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