By Scott Burns

It was a Maalox kind of year. But that's what it takes to build vocabulary. Today, everyone in America has a visceral understanding of the word "volatility."

But when you clear away the market babble, 2007 wasn't such a bad year. In fact, it was a pretty good year if you were sufficiently slothful. It also helped if you avoided insightful analysis and did as little as possible to contribute to the income of those wonderful folks on Wall Street. Yes, we're talking about the ones who purport to know what they are doing, even as they lose hundreds of billions and endanger the entire world financial system.

Skeptics should consider the returns of Couch Potato Building Block portfolios, the investment system that works for the rest of us. Here's the basic idea. Don't look for brilliant managers. Avoid them and all the marketing claptrap they engender. Instead, capture a market return. Give as little as possible of that return to Wall Street. And diversify like mad.

Do this by investing in index funds, in either mutual fund or exchange-traded fund form. Make your investment. Leave it alone for at least a year. Devote your spare time to NFL statistics. Or excel in needlepoint. Anything but investing.

Do that and your results are likely to beat 70 percent of all professional investors, even as you indulge yourself in libidinous thoughts while grinding mint leaves for your next mojito.

The first case in point is the Crispy Couch Potato portfolio--- the one anyone can do if you can fog a mirror and divide by 2 with the help of a calculator. It is a 50/50 mix of a total domestic equity market index fund and an index fund that invests in TIPS, Treasury Inflation Protected Securities. That portfolio returned 8.85 percent for 2007 and 10.02 percent annualized over the last 5 years. Returns like that will double your money in roughly 8 years.

The Margarita portfolio, so named for its three equal-sized building blocks of total domestic stock market, international stock market, and TIPS funds, returned 11.21 percent in 2007. It returned 14.56 percent annualized over the preceding 5 years. That's enough to double your money in 5 years.

Each time you add a building block, you increase the diversification of your portfolio. Eventually you also increase your equity commitment from 50 percent to 80 percent. Here's the recipe, block by block, 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 table below shows the returns of all 9 portfolios over the last year, three-year and five-year periods. During the year, American Century did a "soft close" on its International Bond fund (ticker: BEGBX), closing it to new investors. Existing shareholders, however, may add to their investments.

At about the same time State Street Global Advisors launched its SPDR Lehman International Treasury Bond ETF (ticker: BWX), so there is an international bond fund substitute for new Couch Potato investors. The new ETF has a lower expense ratio (0.50 percent) than the managed fund it replaces (0.83 percent), so the average expense ratio of the seven portfolios that contain international bonds will decline.

The Couch Potato Building Block Portfolios

This table shows the returns of fund portfolios, using mostly index funds, designed to build asset class diversification. The “portion size” is the percentage of the total portfolio committed to each building block. All investments will be of equal size.

Portfolio 2007 3 years 5 years Avg. Exp. Percent Equity Portion Size Blocks
Crispy Couch Potato 8.85 7.01 10.02 0.19 50 50 Total U.S. Equity, TIPS
Margarita 11.21 11.16 14.56 0.23 67 33.33 add Int. Equity
Four Square 11.05 9.15 13.03 0.38* 50 25 add Int. Fixed Income
Five Fold 5.06 9.10 14.04 0.34* 60 20 add REITs
Six-Way 9.92 13.14 17.40 0.33* 67 16.67 add Energy
Seven Value 8.54 12.64 17.05 0.31* 70 14.29 add Large U.S. Value
Eight Value 2 6.58 11.77 16.81 0.30* 74 12.50 add Small U.S. value
Nine Emerging 10.10 14.18 18.98 0.32* 76 11.11 Add Emerging Markets
10 Speed 10.37 14.70 18.47 0.33* 80 10.00 add Int. Value

The Building Block portfolios aren't perfect. Ease of execution trumped persnickety ideas like optimal asset allocation. And adding some asset classes didn't help returns for 2007. Adding REITs (the Five Fold) without also adding energy (the Six-Way), for instance, produced the lowest return of all nine portfolios in 2007--- a sorrowful 5.06 percent. Similarly, value stocks didn't help portfolios in 2007--- although they added return if you look back 5 years.

Which are my favorites?

  • Margarita, for starting investors.
  • Six-Way, for investors looking for maximum inflation protection.
  • Ten Speed, for value-oriented investors seeking maximum diversification.Long term or short, sloth matters.

On the Web:

Thursday, November 7, 2007: A Better Building Block

2006 Couch Potato Report