At AssetBuilder we use Dimensional Fund Advisor (DFA) funds to take four important steps to improve your investment results. We call these steps the elements of investing.

• Simple Indexing: Eliminating manager risk and manager expenses that reduce the return on your money.
• Simple diversification: Expanding the number of asset classes in your portfolio, with the goal of reducing risk.
• Smart indexing: Taking a step beyond market capitalization based indexes to take advantage of the higher returns to small cap and value priced equities, per the Fama/French research.
• Smart allocation: Taking a step beyond “naïve” diversification with portfolio optimization.

Scott created and started writing about the Couch Potato portfolio back in 1987. It takes the first two steps to improve your investment results. Relative to Wall Street, it has worked quite nicely.

Until recently, it wasn’t possible to take the third step because smart index funds simply weren’t available, except to institutional investors. Today, it is possible through a growing group of “smart” index funds and ETFs. We chose Dimensional Fund Advisors funds because they are the purest practitioners with the lowest costs.

Smart allocation is the most difficult step because it involves both rocket science and art. And that’s where we think we can add some real value with pre-constructed, risk-measured portfolios. Lots of people can divide by two, three, four, or five to produce a Couch Potato Building Block portfolio. But optimizing requires more work. With it, we can produce near equity market returns with lower risk.

Higher returns with less risk means

Portfolio accumulators

People still working who have 401(k) rollover accounts, other qualified plans and taxable accounts will enjoy greater growth for any level of risk tolerance.

Distribution portfolios

Retirees and early retirees who need to draw on their nest eggs will enjoy better odds of long-term portfolio survival.

A discipline called Modern Portfolio Theory (MPT) also suggests that your portfolio should be diversified with international equities, REITs, and funds that invest in both small-cap stocks and value stocks. The basic idea is to get the highest possible return with the lowest possible risk, measuring the risk by price fluctuations.

What portfolio designers look for are asset classes that are negatively correlated—i.e., when one goes up, the other goes down. Do this with two asset classes that have the same long-term return, but tend to move in opposite directions, and the risks will tend to cancel out— but you’ll capture the return.

Evolution of the Couch Potato

In the beginning was the Couch Potato portfolio. It evolved into a simple building block approach by adding equal-sized blocks to diversify your investments to provide milder ups and downs. Couch Potato Building Block Portfolios, are designed to be implemented very easily by investors. They are all variations on a balanced portfolio, with different numbers of asset classes/sectors ranging from 2 to 10. These portfolios do well relative to most managed portfolios because they minimize expenses and provide varying degrees of diversification.

At AssetBuilder we take this process a step further, we have now added the “rocket science” to construct our portfolios. It’s about constructing a portfolio that gives you the highest return with the least risk. It can be done with a technique called mean variance optimization, which is close enough to rocket science to have won its creator, Harry Markowitz, a Nobel Prize in 1990. We rely on funds that enjoy higher returns from the small cap and value factors and we use mean variance optimization to build portfolios that offer rising levels of expected returns, calibrated by risk level. Thus, while the Couch Potato 10 Speed portfolio did significantly better than the average “world allocation” fund for about the same level of risk, the AssetBuilder Portfolio 12 does still better, again at about the same level of risk as the average world allocation managed fund.