If stocks are facing a rough future, should a couch potato investor sell his equity fund?

Questions like this have been appearing in my e-mail folder since two recent columns* discussed some dour research. Stocks, the research indicates, usually have low returns following periods of high valuation--- such as the present.

After two years of bear market, no one wants more bad news.

What is a Couch Potato investor to do?

Very little.

If you have forgotten about the Couch Potato Portfolio, let me recap. It is a portfolio designed for people who want to approach their investments with the calm of Yoda, the Buddha-like instructor of young Jedi. The Couch Potato Portfolio is simple, inexpensive, unmanaged, and devoid of hubris. It only requires that you divide by the number "2" with the aid of an electronic calculator. If you prefer the complexity of a 75/25 portfolio, you should be able to mix one-part bonds with three parts equity. If you can mix frozen orange juice, you can be a Couch Potato investor.

The Couch Potato approach, as we saw earlier this year, continues to do well, witness these figures for year-end 2001. As you can see, both versions of the Couch Potato Portfolio have done well against managed balanced and domestic equity funds.

The Couch Potato Portfolios vs. Balanced and Domestic Equity Funds
Period 50/50 CP 75/25 CP Average Balanced Average Domestic Equity
1 year -1.80 -6.91 -4.01 -11.32
3 years    2.89   1.22   2.21      3.33
5 years    9.66 10.29   7.01      8.72
10 years 10.37 11.68   8.98   11.27
15 years 10.96 12.30   9.45   11.85
Source: Morningstar Principia Pro, December 31, 2001 data

Even so, it would be nice if we could increase the odds of superior results in the current environment.

I believe two changes will help.

First, if you are an aggressive Couch Potato--- one who has a 75 percent commitment to equities--- then you should reduce your equity commitment. Note that I say, "reduce," not "eliminate."

Going down to a basic 50/50 couch potato will reduce risk and limit your exposure to a tough equity environment. In the miserable 1973 to 1981 market, for instance, the 50/50 Couch Potato portfolio returned 6.3 percent a year. The S&P 500 index returned only 5.3 percent, with twice as much risk. (You can read about bull and bear cycle returns at: http://www.scottburns.com/920707TU.htm)

Second, you can move from an all-large cap index fund, the Vanguard 500 Index, to a broader index fund that includes mid and small cap stocks. The Vanguard Total Market Index has been in operation since 1992.

Why should we do this?

Simple. Overvaluation remains concentrated in the large capitalization stocks that dominate the S&P 500 Index. Meanwhile, according to research by the Leuthold Group, some 3,000 stocks are selling at reasonable valuation levels. Investing in the Vanguard 500 Index fund (or its competing clones) puts you in the large companies that account for 81.5 percent of all domestic stock market value.

By shifting to the Vanguard Total Market Fund you will own an index fund that represents 100 percent of all domestic equities.

Until recently, Vanguard Total Market Index fund trailed the Vanguard 500 Index fund. The large cap stock decline, however, has changed that: the Total Market Index fund beat the 500 Index in 1999, 2001, and so far in 2002. The table below compares the two funds over recent time periods.




Will a shift to a broader index work miracles?

Sorry. It will only work to dilute the likely underperformance of large cap stocks in the S&P 500 Index. It will do this by adding the 20 percent of stock market capitalization not included in the 500 Index.

The combination of both moves--- more fixed income, broader equity--- is likely to produce better results than the usual soothsaying.

* (http://www.scottburns.com/020519SU.htm and http://www.scottburns.com/020528TU.htm )