. However, I have some disagreements on structure and allocation.
In an effort to design a simple, low-cost portfolio that any investor can implement, I have designed a two mutual fund portfolio named NUCLEUS using the Vanguard Total Stock Market Index Fund and the Vanguard Total Bond Market Index fund (their equivalent ETFs may be used instead).
The first difference between Ellis’s portfolio and NUCLEUS is with structure. He advocates investing the stock portion in the Vanguard Total World Stock Market Index fund, which has a heavier concentration in foreign stocks. NUCLEUS’s stock portion is invested in the Vanguard Total Stock Market Index fund, which is US only. There are several reasons I have purposefully selected the US Total Stock Fund over the World Stock Fund:
  1. The Total US Stock Fund has direct and indirect exposure to foreign markets via multinational companies.
  2. US companies are required to use uniform accounting standards in reporting their financial statements. Even so, it can be difficult in deciphering US companies’ financial reports. Foreign companies are held to other standards, and some aren’t held to any standard. Therefore, because of that additional uncertainty, I exclude analyzing foreign stocks.
  3. By eliminating direct investment in foreign assets, we avoid direct political risk, foreign economic risk, sovereign debt risk, transfer risk (the risk of capital being locked up or frozen by government action), and liquidity risk.
The second difference pertains to allocation. Ellis provides a general portfolio allocation by age, ranging from 100% stocks for those under 40 years old to 50% stocks/50% bonds between ages 70-80. I believe there are fundamental issues with stock/bond allocation rules by age, target-date portfolios and set-it-and-forget-it portfolios. One principle issue being investor’s perceived risk tolerance and actual risk tolerance. When markets go up, all are happy. When they go down, it becomes a much different story. Another principle issue has to do with market value and timing. No, I’m not suggesting anyone can time the market. However, using market valuation as a factor in determining stock allocation and risk may keep a portfolio from suffering a risk of ruin, particularly those investors who are in the withdrawal phase. It also may allow those who are more prone to abort their portfolio allocation during times of crisis to stick with the plan. If anything, it permits buying more stocks as they become relatively cheaper and selling more stocks as they become more expensive.
The NUCLEUS Portfolio
The NUCLEUS portfolio is comprised of the Vanguard Total Stock Market Index fund and the Vanguard Total Bond Market Index fund (or you may use VTI and BND – their ETF equivalents). The allocation is dynamically driven by analyzing current stock market value – an approach I call adaptively-passive. Allocations will range from 10% Stocks / 90% Bonds to 70% Stocks / 30% Bonds. NUCLEUS will never be completely out of the stock or bond market, or completely in. These allocation ranges are not a means of attempting to time the market. I do not attempt to forecast the future of the market. However, when the stock market becomes relatively more expensive, the potential downside risks become more prominent. Therefore, the allocation ranges are a means of risk acceptance.
Based on current analysis, the allocation is 30% Stocks / 70% Bonds. The blended expense ratio using VTSMX and VBMFX is 0.20%. Using VTI and BND, the blended expense ratio drops to 0.11%.
NUCLEUS Portfolio Performance
NUCLEUS’s inception date is 05/1992, the earliest common date for both the Vanguard Total Stock Market Fund and Vanguard Total Bond Market Fund, and hypothetically started with $100,000. Performance data is tracked through Morningstar and includes reinvested dividends and capital gains, but does not include transaction costs or taxes.
NUCLEUS Portfolio Performance
Please remember, past performance does not guarantee future results and investing always carries risk.
The aim is provide investors with a means of investing for slow, steady growth. The analysis steered the NUCLEUS portfolio more into bonds before the ‘07 Great Recession really took hold. While the NUCLEUS portfolio had a -2.81% return for 2008, it fared much better than many blended or stock only portfolios. In almost 20 years, it has had only 2 losing years - the other being 1994 with a -1.77% loss. The largest gaining year was 1995 with a 21.44% gain.
Later, I plan to introduce a couple satellites for use in conjunction with the NUCLEUS portfolio.
Disclosure: I have no positions with any of the investments contained in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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