"Which is the better investment: The Couch Potato portfolio or the Coffeehouse portfolio, for someone who is 58 years old and wants to retire at 60 and live, hopefully till 90?"

The question comes from a San Antonio reader. The short answer is that the Coffeehouse portfolio probably has an edge over the simple Couch Potato. The interesting part is why the Coffeehouse portfolio may have an edge.

In constructing portfolios, we should have three primary goals in mind: achieving market returns by avoiding management risk, keeping costs low, and diversifying. If the portfolio is subject to current taxes we need to add a fourth goal, tax efficiency. Both the Couch Potato and the Coffeehouse portfolios are based on index funds so they are low cost and tax-efficient.

What you gain with the Coffeehouse portfolio is broad asset class diversification. The portfolio is 40 percent fixed income plus 10 percent in each of the following: REITs, International equities, domestic small cap value, domestic small cap, domestic large cap value, and domestic large cap.

The original Couch Potato portfolio is very basic. It's 50 percent total bond market and 50 percent S&P 500 Index. So the original Couch Potato lacks the 10 percent commitments to REITs and international stocks the Coffeehouse portfolio has. It also lacks a commitment to small cap stocks. As a consequence, the Coffeehouse portfolio should have a somewhat higher return, particularly since it has 60 percent equities, while the Couch Potato has 50 percent.

Over the ten years ending December 31, 2004, a $10,000 investment in the Coffeehouse portfolio would have grown to $28,000. The same amount invested in the original Couch Potato portfolio would have grown to $26,800. Expressed as a ten year compound return, the Coffeehouse returned 10.84 percent, while the original Couch Potato returned 10.36 percent.

Both of these passive index portfolios did better than the average managed balanced fund over the same period. This is yet another indication that choosing passive investing, however it is done, is likely to produce better results than looking for a superior portfolio manager.

The Coffeehouse portfolio lost money in only one year, 2002, while the original Couch Potato portfolio lost money in two years, 2001 and 2002. The Coffeehouse portfolio beat the original Couch Potato portfolio in six of the last ten years. Here are figures for the returns, year by year.

  

Comparing Coffeehouse and Couch Potato Portfolios

Annual returns of the seven-part Coffeehouse portfolio and the two part Couch Potato portfolio, 1995-2004
Year Coffeehouse Original Couch Potato

2004

14.18

   7.45

2003

23.56

16.25

2002

(5.56)

(6.95)

2001

   1.88

(1.85)

2000

   7.25

   1.17

1999

   8.30

10.92

1998

   6.88

18.60

1997

17.95

21.32

1996

14.53

13.23

1995

22.89

27.82

Sources: http://www.coffeehouseinvestor.com/, Morningstar
  

You can see the benefit of diversification by examining the results for a shorter period comparing the Coffeehouse portfolio with the "Building Block" portfolios I introduced in March. Basically, as the number of asset classes increases, portfolio return tends to rise because a broader selection of asset classes offset losses in the domestic stock market.

  

Comparing Some Passive Portfolios

This table compares returns over a period of equity market decline for portfolios with an increasing number of asset classes.
Portfolio Number of asset classes 2000 to July 12, 2005 total return
Original Couch Potato

2

17.6 percent

Building Block C.P.

2

32.5

Margarita

3

21.7

Four Square

4

31.8

Five Fold

5

56.3

Six Ways

6

77.7

Coffeehouse

7

50.7

Source: Morningstar, author calculations
  

Ultimately, the better portfolio will be the one that is easiest to do.   Some people will choose the Coffeehouse portfolio, saying, "It's pretty simple."   Others will say, "But it's not simple enough."

Debate serves to obscure the most important fact: Low-cost index investing is better than the vast majority of Wall Street schemes.

On the web:

Sunday, March 20, 2005: Build a better portfolio, block by block

Tuesday, March 22, 2005: Putting the Building Block Portfolios Together

The Coffeehouse investor