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Scott Burns' Articles -- Recent and Archived

The Couch Potato Building Blocks, 2006

couch_potatoe06_sm.jpgIt's time to play with blocks again.

Yes, it's Building Block portfolio time. We're going to see how the building blocks did in 2006. Next week we're going to add more blocks so we can have still more fun.

If you've missed my column for the last 15 years or so, here's the basic idea. Picking managed mutual funds is good for cocktail party conversation (if you have nothing more interesting to talk about), but it isn't a good way to build a retirement nest egg.

Why?

Because stock- and bond- pickers are expensive toys and seldom earn their keep. We have a better shot at higher returns if we buy the index funds that duplicate their benchmark market. The index funds cost little and tend to beat managed money 70 percent of the time. For managers, the game is theirs to lose--- and they generally do.

This doesn't mean they aren't smart and capable people. It just means that beating the market is very, very difficult.

The original Couch Potato had two pieces: a domestic equity index and a domestic fixed income index. It was designed so that you could manage your own money if you had a pulse and could divide by the number two with the aid of a calculator.

The Building Block portfolios aren't much more demanding. Whatever the number of blocks used, all are the same size. So if there are three blocks, you divide your money by three and that's what you need in each fund. We avoid putting 31 percent here, 4 percent there, and 17 percent somewhere else.

Is this ideal?

Hardly. But it gets the job done. The more building blocks we use, the more diversified we are. That, in turn, may help reduce the ups and downs of our portfolio, so we get more return relative to the amount of risk we take.
The Building Block Portfolios
This table shows the annualized returns of equal investment funds, mostly index funds, designed to build asset class diversification.
Portfolio 1 year 3 year 5 year Avg. exp. Percent Equity Std. Dev. Beta Portion
Original Couch Potato 9.91 7.02 5.59 0.19 50 3.84 0.51 50.00% S&P 500, Total Bond
Crispy Couch Potato 7.92 7.59 7.54 0.19 50 4.65 0.56 50.00% Total U.S. Equity, TIPS
Margarita 13.87 11.92 10.54 0.23 67 5.96 0.74 33.33% Add Int. Equity
Four Square 12.62 10.03 10.65 0.38 50 5.63 0.62 25.00% add Int. Fixed income
Five Fold 16.83 13.08 13.05 0.34 60 6.91 0.74 20.00% add REITS
Six Way 17.41 14.75 14.10 0.33 67 7.95 0.81 16.67% add Energy
Vs. Comparisons:
Avg. Moderate Allocation 11.26 8.37 6.30 1.41 60.00 8.05 0.84 na
Avg. World Allocation 16.50 13.34 12.24 1.37 54.00 8.54 1.00 na
Avg. Large Blend 14.14 10.06 5.97 1.29 100.00 12.39 1.03 na
Avg. Money Market 4.43 2.59 1.94 0.66 0.00 0.42 0.00 na
Source: Morningstar Principia, data for 12/31/2006
How do we play with the building blocks? Easy. We start with the Crispy Couch Potato portfolio, a two-block mix of Total U.S. Market and Treasury Inflation Protected Securities (TIPS). Then we add a total international index to make the Margarita portfolio (three equal parts, like a Margarita).

Then we add an unhedged international bond fund block. Sadly, no international fixed-income index fund is yet generally available. So until there is one, we've settled for the American Century International Bond fund (ticker: BEGBX). Given the growth of ETFs, I think we'll have an index substitute before 2007 is over.

The next step is a five-block portfolio, achieved by adding a broad REIT index fund or ETF such as the Vanguard REIT ETF (ticker: VNQ).

Finally, we add a broad energy index fund block, such as the Vanguard energy ETF (ticker: VDE). This isn't conventional, but it is a quick and dirty way to own an interest in the ultimate currency, the British thermal unit.

The annual cost of all this? Well under 0.40 percent plus a few commissions, if you build the portfolio with ETFs. Equity exposure varies from a low of 50 percent (2 blocks) to a high of 67 percent (6 blocks). Basically, the more building blocks you use, the greater your likely return and the greater your risk.

And how did they do?

Nicely. Over the last 5 years the Crispy Couch Potato returned 7.54 percent while the average managed moderate allocation fund returned 6.3 percent and took more risk to do it. Similarly, the Six Way portfolio returned 14.1 percent over the last 5 years while the average world allocation fund returned 12.24 percent--- and both had comparable levels of risk.

Is it possible to diversify still further and get higher returns?

Yes. Next Sunday I'll add four more building blocks.

On the web:

March 20, 2005: Introducing the Couch Potato Building Blocks

The Couch Potato investing archive
Published Feb 03 2007, 06:00 PM by scottb
Filed under:

Comments

 

ABModerator03 said:

Dear Scott,

In today's column, you wrote: "Basically, the more building blocks you use, the greater your likely return and the greater your risk."

I thought you are advocating along the line of efficient frontier in MPT. By using more non-correlating asset classes, one should be getting greater likely return and lesser risk. What am I missing?

Best regards.

From Scott Burns:

You're not missing anything. You're just assuming too much. The portfolios grow from 50 percent equities to over 65 percent equities. Next week they will grow out to 80 percent equities. In a world on non-correlated asset classes, it would be possible to dramatically reduce the increased risk associated with rising equity content in a portfolio. But this is a world of increasingly correlated asset classes so risk continues to build as equity concentration increases.

The good news is that you still get more return per unit of risk as you increase your equity commitment.
February 4, 2007 10:07 AM
 

ABModerator03 said:

Mr. Burns,

I'm confused when you said in your Sunday column: "Basically, the more building blocks you use, the greater your likely return and the greater your risk."

That sounds backwards to me.

I thought more blocks meant more diversification and more diversification meant less risk.

I always heard that less risk meant decreasing your likely return.

What did I miss?

Jack

From Scott Burns:

You didn't miss anything. Saying "the more building blocks you use, the greater your likely return and the greater your risk" is the inverse of saying that "less risk meant decreasing your likely return."

What's confusing you is the idea that diversification is supposed to reduce risk. It does, but within limits. If you look at the percentage of equity in the portfolios, it tends to rise as more pieces are added. It starts at 50 percent equity (2 blocks) and builds to 80 percent equity (10 blocks). The diversification of equity asset classes (eg. Adding international, etc.) reduces risk compared to a single equity asset class but it still increases risk relative to fixed income.)
February 4, 2007 11:59 PM
 

ABModerator03 said:

Scott, did you actually mean what you said???: "Basically, the more building blocks you use, the greater your likely return AND THE GREATER YOUR RISK".

Didn't you mean to say the "lower your risk", ??

Kenny

From Scott Burns:

Yes, I meant what I said. While risk tends to decline with diversification, you are increasing the percentage of equities as you build out the blocks. Returns increase accordingly. So does risk. The good news is that you get more return per unit of risk due to diversification.
February 5, 2007 9:13 AM
 

ABModerator03 said:

Scott,

Do the Building Block results include annual rebalancing back to the original percentages?

Also, it seems that you are moving towards a simplified version of William Bernstein's approach. I'm looking forward to seeing your new building blocks.

Regards, Brian

  

From Scott Burns:

The performance figures are from the Morningstar Principia "unscheduled" portfolios tool which automatically rebalances but does not consider the cost of that rebalancing. How much it would cost would depend on whether you were investing via funds in a family (e.g. Vanguard), all ETFs or a combination of funds and ETFs.

There is nothing revolutionary in the Building Blocks. Like Bernstein's approach it offers good diversification, as does the Coffeehouse portfolio. The difference is that every commitment is the same size/percentage so there's a lot less complication to keeping the portfolio in balance. Less complication means it is more likely to (1) be initiated and (2) be kept up.
February 5, 2007 10:25 AM
 

ABModerator03 said:

My results calculations appear to be off in comparison to yours..

I used 2006 end of the year results and STDs reported by Morningstar for each fund.

Did I miss something in my calculations or is there a difference in the data for year-end results/STDs we both are using?

Regards,

Tom

From Scott Burns:

The answer may be inside the Morningstar Principia program: I don't know how it does its calculations or how often it rebalances. If it is only 1x per year the figures should be the same as the annual figures on their website, which is what I use when I'm doing the same thing in Excel. I don't like to use spreadsheets for published columns, preferring to use results others can reproduce easily based on 3rd party software.
February 5, 2007 2:56 PM
 

ABModerator03 said:

Do you have any suggestions for an entry investor without the large amounts of money needed to buy ETFs and invest in all these different funds.

Currently I have $3000 in Vanguard's Total Stock Market Index (VTSMX) and I plan on diversifying until I have 70% U.S. stocks (VTSMX), 20% international stocks (VGTSX), and 10% bonds (VBMFX).

Do you think this is a good option or are their better index funds out there?

Also, what is your opinion on a life cycle fund when invested in a roth IRA?

From Scott Burns:

If you are investing in an IRA you could get very close to your plan with a single fund, the Fidelity Four-in-One Index fund (ticker: FFNOX).

While the fund has a minimum initial investment of $10,000 for taxable accounts, the minimum for IRA accounts is only $2,500. The fund invests in four Fidelity funds: Spartan 500 index (55%), Spartan extended market index (15%), Spartan international index (15%), and Fidelity U.S. Bond Index (15%).

As a consequence, you would have access to domestic large cap, domestic mid and small cap, international equities and, of course, a 15 percent commitment to fixed income. You can learn more about the fund by visiting the Morningstar website.

Sadly, if you are investing in a taxable account you'll have to go back to your original plan and build out your portfolio in a variety of Vanguard funds.

Is there another way to get to the same destination with less money?

I think so. A two-fund way to get there would be to invest in Vanguard Balanced Index fund (ticker: VBINX) and Vanguard International Value (ticker:VTRIX). If you invested $5,000 in VBINX and $3,000 in VTRIX your initial portfolio would be $3,000 domestic total market index, $2,000 domestic fixed income, and $3,000 international equity. The international equity piece would be in a managed fund that operates at an expense ratio of 0.44 percent. Your total beginning equity allocation would be 75 percent.
February 5, 2007 10:16 PM
 

ABModerator03 said:

I am an avid reader of your Sunday columns, often pitching the rest of the newspaper on the day(except the funnies for me and my 10 year old daughter).

I am nearly 56, my wife 52. We are very good at saving and have put aside a very nice egg. Most of it is in our plan at work. Since I'm the boss, I like having the peace of mind (from lawsuits, accounting, etc.) of having Smith Barney manage the money for now, but I hope to retire in 3 years or so and would most likely take over the management myself of our own monies.

The rebalancing, accounting, and other details of using one of the couch potato portfolios seems a bit daunting (finances are not my primary field).

Are there classes on how to do this and use ETF's and such? Thank you.

David

  

From Scott Burns:

If classes don't currently exist, I am sure the growing number of ETFs will lead to their creation. Meanwhile, I'll continue developing the Building Blocks--- including exact "recipes" for making them. Just stayed tuned to the website.
February 6, 2007 1:16 PM
 

ABModerator03 said:

In most investing schemes, I have noticed that you start with a risk level leading to a mix or stocks and bonds and then diversify while maintaining that mix.

So if that mix was say 70-30, in couch potato approach it would remain same whether you used the original or six way.

Then one could also compare the return vs risk for couch potato approaches.

Also one could build any of the above couch potato portfolios for different risk levels by adjusting the amounts in each bucket.

What's wrong with that approach. Why don't you take it. In your approach, what is the final recommendation - how does one decide which portfolio to chose for short term investments say about 5 years vs long term investments.

neeraj

  

From Scott Burns:

There are big differences between the Building Blocks and Modern Portfolio Theory. What I'm trying to do is provide a simple way to increase diversification while slowly building the equity content of the portfolio.

One eye is on portfolio theory. The other eye is on ease of execution. The end result is less than perfection, but it is easily done and inexpensive.
February 6, 2007 4:56 PM
 

ABModerator03 said:

Dear Mr. Scott,

why do you add vde. Energy stocks would already be present in right proportion in total stock index of portfolio one. Adding vde seems like sector investing.

thanks

neeraj

  

From Scott Burns:

I added energy not as a sector but as a global currency alternative.

This is unorthodox, but if you consider that the global economy runs on energy and that energy may be our ultimate currency, it starts to make sense. You can read more about the choices for TIPS, REITs, and energy in "The Coming Generational Storm" (MIT Press 2004), the book I co-wrote with economist Larry Kotlikoff.
February 6, 2007 4:59 PM
 

ABModerator03 said:

Dear Scott

I have been a reader and had a couch potato fund for several years. I am interested in moving to more funds and you have shown but have a problem with Vanguard needing $100 per deposit. At this time I have over $50,000 in the two accounts and would like to move to the 10 accounts that you are showing this weekend. My question is if I go this way should I open a money market account to deposit into monthly and then transfer as the funds become available, and if so should I deposit into the lowest accounts to keep all at the equal amounts.

Thanks, Mark
February 6, 2007 8:30 PM
 

ABModerator03 said:

Dear Scott,

I am a regular reader of your column in the Dallas Morning News and it has been very helpful in my financial education - thank you! I have been reading about your Couch Potato investing portfolio. I am waiting to read your column on Sunday about the additional 4 building blocks. I have some money in an IRA which I plan to invest based on your building blocks (maybe Six Ways or with more). My question is what age group, if any, is this geared towards ? I am 42 and am trying to figure out what building blocks would be suitable for my age.

Thank you.

  

From Scott Burns:

I think more in terms of risk sensitivity than age because your circumstances have a greater impact on the risks you should take than your age alone. A long term government worker with an inflation adjusted pension, for instance, can take more investment risk than a younger worker who will have no pension.

Why?

Because the meaningful measure is your living standard risk--- how much your standard of living could change if your investment results were bad.

The more building blocks you use, the greater your exposure to equities, the higher your probable return, and the higher your risk level. The original Couch Potato, for instance, is 50/50 equities/fixed income. The Ten Speed, with ten blocks, is 80/20 equities/fixed income.

With a regular flow of new savings and a fairly long accumulation period ahead of you, you can afford more risk than most, maybe all the way out to the Ten Speed.
February 9, 2007 2:00 PM
 

ABModerator03 said:

Hi Scot, Thanks...Wonderful article.. I asked you before and asking you again because you are discussing couch potatoes....I am a new investor. My money is in saving accounts and I like to move it to six way portfolio. My question is: 1. If I have the money should I right away buy the funds you suggested or should I come in the market slowely. Please tell me how to start... 2. Would you advice building six way by using only ETF's. ETF's are low cost and i am therefore little confused why you are not advising us to build this portfolios using only ETF's?

Again thank you very much..
February 9, 2007 10:16 PM
 

ABModerator03 said:

Scott,

I have wondered when doing a total investment plan how should home ownership equity and second home equity be addressed? Does the Building Blocks approach address this? Could the equity in the two homes be counted towards the amount in Block 5 for a REIT? Both homes are in currently growing markets in Texas so I believe that the increase in value is likely to continue at a reasonable rate. Do plan on selling at some time in future and downsizing. Or, do you recommend the home equity investment plan be separate from the Building Blocks approach?

Thanks for the help.

From Scott Burns:

There isn't a calculus for this. A good case can be made that REITs, as an asset class, will increase portfolio returns while providing a slight reduction in risk. For that reason, they are good to include in your financial asset portfolio. This is an entirely separate consideration from the equity in your first or second home.

There is a point, however, where real estate looms so large in your net worth that adding still more via your financial assets is counter productive. Where that point is depends on your future plans for change. If 80 percent of your net worth is tied up in your home and you plan to sell in the near future, it doesn't make a lot of sense to add REITs to your financial assets. If, however, you own your house and intend to live there until you die, a touch of REIT wouldn't be unreasonable.

I think it's about the assets with which you expect to transact. I'm not aware of any research on this issue.
March 6, 2007 12:15 PM
 

Registered Investment Advisor said:

By Scott Burns It was a Maalox kind of year. But that's what it takes to build vocabulary. Today

February 26, 2008 10:27 AM

About scottb

Scott Burns has covered the changing world of personal finance and investments for nearly 40 years. Today, he ranks as one of the five most widely read personal finance writers in the country. Scott began his career as a newspaper columnist at the Boston Herald in 1977 where he was also the financial editor. Nationally syndicated in 1981 and now distributed by Universal Press, the column appears in newspapers from Boston to Seattle. In 1985 he joined the staff of the Dallas Morning News where his column quickly became one of the most widely read features in the paper. He left the Dallas Morning News in 2006 to become one of the founders of AssetBuilder and its Chief Investment Strategist. Burns is a graduate of Massachusetts Institute of Technology (1962). He has written four books, including "The Coming Generational Storm" (MIT Press, 2004) coauthored with economist Laurence J. Kotlikoff. His fourth book, also coauthored with Kotlikoff, will be published this spring by Simon & Schuster. "Spend Til' the End" uses consumption smoothing to demonstrate the errors of conventional financial planning. His business experience includes working as a staffer for a major consulting company and service as a director and audit chairman of a NASDAQ listed manufacturing company. He and his wife divide their time between Dallas and Santa Fe, New Mexico.
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