Last Updated on 27 January 2021 by F.R.Costa

Do you know you can build a diversified portfolio on your own, for cheap and then easily add more funds into it over time, keep it for decades and beat most actively managed funds? All you need is two assets.

Don’t expect your broker or bank to advise you a strategy like this one because it isn’t profitable for them. After all, the industry lives from your transaction costs and buying two assets while keeping them for decades is certainly not the kind of commission most providers are looking for. Still, I believe no one should be scared with the stock market. All it takes to be successful is to set goals, identify opportunities and limitations, and understand the risks.

You don’t need to know much about finance and investment to manage your own savings pot, as long as you don’t attempt to beat the market, but instead accept market returns as being good enough.

In jargon, you should act as a passive investor, instead of trying to time the market and hand pick stocks. Not that selecting only those stocks with better characteristics would hurt your portfolio; but if you know nothing about it, following your instincts would tie any extra performance with pure chance. After all, there’s no need to be greedy, as the S&P 500 has returned something around 10% on average since its inception in 1926 and through 2018.

Getting Started

First of all, we need to identify the purpose of investing. For the sake of speculating in the market to achieve high returns in short time spans, this article doesn’t help. Sorry!

Speculation is fine, but I’m going to centre my focus today on someone willing to put aside money for the future and eventually add to that pot every month or, at least, from time to time. Keeping your money at the bank doesn’t work anymore, as interest rates are so low that banks may start charging for the privilege of borrowing from you. Some governments already have such privilege

Hence, in the perspective of a saver who puts money aside today in order to purchase more things in the future and keeping in mind things are ever more expensive, you do need your money to appreciate over time. What you need is a return on your investment that surpasses the price rise. Eventually, something more than that! In order to accomplish your goal, you’re willing to risk your money. For a risk-free investment you need to place all your savings in fixed income. And to be risk-free, you would need to place the money in the highest rated bonds. But, an all-bonds portfolio usually underperforms over long-periods of time. It may happen that the accumulated return is not enough to pay for the rise in prices.

So, let’s accept some risk. Bonds are great when the market declines and inflation is under sight, but for the sake of keeping the money invested over a decade or two (if not more), we need part of our money to be tied to stocks. We need to diversify across stocks and bonds.

The most common diversified portfolio, holds 60% in stocks and 40% in bonds. This is usually referred to as the 60/40 stock-bond portfolio. But, a 80/20 and a 40/60 alternatives are equally possible. It all depends on your own preferences and attitude towards risk. Negative allocations are also possible, as long as there is someone willing to lend or borrow from you. For example, if your risk tolerance is great, the perfect portfolio could be a 150/-50 stock-bond holding. Let’s say you have £100,000. You borrow £50,000 and invest £150,000 in stocks. A long holding of a bond represents lending while a short holding represents borrowing. Hence, in this case, you would be selling short £50,000 in bonds or borrowing the money directly from your bank or broker. That explains the -50 holding.

The exact allocation between stocks and bonds cannot be discussed here in generic terms because each case is a different case. You should find advice for your particular situation. Still, the 60/40 allocation is the most common.

Building a Diversified Portfolio

We just jumped over the first hurdle of deciding on the proper allocation between stocks and bonds (hopefully!!). But there is a much bigger problem still open. Which stocks are we going to buy? And how many?

Those questions may be asked for the bond part of the portfolio too.

In order to build a properly diversified portfolio we need a few stocks, not just one. In fact, not even a few is enough. In the Markowitz Modern Portfolio Theory, later complemented with the Capital Asset Pricing Model (CAPM), a diversified portfolio corresponds to the total market. Theory states that a diversified portfolio is a combination of a proxy for the total market with some other proxy for the risk-free asset.

The total U.S. market is composed by a few thousands of stocks. That’s not good news for you and other investors. You eventually don’t have the time to purchase 50 stocks, let alone 5,000. And what about the trading costs associated with such a big fragmented purchase? If minimum fees apply, your money vanishes before hitting a hundred stocks.

There is one additional issue. You want to add savings into the pot every month. How would it be possible to split one-month savings in 5,000 parts?

ETFs To The Rescue

What you need is to find someone willing to sell you a share of the broad market. Someone that purchases the 5,000 stocks in the right proportions and then sells you a share on his portfolio. That’s where Exchange-Traded Funds (ETFs) come handy. Some institutional investors build portfolios that mirror the performance of an index to then market them in fractions to investors. For our investment case, we need a share on the broad equity market and a share on the risk-free rate or bond market.

The Vanguard Total Stock Market ETF (NYSE:VTI) offers broad exposure to the U.S. equity market, currently holding more than 1,500 stocks. While the broad market has a lot more stocks, the number seems enough to keep track of the total market. As the fund doesn’t need to rebalance too often, expense costs are really low, just 0.03%: You pay £3 in annual expenses for each £10,000 invested. That’s ridiculous low!

We now have the stocks we need. It’s time to find the bonds. Fortunately, Vanguard (among other providers) offers a broad bond ETF – the Vanguard Total Bond Market (NYSEARCA:BND). This ETF provides broad exposure to U.S. investment grade bonds with the aim of keeping pace with U.S. bond market returns. Its expense ratio is just 0.04%.

The CAPM states that all investors should purchase a market portfolio and a risk-free asset, even though the exact proportions depend on each investor own preferences. With the help of the above ETFs, you can build your own portfolio according to the optimisation predicted by the CAPM. Your market portfolio is the Vanguard Total Stock Market ETF and the risk-free asset is the Vanguard Total Bond Market ETF.

In truth BND is not exactly a risk-free asset, but it’s a good proxy for it.

The advantages of using ETFs for our purpose of building a balanced portfolio are huge. Just to mention a few:

  • No need to purchase hundreds of assets, because two assets are enough to proxy the stock market and the risk-free asset.
  • The annual costs of running this portfolio are very low, as the expense ratio of VTI is 0.03% while the same for BND is 0.04%.
  • It’s relatively easy to add funds to this portfolio every month as there are just two assets in it.
  • If Vanguard goes out of business that’s not a problem for you because you own the shares that are part of the ETF and can sell them, if needed. In jargon, there’s no counterpart risk. This is not true for many structured products that banks offer you.
  • Both VTI and BND are highly liquid, which means you can easily buy and sell shares on them without interfering with market price.

Beating Actively Managed Funds

Now that we have the portfolio, it’s time to look back and check what would have happened to our funds if we set this portfolio a few years ago.

There’s no data available for the two ETFs to go before 2008. But we still have 11 years of data, for the period between May 2008 and May 2019. I simulated a few metrics using Portfolio Visualizer, for 3 different allocations: a classic 60/40 allocation, an aggressive allocation of 80/20, and a more conservative allocation of 40/60. A few metrics are reported on the table below:

PortfolioCAGRStdevBest YearWorst YearMax. Drawdown
60/4011.59%9.40%19.23%-19.44%-28.86%
80/2012.52%12.47%26.34%-28.21%-38.77%
40/6010.54%6.56%13.74%-10.67%-18.43%

As you can see, the classic 60/40 portfolio performed well, returning 11.6% per year. It began in an awful year, 2008, exactly at the peak of the financial crisis and then started losing money. But that’s not really a concern for someone looking for returns over long time periods. The conservative 40/60 portfolio shows inferior returns but still at an impressive pace of 10.5% per year. During the financial crisis it lost 18%, which is not much considering how bad the situation was.

A Few Final Words

You don’t need to be a professional to beat most actively managed funds and you don’t need to handle your funds to anyone. You can do it yourself and still beat more than half the actively managed funds. All you have to do is to find simple diversified assets that you can add to your portfolio almost for free and without needing to rebalance too often. A lot of money is lost by investors trying to beat the market and in transaction costs. Hence, unless you know what you’re doing, the best is to keep it as simple as possible.

About F.R.Costa

Filipe has more than 20 years experience with financial markets. He holds a degree in Economics with a specialisation in Finance and he's currently finishing a PhD in Finance. He used to work as financial consultant and research associate but then decided to return to academia five years ago. Since that, he has been an Invited Lecturer, teaching courses on Investments, Financial Markets, and Monetary Economics. He is also a regular contributor writer at The Master Investor Magazine.

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