yellowbrickroad-copy.jpgAllow me to introduce the yellow brick road of investing. Follow this road and you will be a happy investor. Ignore it at your peril.

The yellow brick road has four major milestones. The first three are clearly visible. Anyone can get good investment results if they follow these three markers. The fourth is also easy to see, but more difficult to do. Follow me.

Simple indexing. This has been around for three decades and is now as common as pizza. The vast majority of us will do better owning index funds because index investing will give us a higher return than most of the more expensive managed alternatives.

Skeptics should visit Standard & Poor's Web site. If you do, you can download its regular SPIVA report, otherwise known as the Standard and Poor's Indices Vs. Active funds scorecard. In the most recent report, its analysts found that over the trailing five-year period, 71 percent of large-cap funds had failed to beat their benchmark. The fail rate was 83.6 percent for mid-cap funds, 80.5 percent for small-cap funds, 78 percent for international funds, 89 percent for emerging market funds, 88 percent for long government bond funds, 87 percent for mortgage securities funds and 84 percent for high-yield funds.

Does everyone see the pattern here?

If you bet your future on picking fund managers, you are playing a loser's game.

Simple diversification. AKA, don't put all your eggs in one basket. You'll do better in a variety of assets because one will surely be going up when another is going down. Skeptics should consider my building block portfolios -- simple portfolios that use equal-sized investments in different asset classes to diversify. The Margarita portfolio, named in honor of the musical Buffett, has returned 12.92 percent this year to Nov. 29, while the Four Square, Five Fold and Six Ways From Sunday portfolios -- which add a REIT building block, an international bond building block and an energy building block, respectively, to the basic Couch Potato -- provided YTD returns ranging from 16.88 percent to 18.75 percent.

SIMPLE DIVERSIFICATION: THE BUILDING BLOCK PORTFOLIOS

Building from a two-fund portfolio to a six-fund portfolio, the building blocks add asset classes to increase portfolio diversification.
Portfolio YTD Portfolio Return 12-Month Portfolio Return
Couch Potato (1)

8.18

8.54

Margarita (2)

12.92

15.08

Four Square (3)

18.75

20.19

Five Fold (4)

16.88

18.31

Six Ways From Sunday (5)

17.48

19.39

(1) 50/50 VTSMX and VIPSX; (2) in thirds, adding VGTSX; (3) in quarters, adding VGSIX; (4) in fifths, adding BEGBX; and (5) in sixths, adding VGENX. All but one of these funds, BEGBX, is a low-expense index fund.
Data source: www.morningstar.com, 11/29/06
This is neither painless nor guaranteed. The Couch Potato portfolio returned only 8.18 percent year-to-date, trailing a large majority of managed balanced funds. Fortunately, this is a rare event.

Smart indexing. Researchers Eugene Fama and Kenneth French have shown that we can get higher returns if we build portfolios with value stocks -- those with prices at low price-to-book-value ratios. They also found we get higher returns with small-capitalization stocks. According to Ibbotson Associates, for instance, large company stocks returned 10.4 percent, compounded annually from 1926 through 2005. Small company stocks provided a return of 12.4 percent. The higher return was no free lunch: You got it only by surviving some catastrophic declines.

A tilt toward value stocks does much the same. Over the long term, the bargain hunters have always prevailed over the hyperventilators.

Today, the building blocks are easy to find, either as mutual funds or exchange-traded funds (ETFs).

Smart asset allocation. The first three milestones are pretty easy. No rocket science required. The fourth step is a lot harder. It is 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.

Today a number of software venders sell optimization packages. Unfortunately, having the tool and getting reasonable results isn't the same thing. Many would do better with a Ouija board than with an optimizer.

So what do we do?

Note the milestones and then park. Until the optimizer bus comes along, make reasonable guesses and you'll do fine.

ON THE WEB

Couch Potato investing archive

Index and ETF investing archive

Looming Battle: Fundamental vs. Traditional Indexing

Dallas Morning News Archive, "The Glorious History of the Couch Potato"

Dallas Morning News Archive, "Reports on Couch Potato Investing"

Dallas Morning News Archive, "The Building Block Columns"