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SMar 20, 2005

Introducing: The Couch Potato Building Blocks

Scott Burns
I've advocated index investing and have tracked the Couch Potato Portfolio in this column for more than 13 years. There are two good reasons for this. First, index investing will do better than about 70 percent of managed portfolios. Second, index investing is so simple anyone can do it. If you can divide by two with the help of a calculator, you can be a Couch Potato portfolio manager.

But a nagging question remains.

Could we do better by having more than two asset classes?

Could we increase the return---or reduce the risk--- by adding more funds? One such portfolio is the well-known "Coffeehouse Portfolio." An all-index fund portfolio, it consists of 40 percent Vanguard Total Bond Market and 10 percent in each of six different index funds. Another is William Bernstein's "Coward's Portfolio", a mixture of up to ten index funds in amounts from 5 percent to 20 percent.

Either way, the idea of owning seven to ten funds, in different proportions, is enough to cause most people to leave the room.

Enter the Couch Potato Building Blocks.

The basic idea is that we start with the Couch Potato portfolio of two funds, invested in equal amounts. Then we do the same thing with three funds, invested in equal amounts. Then we graduate to a portfolio of four funds, invested in equal amounts. We can keep doing this until we have a portfolio of six funds, invested in equal amounts. Each added fund changes the proportions in the portfolio, but we are always investing equal amounts.

That's pretty simple but it means we are always investing 50 to 67 percent of our money in equities--- the usual range of "balanced" funds.

Here, block-by-block, are the five portfolios.

---The Updated Couch Potato is 50 percent Vanguard Total Market Index (ticker: VTSMX), 50 percent Vanguard Inflation Protected Securities (ticker: VIPSX). In the five years ending December 31, 2004 this portfolio had one losing year (2001), two just above zero years, and provided a total return of 30 percent. At its worst, it lost 12 percent of original value. (Note: Vanguard Total Bond fund was used in 2000 because Vanguard Inflation Protected Securities wasn't available.)

---The Margarita Portfolio is equal amounts of three funds, the two in the Updated Couch Potato plus the Vanguard Total International Stock Index (ticker: VGTSX). This portfolio returned 19.6 percent over the period. It trailed the Updated Couch Potato because it was two-thirds equities during three years of bear market while the Updated Couch Potato was only 50 percent equities. It also lost money in three years.

Had the Updated Couch Potato portfolio been 2/3rd Total Stock Market and only one third Vanguard Inflation Protected Bonds, the returns would have been virtually identical. At its worst the Margarita Portfolio lost 16.5 percent of original value. As reported earlier this year, its return over the last three years has been better than the standard Couch Potato.

In theory, this portfolio should provide more diversification, less risk.

---The Four Square Portfolio is equal amounts of four funds, the three in the Margarita Portfolio plus the American Century International Bond fund (ticker: BEGBX). This returns us to the basic 50/50 equities/fixed income mix but it commits half of our money to international investments, half to domestic. This portfolio provided a total return of 30 percent over the period and lost money in two years. At its worst it lost 11 percent of original value. American Century International Bond fund is a managed fund, not an index fund.

Again, the benefit of diversification isn't apparent. So we have to trust the academics--- or just distrust the value of the dollar.

---The Five Fold Portfolio is equal amounts of five funds, the four in the Four Square Portfolio plus the Vanguard REIT Index fund (ticker: VGSIX). This gives us domestic and international stocks and bonds plus real estate. This portfolio had only one losing year and provided a total return of 51.3 percent. At its worst, it lost only 0.5 percent of original value.

Research shows that REITs add true diversification, improving returns while reducing risk--- and it shows in the results.

---The Six Ways From Sunday Portfolio is equal amounts of six funds, the five in the Five Fold Portfolio plus the Vanguard Energy fund (ticker: VGENX). This gives us domestic and international stocks and bonds, real estate, and energy. This portfolio had one losing year (2001) and provided a total return of 64.6 percent. At its worst, it never went below its original value. Vanguard Energy fund is a managed fund with a very low expense ratio. Unfortunately, it was recently closed to new investors. An alternative is its exchange-traded fund, Vanguard Vipers Energy, ticker VDE.

While no market scholar will argue that energy stocks are a separate asset class, I offer this rationale: energy is the ultimate currency and the ultimate commodity. Whether we are talking about grain, chicken, beef, iron, copper, or gold every commodity in our daily life is directly affected by the cost and availability of energy. The best way for most people to invest in energy is through the stocks of major energy companies.

Tuesday: Using other funds and exchange-traded funds to make the building block portfolios.

On the web:

The Coffeehouse Portfolio

The Coward's Portfolio

Tuesday, March 16, 2004: Margarita Portfolio, a new investment recipe

Sunday, January 23, 2005: Margarita Investors can toast higher gains

Sunday, September 29, 1991: On the Importance of Being a Dull Investor

Filed Under: Couch Potato Investing