scott_buldingblocks.jpgOK. You're tired of the original Couch Potato portfolio. (It is possible to have too much of a good thing, even sloth.)

And now you've expanded to the Margarita portfolio. Do you dare build a portfolio more complicated than mixing a three-part drink?

You can do it easily if you use the building block approach. Rather than using a complicated recipe for different investments, all in different amounts, you can build a portfolio out of equal-sized blocks. And it can have 4, 5, or 6 pieces.

How about more? Like up to 10?

Well, it's more than possible. One of the nice things about the number 10 is that it makes for easy division. Just subtract a decimal place from your total portfolio and that's what you need to invest in each of your building blocks.

Here's the recipe, by pieces, for up to 10 building blocks:
  • Block 1: Domestic total stock market, such as Vanguard Total Market Index fund/ETF
  • Block 2: Treasury Inflation Protected Securities, such as iShares TIPS
  • Block 3: International total market, such as Fidelity Spartan International Market
  • Block 4: International bonds, such as American Century International Bond
  • Block 5: REITs, such as the Vanguard REIT ETF
  • Block 6: Energy, such as the Vanguard Energy ETF
  • Block 7: Large U.S. value stocks, such as iShares Russell 1000 Value ETF
  • Block 8: Small U.S. value stocks, such as iShares Russell 2000 Value ETF
  • Block 9: Emerging markets, such as Vanguard Emerging Markets ETF
  • Block 10: International value stocks, such as iShares International Value ETF

The building block portfolios start with a conservative 50 percent equity commitment that earned 7.92 percent in 2006. Then, block by block, you can add broad diversification until you have a portfolio that is about 80 percent geographically diversified equities.

More important, the last three blocks will add a value and size tilt to your portfolio. This will allow you to capture the added return that research by Eugene Fama and Kenneth French has shown to explain virtually all additional returns over a broad market index.

The last building block, International Value, has become available as an ETF index fund only in the last year, so I can't provide returns for the three-year and five-year periods. But if you examine the table below, you'll find that the returns rise smoothly as the equity commitment increases from 50 percent to 80 percent.

Will this much diversification save you from a down market?

Sorry, no. It is likely, however, to provide milder ups and downs than less-diversified portfolios.
The Building Block Portfolios
This table shows the 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 Blocks
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
Seven Value (new!)

18.10

14.75

13.39

0.31

70

7.54

0.82

14.29%

add Large U.S. Value
Eight Value2 (new!)

18.26

14.96

13.39

0.30

74

7.82

0.90

12.50%

add Small U.S. Value
Nine Emerging (new!)

19.52

16.53

14.83

0.32

76

8.70

1.01

11.11%

add Emerging Markets
10 Speed (new!)

20.54

Na

Na

0.33

79

Na

Na

10.00% add Int. Value
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 unscheduled portfolios 12/31/2006
Will it be expensive?

Not a chance. The combined expense ratio of the 10 investments is only 33 basis points--- one third of one percent. A $50,000 portfolio of 10 investments, rebalanced annually, would have a maximum commission cost of $120 a year, assuming a $12 commission rate. That would add another 0.24 percent. It would bring total costs to 0.57 percent. If you have a larger portfolio, use a smaller number of blocks or use a few index mutual funds instead of ETFs, your costs could be much lower.