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Lazy Portfolios Beat Professionally Managed Portfolios
July 28, 2012

Lazy Portfolios Beat Professionally Managed Portfolios

Written By: Scott Burns

Some things change. Others don’t.

Costs matter. This is one of the eternal verities of investing. We know this from John Bogle, the founder of Vanguard and patron saint of index investing. If we act on this simple fact— that costs matter— we can improve our investment results.

This isn’t what Wall Street tells us. The investment community tells us that only their constant attention, their cadres of MBAs and PhDs, and their special knowledge of the world can lead us to good returns. They intimate that the more we pay them, the more likely we will get superior performance. They spend millions of dollars on advertising to convince us.

Alas, it isn’t so.

A simple exercise with the cost factor, however, can improve our results. Let me demonstrate.

At the end of May there were 194 mutual funds that Morningstar categorized as “moderate allocation,” or balanced, funds, with at least 5-year histories. These funds are typically a 60/40 mix of equities and fixed income. Their annualized return over the last five miserable years was 0.94 percent. Their average net expense ratio was 1.17 percent.

The top 25 percent of funds by expense cost at least 1.35 percent to manage, averaged 1.80 percent in expenses and produced an average return of 0.21 percent. If you selected from this group at random, hoping that high expenses would buy better management, you had only a 32 percent chance of doing better than average.

If you went in the other direction and chose from the 25 percent of funds that were least expensive, costing 0.88 percent or less a year to manage, the average return was 1.40 percent a year. You had a 55 percent chance of beating the average for the category. In other words, you’ve got a better shot— not a guaranteed shot, just a better shot— at superior results if you insist on lower expenses.

We can improve our odds a bit by selecting from the 25 largest funds. Doing that gives us an average return of 1.33 percent and a 60 percent chance of beating the average fund. One reason is that the largest funds also tend to have lower expense ratios— the group averages 0.75 percent. We can, in other words, virtually double our chance of above-average performance simply by favoring the large funds that tend to have lower expense ratios. We’ll have a 60 percent chance of above average return rather than only a 32 percent chance.

Not thrilled by those odds? I don’t blame you. This is your retirement money we’re talking about.

Thankfully, there is a better way. Marketwatch columnist Paul Farrell calls it the “lazy portfolio” way. Years ago he started reporting on the performance of do-it-yourself portfolios that could be built with low-cost index funds. These portfolios range from some of my Couch Potato portfolios to Bill Schultheis’ Coffeehouse portfolios, William Bernstein’s “Coward’s Portfolio” and David Swensen’s “Yale Model” portfolio. Today there are quite a few of these funds—trailing performance figures for 30 of them are reported monthly on my website.)

Eighteen months ago I showed that 11 of 14 balanced “lazy portfolios” beat the average for all balanced mutual funds over the preceding 3 years. So taking the lazy way out gives you a 79 percent chance of beating the category average.

The superior performance of these lazy portfolios continues today. If there were ever a period when perceptive selling and wise buying should have made a difference and put managed funds on top of the heap, it has to be the last 5 years. But superior decision making, once again, did not prevail. Measured over the 5 years ending May 31, the average managed balanced fund provided an annualized return of 0.94 percent. Over the same period the 25 largest funds returned 1.33 percent. But the 14 lazy portfolios averaged 1.45 percent and a random choice would have provided an 85 percent chance of beating the average.

What does this mean for you and me?

It means don’t be afraid. If you have fear and anxiety about making your own investment decisions— fear that you don’t know enough, fear that professionals will make much better decisions— it’s time to take a reality bath. The reality is that if you choose just about any “lazy portfolio,” the odds are that you will do better than if you choose the more expensive alternatives.

Would you like certainty?

Yeah, so would I. But there is no certainty. All we can do is search for the best odds.

Do-It-Yourself Portfolios Rule!

This table shows the rank-ordered performance, by five-year annualized return and decile, of 14 lazy portfolios whose asset allocations match what Morningstar calls “moderate allocation” mutual funds.

Portfolio 5 Year Annualized Return Performance Decile
Vanguard Balanced Index 2.78 1
Yale Model 2.78 1
Coffee House Vanguard 2.54 1
Couch Potato Five Fold 2.32 2
Couch Potato Six Ways 2.12 2
Aronson Family Portfolio 2.06 2
7Twelve Balanced 2.06 2
Coffee House ETF 1.70 3
Ultimate Buy and Hold 1.55 3
Lazy Portfolios average 1.45 3
Avg. of 25 Largest in Category 1.33 3
Cowards Portfolio 1.32 4
Couch Potato Margarita 1.07 4
Andrew Tobias Lazy 1.07 4
Category Average, all funds 0.94 5
Frank Armstrong Index 0.28 8
Coffee House 3 ETF (0.18) 9

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.