Sunday, August 9, 1998

Whenever one of the Couch Potato portfolio columns appears, the next day brings phone calls and e-mail from readers who are having trouble finding the exact funds.

This isnt the readers fault: the Vanguard list of fixed income funds is confusing. Starting with a total of 31 fixed income funds available for retail clients (there are others but you have to plunk down a cool million), you discover that the Mecca of Indexing actually offers only four fixed income funds that are index-managed. The other 27 are actively managed, but at very low expense, and have confusingly similar names.

There is, for instance, Vanguard F/I Intermediate Term US fund (ticker: VFITX); Vanguard Bond Index Intermediate Term (ticker: VBIIX), and Vanguard Admiral Intermediate Term US Treasury (ticker: VAITX). You can also choose from a number of short-term or long term bond funds. Basically, its pretty easy to get lost in the fine distinctions.

Should this cause you a problem?

Not really.

Just as there are people who insist on following cookbook recipes exactly and people who like to improvise, the basic idea of the Couch Potato portfolio is flexible. It will survive some fairly heavy-handed improvisation.

Lets start with the original, pure recipe. If you look on page 122 of the 1998 SBBI Yearbook, better known as "Stocks, Bonds, Bills and Inflation" from Ibbotson Associates, youll find some interesting* figures. ( * Providing, of course, that your favorite reading material is airline, bus, and train schedules.)

While long term bonds tend to have higher yields, owning them has been a losing proposition. Specifically, while the income return on long term government bonds averaged 5.2 percent from 1926 through 1997, the change in value of the bond averaged a loss of 0.1 percent and the total return was 5.2 percent. (The figures dont add.)

It has been just the reverse for intermediate term bonds. Theyve produced an income return of 4.7 percent but a capital appreciation of 0.3 percent. The total return has run 5.3 percent. In other words, they produce slightly more return but with far less risk.

Thats why I used the Lehman Intermediate Bond Index in the original couch potato portfolio. You and I can invest in funds that have intermediate maturity portfolios and low expenses.

The choice of stock portfolio was similar: since 70 percent of all managed funds tended to trail the S&P 500 index, this broad index was chosen for the Couch Potato portfolio. More recently, the index has been doing better than about 90 percent of all domestic equity funds. That makes it close to irresistible, perhaps dangerously so.

A Collection of Couch Potato Portfolios from Different Fund Firms

Portfolio Ticker Min Investment Expense Ratio Telephone
Vanguard Index 500 VFINX

$3,000

0.19%

800-662-7447
Vanguard F/I Intermediate Term US VFITX

$3,000

0.27%

800-662-7447
Vanguard Index 500 VFINX

$3,000

0.19%

800-662-7447
Vanguard F/I GNMA VFIIX

$3,000

0.31%

800-662-7447
Vanguard Balanced Index ( 60/40 stocks/bonds) VBINX

$3,000

0.20%

800-662-7447
Vanguard STAR** ( approximately 60/40) VGSTX

$3,000

0.00%

800-662-7447
Vanguard Total Stock Market VTSMX

$3,000

0.20%

800-662-7447
Vanguard Admiral Intermediate Term US Treasury VAITX

$50,000

0.15%

800-662-7447
Fidelity Spartan Market Index FSMKX

$10,000

0.44%

800-544-8888
Fidelity U.S. Bond Index FBIDX

$100,000

0.31%

800-544-8888
T. Rowe Price Equity Index PREIX

$2,500

0.40%

800-638-5660
T. Rowe Price Intermediate Term U.S. PRTIX

$2,500

0.64%

800-638-5660
Dreyfus S&P 500 PEOPX

$2,500

0.50%

800-373-9387
Dreyfus Bond Market Index DBIRX

$10,000

0.35%

800-373-9387
Schwab S&P 500 e shares SWPEX

$1,000

0.28%

800-435-4000
Schwab Total Bond Market Index SWLBX

$1,000

0.20%

800-435-4000
USAA S&P 500 Index USSPX

$3,000

0.07%

800-382-8722
USAA GNMA USGNX

$3,000

0.30%

800-382-8722

Source: Morningstar Principia (**STAR is a fund of funds, it has no expense itself but has the expenses of the individual funds.)

Query: With the stock market worth twice as much as it was only three years ago, why bother with bond funds at all? Why not just drop it all on the index and let it run?

Probably not a bad idea if youre 25, immortal, and invulnerable.

But it isnt always this way, with the S&P 500 Index whacking the world. Things change. The figures below, for instance, show how the fifteen year annualized return on cash, intermediate government bonds, and large stocks compared at the end of 1981. Cash, at 6.8 percent, was king while stocks and bonds were in a near dead heat at 5.9 and 5.8 percent annualized returns, respectively. In 1966 the conventional wisdom was that stocks were they only long term investment. In 1982, stocks were reviled.

Looking Back, from 1998 and 1982

Period Cash Int. Govt. Bonds Large Stocks
1966-1981 6.8% 5.8% 5.9%
1982-1997 6.4 10.6 17.8

Source: Ibbotson Associates, SBBI 1997 Yearbook

Another sign for caution comes from Nolan Jones, the master quant at Optima Management in Dallas. In a recent visit, Mr. Jones dropped a long term graph on his office table. It showed the trailing 36 month annualized return on the S&P 500 from December 1928 to the present. Until recently, there had been only three occasions when the trailing return exceeded 32.8 percent: in 1929; in the early thirties in a post Crash recovery; and in July, 1987. Each period of extraordinary returns was followed by a period of major losses.

Guess what?

The trailing annualized return has exceeded 32.8 percent again— in March.

Maybe a 50/50 Couch Potato is too cautious for you, but something less than all out stocks could prevent a lot of grief.