Have you shifted into a Permanent Portfolio yet?

Here are the returns of the individual components of the lazy portfolios:

*Note that these results use Yahoo! Finance adjusted historical returns with the exception of IFA portfolios results from IFA.com that include IFA’s fee.

Permanent Portfolio performance during the very volatile month of May

This May was the worst May since 1940.  The Dow and VTI (total stock market) both had losses of -7.9%.  Volatility has returned to the market!  When the market is volatile, the wisdom of investing in the Permanent Portfolio becomes apparent.  The Harry Browne Permanent Portfolio always has the same four assets: total stock market (VTI), gold (GLD), long term Treasury bonds (TLT) and short term Treasury bonds (SHY).  These assets are rebalanced each year.

Let’s see how the Permanent Portfolios performed on a weekly basis for the very volatile month of May.

Date                Stocks            Gold           Long Bonds     Short Bonds      PermPort
—               VTI               GLD                 TLT                  SHY

May   3 –   7          -7.0%               2.5%              4.1%                  0.3%                     0.0%
May 10 – 14           3.0%               1.8%             -0.7%                  0.1%                     1.0%
May 17 – 21          -4.5%              -4.3%              3.7%                 0.1%                    -1.2%
May 24 – 28           0.7%               3.2%             -2.0%                  0.0%                     0.5%

Total for May       -7.9%               3.1%              5.1%                  0.5%                     0.2%

2010 to May          -0.1%             10.8%              8.9%                  1.4%                     5.5%

The week-by-week returns show that the Permanent Portfolio is much less volatile than the VTI.  The volatility is amazingly low because the VTI and TLT (and GLD) move in opposite directions — they are negatively correlated.  The first week of May provides a good example of the negative correlation of the assets:  the VTI was down -7.0% while GLD was up 2.5%, TLT was up 4.1% and SHY was up 0.3%.  This resulted in a 0.0% change for the Permanent Portfolio.  The returns for each of the other three weeks further demonstrate the negative correlations of the assets.

The final returns for the month of May show that if you had been invested in the Permanent Portfolio you would have been ahead by 0.2% instead of being behind by -7.9% for a VTI investment.  A Permanent Portfolio investor would not think that this May was the worst May since 1940.

The last line in the table shows the year-to-date returns for each of the assets.  The advantage of the Permanent Portfolios over the VTI (total stock market) is obvious.

The main problem with the Permanent Portfolio is that it is just too boring for most investors!

Below is a Return vs. Risk Chart for these portfolios from 1985 through 2009 (Note: this chart does not include returns through the end of May 2010). The ideal portfolio would be high return at low risk and thus appear at the top left of the chart. [Chart data is computed using Simba's spreadsheet from the Bogleheads.org forum with the exception of IFA portfolios from ifa.com.]

See how there is almost an invisible boundary line from lower left to upper right? That is the “Efficient Frontier” and shows that returns are correlated with risk over the long term. It is nearly impossible to construct a portfolio that will be above that efficient frontier. So the only question you need to answer is, how much risk are you willing to accept. That is, can you tolerate the downturns in the market in the short term?

Looking at a shorter term, here is a chart showing just the previous ten years from 2000 through 2009.

I like the boost to returns the Paul Boyer Permanent Portfolio got during prosperity and it didn’t hurt too much during recession either.

And to see if you can indeed stomach a bad short term, here is a chart with just the previous three years:

How about a chart of just the recent heyday of stocks from 2003 thru 2006:

Looking at past charts is fun, but should not be the only data you use to make investment decisions. I like the Permanent Portfolio concept because it is so simple, has low fees, and covers the four economic cycles of prosperity, inflation, deflation, and recession. It has been shown to be the lowest in risk among the lazy portfolios while not sacrificing returns. They are the only portfolios to include gold.

Here are the components of each of the portfolios*:

*Note that these results use Yahoo! Finance adjusted historical returns with the exception of IFA portfolios results from IFA.com that include IFA’s fee.

Would you be interested in an all-weather portfolio that, despite hardly ever changing its composition, performs creditably in almost all market environments?

Hulbert characterizes the Permanent Portfolio this way:

Browne’s idea was to invest in a basket of asset classes, each one of which has a low correlation with the others. As a result, when any one of the asset classes is performing poorly, there is a good chance that the others will at least be holding their own — if not actually appreciating in value.

He describes Harry Browne’s Permanent Portfolio as an antidote to volatility. He then gives some past performance of the PRPFX fund which somewhat implements Harry Browne’s concept:

This fund over the last 15 years (through Apr. 30) has produced an 8.2% annualized return, which is remarkable given that stocks, gold and bonds did not, individually, do as well: The Wilshire 5000 index gained 7.9% over the same period, the Shearson Lehman Treasury Index produced a 6.3% annualized return, and gold bullion rose at a 7.7% annualized pace.

I might suggest that while the result of the four asset classes is low correlation, that is not the way Harry Browne explained the reasoning. Instead, the portfolio is designed to have one component that does well in each of four different economic circumstances: prosperity (stocks), inflation (gold), deflation (LT Bonds), and recession (cash). Harry said that while you can expect one of the assets to go down, the one that goes up more than makes up for the loser. For example, while one asset may go down 30% or 40%, the winning asset can go up 200% or 300%, more than making up for the loss.

I think the best thing about the portfolio is this: No one can predict the future so we might as well invest in all possibilities.

Thru yesterday’s market turmoil, the components have done the following:

VTI +2.8% (Stocks)

TLT +9.2% (Bonds)

SHY +1.3% (Cash)

GLD +10.4% (Gold)

And the total portfolio, assuming 25% in each at the start of 2010 is…

+5.9%

How’s that compare with YOUR portfolio?

And here’s the book you need to read:

First, the original portfolio:

Stocks: VTSMX (Total US Stock Market)
Bonds: VUSTX (Long-term Bond)
Cash: VMPXX (Money Market)
Gold (Kitco 1972-2004, GLD 2004-2009)

yielded the following return vs. risk:

P1 (HBPP):

Compound Annual Growth Rate (CAGR): 9.1%
Standard Deviation (Risk): 8.02%
Sharpe Ratio: 0.46

Next, substitute 2-Year Short Term Treasuries (VFISX) instead of Money Market:

P2 (P1 with 2-yr T-Bills):

CAGR: 9.5%
Standard Deviation (Risk): 8.17%
Sharpe Ratio: 0.50

Alternatively, how about for the “Prosperity” component, i.e., Stocks, we substitute  half US Small-Cap Value and half Emerging Markets for the US Total Stock Market:

P3 (P1 with 12.5% VISVX and 12.5% VEIEX):

CAGR: 10.8%
Standard Deviation (Risk): 8.57%
Sharpe Ratio: 0.64

And finally, combine P2 and P3 to have 2-yr T-Bills, US Small Cap Value, and Emerging Market:

P4 (P2 with 12.5% VISVX and 12.5% VEIEX):

CAGR: 11.3%
Standard Deviation (Risk): 8.65%
Sharpe Ratio: 0.68

And just for comparison I ran “Solver” on Simba’s spreadsheet to find the least risky portfolio that yielded 11.3% of that time span. It came up with the following mix:

VISVX (US Small Cap Value): 13.43%
VEIEX (Emerging Market): 14.30%
PCRIX (Commodities): 5.19%
VFITX (5-Yr T-Bills): 49.31%
VFISX (2-Yr T-Bills): 7.88%
Gold: 9.88%

Which resulted in:

P5 (Solver optimized portfolio):

CAGR: 11.3%
Standard Deviation (Risk): 7.25%
Sharpe Ratio: 0.80

And here is a chart with them all plotted, CAGR vs. Standard Deviaion (Risk):

I’ve played with lots of combinations of back-tested portfolios through many different time periods and one thing is common: substituting VISVX and VEIEX for VTSMX resulted in higher returns and a higher Sharpe Ratio. And short term T-Bills for cash also added nicely.

Note that I only show the Solver optimized portfolio (P5) for reference. I believe it strays too far from the Permanent Portfolio strategy to be safe going forward.

I talked about P4 on MMM-175: The Perfect Portfolio. While I am not yet invested in it, it is the one I am targeting. I do not expect a CAGR of 11.3% for the next 37 years, but if I can get 6% I will be very happy.

To start, I selected a widely-followed portfolio of stocks and bonds. The Fund Advice Vanguard Moderate portfolio has the following composition:

(Fund Advice recently split their recommended 12% of VDMIX into 6% VDMIX and 6% VFSVX, the All-World ex-US Small Cap index.)

The Fund Advice portfolio placed 32% in fixed-income and 68% in equities. For the period 1972 through 2009, the portfolio achieved a compound annual growth rate (CAGR) of 10.95% with a standard deviation (risk) of 11.6%. This works out to a Sharpe ratio of 0.51.

Let’s now see what would have happened if instead of 100%, we placed 75% of our investment in the Fund Advice portfolio and the remaining 25% in gold. We would have achieved a CAGR of 11.09%, a risk of 10.08%, and a Sharpe ratio of 0.58. So gold did add to the returns for the period while reducing the risk. How could that be since gold itself was very risky over the period? Gold by itself returned only 8.62% while being a whopping 26.88% risky.

How about instead of investing the 25% in risky gold, we had placed the 25% in safe but similarly rewarding Treasury Money Market fund? The Vanguard VMPXX by itself for 1972 through 2009 had a CAGR of 5.66% with a risk of only 3.03%. The resulting combination with the Fund Advice portfolio shows a CAGR of 9.75%, a risk of 8.77%, and a Sharpe ratio of 0.5.

The return vs. risk of the three portfolio mixes and the individual components gold and money market (MM) are shown in the following graph.

So against our intuition, investing in risky gold actually reduced risk in the overall portfolio while adding to the returns. It even beat a comparable portfolio that invested in money markets. This is the power of Modern Portfolio Theory in action showing that while some assets zig, others zag to combine in wonderful ways.

Sources: Vanguard.com, Simba’s spreadsheet (with 2009 data added), Bogelheads.org, FundAdvice.com.

Here is the model portfolio composition which is based on the IFA Index Portfolio 25 (source). We will call this the Vanguard 25 portfolio:

I am going to use the time period from 1999 through 2009 for the analysis. Crunching the numbers in Simba’s spreadsheet (Revised with 2009 data added. More info about the spreadsheet at the Bogleheads forum.) I come up with a compound annual growth rate (CAGR) of 5.6% with a average annualized standard deviation (risk) of 7.1%. This works out to a Sharpe ratio of 0.41 for the time span.

So, what if instead of having 100% of our total investment in the Vanguard 25 portfolio we placed just 75% of our investment in it and placed the remaining 25% in gold? Running the numbers in Simba’s spreadsheet (Simba uses this source for gold’s annual return.)  I come up with a CAGR of 7.5% with a risk of 6.9% resulting in a Sharpe ratio of 0.70. Call this one Vanguard 25 w/ Gold. The following chart plots these two results. As a reference I also show on the following charts the Harry Browne Permanent Portfolio which is comprised of 25% each of Total Stock Market (VTSMX), Long Term Gov’t Bond (VUSTX), Money Market (VMPXX), and Gold.

Also shown in the chart is the same exercise but instead of placing 25% in gold we substitute a Treasury bill money market fund (VMPXX) for the 25%. The portfolio with money market fund added resulted in a CAGR of 5.0%, risk of 5.3%, and a Sharpe ratio of 0.41. Call it the Vanguard 25 w/ T-Bills. Note that the Sharpe ratio is the same as the original portfolio because in a Sharpe ratio calculation we subtract out the risk-free rate of return of money markets. So adding money markets to a portfolio does not change the ratio of return vs. risk.

The next chart adds the individual return vs. risk of gold and money market for the same time period showing the higher risk with accompanying higher return of gold for the period.

This next chart adds the individual return vs. risk of all of the other components of the Vanguard 25 portfolio for the same time period.

And for the fun of it, I computed the optimal portfolio for the time span based upon the highest Sharpe ratio and as computed by Excel Solver. This tool allows you to specify an attribute you wish to maximize while varying the percentage amounts of the various funds. In this case, we chose to maximize the Sharpe ratio and allow Excel Solver to pick which combination of which funds achieved it. The following table shows the result.

The OPTIMAL portfolio resulted in a CAGR of 5.8%, a risk of 2.6%, and the resulting Sharpe ratio of 1.12. Its addition to the first chart is shown below.

How about continuing to optimize with a high Sharpe ratio yet obtaining greater return? To do that I subtracted some short-term bonds and added some gold leaving the other two components the same. That is, gold at 35% and bonds at 57%. This resulted in a CAGR of 7.6%, risk of 7.7% and Sharpe ratio of 0.99 and can be seen in the following chart.

Therefore, to answer the original question, “Should a portfolio own gold?” it appears that for the period 1999 through 2009 the answer would have been a resounding “yes.” We find that adding gold to the portfolio resulted in higher returns with less risk.

I caution that this process is called data mining and should only serve as input into future portfolio analysis and not serve as the only decision regarding future investments. In subsequent analysis I will not limit the possibilities to just the Vanguard 25 fund set but will open it up to Vanguard funds available since 1972 and/or 1985.

Sources: Vanguard.com, Bogleheads.org, IFA.com, and http://www.finfacts.ie/Private/curency/goldmarketprice.htm

As you can see, the Harry Browne Permanent Portfolio still has the best “top-leftedness” of these select Lazy Portfolios. It had an annualized return of 8% with an annualized standard deviation of 8.8%. That results in a nicely high Sharpe ratio of 0.75, assuming a risk-free rate of return of 1.37% for all 5 years (not likely).

The HBPP’s out-performance is due to the stellar performance of gold through all of these years. I am still not convinced this is the one for all seasons. So I will be performing some analysis of this portfolio for the years that were most favorable to equities and not gold and see how the HBPP would have held up.

Remember that you’d want your portfolio to be at the top left of the chart because their you get the higher return with the lower risk.

So for the three year period from 2007 through 2009 the Harry Browne Permanent Portfolio showed the best return and the least risk of any of the featured lazy portfolios. More analysis to come…

Here are some takeaways from the table:

1. These portfolios have different objectives, different asset class mixtures, and different risk profiles. Simply comparing them on historic returns is not a way to pick one for an investment.
2. Therefore, a better way to view these would be to look at them on a return vs. risk graph where risk is defined as the standard deviation of the portfolio. Then we could see at a glance which portfolio has the more desired “top-leftedness” (meaning it had higher return for its level of risk).
3. Only two of the portfolios invested in gold, the two top performers. Future results may vary.
4. I believe most funds have no load.
5. I changed the Harry Browne Permanent Portfolio cash holding from VFISX to SHY which results in a slightly lower return (about 1% less). I would prefer to hold it in a money market fund, but Yahoo! Finance does not give me historical returns for them.
6. Remember, this table probably has errors!

Fed Chairman Ben Bernanke said the same thing on February 18th:

Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve will ultimately stoke inflation. The Fed’s lending activities have indeed resulted in a large increase in the reserves held by banks and thus in the narrowest definition of the money supply, the monetary base. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of unacceptably high inflation in the near term; indeed, we expect inflation to be quite low for some time.

He acknowledged that they are inflating. But he threw a red herring into the mix by talking about weak economic activity and low commodity prices (Heh, except gold, right Ben?) trying to infer that they are somehow the cause of inflation. No, they are the result of inflation. Next, he went into how they will correct their inflation:

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to moderate growth in the money supply and begin to raise the federal funds rate. To reduce policy accommodation, the Fed will have to unwind some of its credit-easing programs and allow its balance sheet to shrink. … However, the principal factor determining the timing and pace of that process will be the Federal Reserve’s assessment of the condition of credit markets and the prospects for the economy.

Bernanke recognized that the plane is in a nosedive and at the last minute he plans to push on the stick and go airborne again. I hope it is not a cloudy day when he has to judge how far the plane is from the ground. He wrapped up his thoughts on inflation and how to avoid it:

As we consider new programs or the expansion of old ones, the Federal Reserve will carefully weigh the implications for the exit strategy. And we will take all necessary actions to ensure that the unwinding of our programs is accomplished smoothly and in a timely way, consistent with meeting our obligation to foster maximum employment and price stability.

What do *you* think the chances are that the Fed will get all of the necessary actions right? Have they gotten the necessary actions right up to this point? Let us examine a scenario where they are not able to get it right and we do indeed experience undesirable inflation, which I will define to be anything above 5% annually.

How might the various asset classes be affected in times of inflation? To answer this question, I utilized Simba ’s spreadsheet for back-testing portfolios (which I imported into Google Spreadsheets) to do a correlation between CPI (Consumer Price Index, the government’s official inflation number) and various stock fund, bond fund, and gold returns. The data in the spreadsheet uses annual returns of Vanguard index funds along with the yearly closing price of gold from the years 1971 – 2008.  The spreadsheet already calculated the cross-correlation between each of the mutual funds and it lists the annual CPI index. So it was very easy to drop the CPI into one of the mutual fund slots and instantly see the correlation between every asset class and inflation. Here are the results, sorted by correlation:

The table shows those asset classes that were most closely correlated with the CPI at the top. Note in the third column that a value of 1 would mean the asset is perfectly correlated, -1 would mean perfectly correlated inversely (it went down exactly as CPI went up), and 0 means there was no correlation: it was random.

So we see that those assets that were most highly correlated with CPI were T-bills, gold, long-term government bonds (inversely), short-term Treasuries, and commodities.  Everything else was below 0.25 correlation. Interestingly, micro cap stocks were totally uncorrelated with inflation.

So how did a portfolio of those assets perform during the years 1973-1981 in which CPI was 8.7, 12.3, 6.9, 4.9, 6.7, 9, 13.3, 12.5, and 8.9%?

I constructed a portfolio along the lines of the Harry Browne Permanent Portfolio (HBPP invests 25% each into total US stock market, long-term bonds, money market, and gold) but I added some small cap value, micro cap, and eliminated the long-term bond fund. I then back-tested that portfolio during those inflation years. Here is the portfolio what I came up with:

The Inflation Portfolio:

VISVX (Small Cap Value) 15%
BRSIX (Micro Cap) 15%
PCRIX (Commodities) 10%
VMPXX (Money Market) 45%
Gold 15%

The "Inflation Portfolio" had a CAGR (Compound Annual Growth Rate) of 15.5% and a risk (as measured by standard deviation) of 10.5%. Plotting that on a chart, here’s what it looks like compared with some other portfolios and the assets themselves:

The chart shows plots for various portfolios during those inflation years. The plot point directly above HBPP simply substituted BRSIX for VTSMX in the HBPP. The major components of the Inflation Portfolio are also plotted separately showing how volatile gold and BRSIX were themselves. When tempered together with VMPXX, the risk came down considerably while retaining significant returns. You can see all of the rest of the details in the Google spreadsheet that I created for this scenario and you can test out other hypotheses yourself.

The Inflation Portfolio worked from 1973 through 1981. If we see inflation return, would it work again? Some folks are discussing these findings at the Bogleheads forum if you want to chime in.

Please note this is not a recommendation to invest your net worth in the Inflation Portfolio!

That posting is in error (that I do not believe was my fault). I have corrected it. It turns out that Feb 1, 2008 thru Jan 31, 2009 was not the worst 12-month rolling period, but it did come close.

I’ll be watching to see what happens at the end of this month.

Here is the corrected chart.

I have copied Simba’s Backtest Portfolio spreadsheet from the Bogleheads forum into a Google Spreadsheet that you can use to back test a portfolio of Vanguard mutual funds and compare their performance from 1972 – 2008 to the IFA Index Portfolios. Combine the funds any way you like and compare them against IFA’s twenty portfolios. I included the "returns" for gold there for your convenience.

This graph from that spreadsheet shows the plots of a few others including the Coffeehouse portfolio, Harry Browne’s Permanent Portfolio, Scott Burns’ Four Square portfolio, and a couple of others along with IFA’s portfolios (they follow a nice line). Unfortunately, Google spreadsheets doesn’t do labeling very well on the data points. I would have liked each point to be colored and have a legend identifying those colors. Anyway, remember you want to be at a point at the top left on this graph. The line that is formed is called "The Efficient Frontier" beyond which it is difficult if not impossible to achieve. The strong correlation between returns and risk is evident.  However, it is easy to be bottom right!

If you want to play with the spreadsheet yourself, feel free to bring it up. You’ll need a Google account. Leave the years to be 1972 – 2008 in order for the comparisons to be valid. Here’s the link:

https://spreadsheets.google.com/ccc?key=pOjc3ot10vgs0eml-DJZKcw&newcopy

But wait, there’s more!

IFA is now allowing you to submit your past financial statements to them so that they can compare you’re portfolio’s performance against their index portfolios. Go their web site at ifa.com to learn more. Here are some comparisons they have already performed.

The web site is http://www.icarra.com

Get over there and create an account and try it out. They have really made some nice improvements since I last used it.

At the end of October 2008 we experienced the worst 12-month rolling period for stocks in 50 years. Then at the end of November we outdid that.  Now at the end of January 2009 we have a new low for a 12-month rolling period in many indexes and portfolios. We came close to the worst rolling 12 months again, but did not pass it.

The following table is taken from ifa.com, combining the returns for 11 months from 1 Feb 08 through 31 Dec 08 and the 1 month return for Jan 09.

Here is the corrected table.

Previous table, wrong:

Source: http://www.ifa.com/portfolios/PortReturnCalc/index.aspx and http://www.ifa.com/portfolios/

So let me outline a few points that need to be understood in order to discuss this rationally.

The Lazy Portfolio Smackdown was set up to compare the return vs. risk characteristics within index investing. We did not compare index investing vs. other strategies. However, in 2006 we did run a comparison against a stock-picking strategy. We compared Jim Cramer’s buy buy buy stocks against two lazy portfolios, one with ETFs and one called the IFA Index Portfolio 100 . The lazy portfolios gained over 20% that year and the stock-picking portfolio was -0.2%. But that’s just me, not a scientific study. Let’s move on.

He asks, "what is the point of standard deviation in this table?" Yes, it is shown over one year here. The context is that we are comparing the volatility of an investment vs. the return it generates. After all, risk is the source of returns. Why use standard deviation? It helps us compares apples to apples. It is a good way to compare the performance of a 100% equity allocation against a 60/40 equity/bond allocation, for example. The 100% equity is expected to have a higher risk than the 60/40 split. But what if both portfolios had the same return? Obviously the 60/40 would have been a better choice. Said another way, there must be something wrong with the composition of the all equity portfolio.

But I do caution that looking at portfolios over just a one year period is not sufficient. We really need to look at much longer time frames to statistically capture the correlation of return to risk. But this is also the escape hatch of active managers. If they are lucky one year, they tout their "out performance" as proof they know something. Why do we never hear from the "under-performers?" Very few of active managers have long term records of performance. And of those that do, fewer still have outperformed the market. In fact, I don’t know of any who have. Remember Bill Miller of the Legg Mason Value Trust fund (LMVTX) who was the only manager to outperform the S&P 500 for 15 consecutive years? Have a look at a chart of LMVTX for 2008. His long-term returns are completely wiped out.

Let me answer another way. The standard deviation is used to calculate the Sharpe Ratio of the portfolio. The simplest definition of this ratio is that it measures "top-leftedness" of a portfolio when plotted on a chart of return vs. risk. As return goes higher on the y axis and risk gets larger going right on the x axis we want our portfolio to be top left as far as possible. High returns at low risk is the ideal.

Here is a return vs. risk chart of some of the Lazy portfolios in 2008:

Source: Foliodex.com (when it works) You can see a pretty tight correlation between risk and return.

Remember that risk also measures the potential losses in a portfolio as well as the potential gains. The higher the risk, the higher the potential magnitude of both losses and gains. Sure the Lazy Portfolios had large losses in 2008. But compared to what? Freddie Mac? GE? AIG? GOOG? Or how about these gems from one of Andrew’s posts at the beginning of 2008. He says, "It is a good time to look for deep value…" while cautioning not to chase yield.

I skipped some of the banks in his "screen" just to save time. What would these stock picks look like plotted on the chart above? Pretty much bottom right. Some would be completely off the chart both bottom and right.

But let’s say you were an absolute genius and picked the five best of these and invested your portfolio there. With 20% in each of LEG, PFE, EQR, PGN, WIN I calculate a 2008 return of -14.9% with a risk of 23%. Looking that up on the chart, it would indeed have been better than most. So, what are the chances you would have been a genius and picked the absolute five best? And when should you sell? You have to be right twice, remember? What if, instead, you picked a couple of the worst stocks?

I mentioned that risk is the source of returns above. But keep in mind that there are various types of risk: unsystematic and systematic are two. Systematic risk refers to the risks of the entire market as opposed to the unsystematic risks specific to one stock. Unsystematic risk is not rewarded. Investing in the stock of a single company adds only risk but not return. Better to invest in a market portfolio which minimizes the unsystematic risk of any one particular company. Take a look at this reward vs. risk chart over a period of 20 years. It compares a market-based approach vs. picking individual stocks. Remember that you want to be top-left. Sure, MSFT had higher returns, but would you have been able to put your entire net worth in that one stock and ride its volatility? Even the entire Dow Jones underperformed portfolios 50 thru 100.

What portfolio of stocks can you pick that go further top left than in that chart? And at what effort? If being lazy yields such great reward vs. risk characteristics, why waste time, energy, bid/ask spreads, commissions, tax consequences, and other expenses doing anything else?

Why would someone be so antagonistic towards lazy portfolios when it can be shown they have the best return to risk ratio over the long term? Let’s look at the economic incentives of holding different positions on investing. If someone wants to make money in the investing business, would they try to come up with a unique angle and give their clients the impression they know something that everyone else does not? Or would they follow a scientific approach that most everyone else already knows? Most try the former, thinking it appeals to clients who are seeking answers.

If one were to make commissions from trading stocks, would that person advocate trading or not trading? If one were to make a fee from assets under management, would that person ask you to invest with them or would they say you can do it yourself? Sure, some people don’t want to do it themselves. In that case they need an advisor that can assess their risk capacity and place their investments in a portfolio of index funds.

If one were to write a book on investing, would they try to come up with unique strategies to outperform the market or would they simply tell people to invest in the market? You know there have been studies of active managers showing that the odds of them beating the market over the long term are about 1 in 38, the same odds of picking one number on a roulette wheel? But of course your manager is the one that beats the market, right? Hey, maybe he actually did beat the market last year. Everyone floods into his fund or firm. Like Bill Miller’s or Bernie Madoff’s. It is what happens next that sickens.

When one takes a rational look at Lazy Portfolios, one can hardly call them "idiotic." Unless of course one is in the business of making money trading stocks on behalf of others.

The game started one year ago. I asked people to create a buy and hold portfolio of index funds or ETFs that would exhibit the best return-to-risk ratio in 2008. This would be measured by “top-leftedness” on a plot of Return on the Y axis and Standard Deviation on the X axis. For positive returns, the Sharpe Ratio accomplishes this nicely. But when all returns are negative, the Sharpe Ratio gets screwy (a technical term) and I had to reset 0%  to be at -50% to make it work. Even when all returns are negative, we still want to be top left on the chart.

Winners were to be selected from each of three risk bands: 0% to 8%, 8% to 16%, and then 16%+. Funny how the game worked out. Last year was a RISKY year. Only one person had a portfolio with a Standard Deviation of less than 8%. Congratulations Cosmo, you had a STDEV of 3.5% and a return of 5.1% with your portfolio holding a single fund: the Vanguard Short-Term Bond Index (VBISX). You are the winner of Index Funds: The 12-Step Program for Active Investors by Mark Hebner. And if you actually had your net worth invested in that portfolio, you had a great 2008.

Next up, the medium risk band. As it turned out, nobody had a positive return here, as you can see in the following chart. Which one is top left? The one who lost the least amount is Ariel with a return of -12.6% and a STDEV of 8.2%. Ariel also put the entire net worth in one fund: Vanguard Wellesley Income Adm (VWIAX). Congratulations Ariel, you too are the winner of Index Funds: The 12-Step Program for Active Investors by Mark Hebner. 

Finally the guys who took great risk. This one is a littly silly because here you can gamble on something extremely risky and come out the winner if your number comes up. I should have limited it to something reasonable like 25% or something. Nonetheless, the winner is mudfud who invested in one fund: the China Bear 2X Fund (which was closed on November 14th by the way). Now who in their right mind would really put 100% of their portfolio in this fund? That wasn’t the idea behind this game. Still, if you could handle a risk of 56.1%!!!! OUCH!!! then you got a return of 42.4% for your gamble. Congratulations mudfud, you too are the winner of Index Funds: The 12-Step Program for Active Investors by Mark Hebner.

You can see all of the other entries at the Lazy Portfolio Smackdown page and you can see the portfolios of the so-called “Professionals” — those who make a living recommending portfolios to folks like us.

I’ll be talking more about the results on the Mad Money Machine podcast. Please load it into your iTunes or visit MadMoneyMachine.com to listen on your computer.

Pull the covers up over your head.

Don’t look. 

Well… how about just a little peek?

After ten months of this relentless bear market nonsense, the leader of the professional lazy portfolios has a return of -10.3%. That’s the Harry Browne Permanant Portfolio which bests the rest by at least 10% so far this miserable year. The secret to its “success?” It’s 25% each in Total US Stock Market, 20-year bonds, treasuries, and gold.  The average of the 27 “professional” lazy portfolios is -28.5%.

Ah, but the leader of the individual entries? How about a positive 41.8%! Of course that’s our non-diversified, anti-china gambler mudfud with his china bear fund. The other winner is Mr. UltraShort himself, Tex Williams, with 80% of his portfolio in ultrashort ETF bets. Most everybody else is playing the game to go long the market for a long time, and is savagely to the down side where they are suppose to be. hahaha. The average of the individual entries is -28.0%

A reminder of what this game is all about for those of you who are new here. At the beginning of 2008, I asked people to design a portfolio of index funds or ETFs that will exhibit the highest Sharpe Ratio by the end of the year. (I didn’t put it in exactly those terms at the time, but now I realize that’s what I meant.) Winners in three risk bands (less than 8%, 8% to 16%, and 16% plus) get a free copy of Index Funds: The 12-Step Program for Active Investors by Mark Hebner. I’m hoping Foliodex.com will be working in early 2009 to help me compute the Sharpe Ratios. Otherwise, I have a handy spreadsheet ready.

I’ve updated the Lazy Portfolio Smackdown returns through the end of Q3. Only mudfud and Tex Williams are in the black. They both invested in short funds, surprise! Of the professional lazy portfolios, the Harry Browne Permanent Portfolio is *only* down 2.2% YTD. It invests equal parts in total US stock market, 20 year bonds, short-term treasuries, and gold. Biggest loser so far is poulinbob, down 30% with equal parts of three Vanguard funds: Growth Equity, Precious Metals and Mining, and Total International stock index. OUCH!

BTW: Some returns may be adjusted in the days to come as dividends get reinvested in some funds.

A reader at Diehards.org/forum asked me to add Harry Brown’s Permanent Portfolio to the professional entries. His portfolio is made up of 25% each of the Vanguard Total US Stock Market (VTI), iShares Lehman 20 yr Treasuries (TLT), Cash or short-term Treasuries (I used ticker symbol VFISX), and Gold (GLD). The portfolio is up 1.58% YTD.

You can see graphs of the all of the portfolio results for several different time periods by going to Foliodex.com. One group is for the Lazy Portfolio Smackdown Game Entries and another group holds the Professional Lazy Portfolios, although it is polluted with more portfolios than I am currently tracking.

Total return leaders YTD for the Professionals is Harry Browne (up 1.6%) and Scott Burns Five Fold (down 0.8%).

Total return leaders for the game entries are mudfud, with his 2X China Bear fund, up 25.5% and Tex Williams with his UltraShort funds up 14.6%.

Note that the leading YTD return portfolios are not the kind of buy-and-hold portfolios that are most frequently recommended by the sages at the Bogleheads Forum.

It seems to me that if someone is in the accumulation phase of their long term investing career that these times where stock prices are significantly off of their highs may make it more appealing to continue to add to their portfolios.

But the article’s author concludes that the Barron’s piece is sound. And I particularly agree with the author on this point, something that I have been saying also:

First, and foremost, CNBC is wrong to air a show that is centered on stock picking without tracking its own performance or even keeping a record, using whatever criteria it chooses, of the stocks it picks.

Either that or come out and say, "Do not trade on these recommendations."

Too bad the Barron’s article didn’t use the research we conducted here at the Mad Money Machine in both 2006 and 2007 that showed experimentally that following Jim Cramer’s stock picks lagged the markets.

wizkid writes in Some Lazy Portfolio Entries Backtested:

OK – Ready to audit the calculations.
Please define the calculation of Return and Risk using the multiple periods.
Is return – average annualized return, compounded return with reinvesting dividends, rebalanced annualized return, etc. etc.
Is the risk based on monthly returns, monthly rolling etc.

Explain the reason for the timeframe – why Aug 2000 as the start date?

Great job on comparing the portfolios!

To which I replied:

Oh excellent! Love a 2nd pair of eyes.

I started with August 2000 because if I went back further in time, VIPSX (Vanguard Inflation Protected Securities) didn’t exist prior to that (at least according to Yahoo). And it is used in several portfolios.

I pull monthly “Adjusted” historical stock quotes from Yahoo finance (using that free tool RCHGetYahooHistory) These presumably account for reinvested dividends and for things like splits.

I calculate but do not report the annualized return and annualized risk for each fund. Then I also calculate and report the total portfolio’s return and risk, as below:

Five columns are used in the spreadsheet for each fund:
Date, Adj Close, Normalized, Gain, Value
Date = the first trading day of each month
Adj Close = the funds value brought back from Yahoo including (subtracting) reinvested dividends
Normalized = first month, fund value starts at 1. Each subsequent month therefore shows the total gain
Gain = delta in the value between each month. This is used to calculate the annualized standard deviation.
Value = this fund’s contribution to the total portfolio. Basically, multiply the Normalized column by the fund’s percentage in the portfolio

Then to compute the returns and risk on the total portfolio, I add up all the Value columns for each month, calculate another monthly gain difference column for the total portfolio, compute the total annualized standard deviation, and report the annualized return as:

=+(Last value/First value)^(1/((End date-Start date)/365))-1

I calculate Annualized Standard Deviation as
=STDEV(RANGE*SQRT(12)) where RANGE is the gain column (each monthly difference in value).

It takes about a minute for the spreadsheet to load as it draws all the stock histories from Yahoo.

I DO NOT PERFORM REBALANCING. I should probably do this, huh? Will have to think about how to code it up in Excel.

Suggestions for improvement greatly welcomed.

The graph below plots the values from the above table. The best place to be is top and left. Note how you could almost draw a line from bottom left to top right. That would be the efficient frontier line. The idea is that the more risk you take, the more you should be rewarded. If a winner were to be awarded in each of three risk bands (0-8%, 8-16%, and 16%+) based upon this graph it looks like HAZEL, Jennifer & Mark, and poulinbob would each get a copy of Index Funds: The 12-Step Program for Active Investors. Although Kevin Ucker and Bev and Mike Cote have it going on too.

It is worth comparing these results with the Professionals I showed in a previous posting.

And just to see what you would have gone through in the past one year, here is how the portfolios did since the start of 2007:

Some of the IFA Index Portfolios are shown in circles. Notice how as the portfolios take on greater risk, they also achieve greater return. Notice how the IFA Index Portfolios generally have greater return for the same amount of risk than the other portfolios. There is a single outlier in the Scott Burn Six Ways from Sunday Portfolio. So let’s take a detailed look at it.

This portfolio returned 11% annually with 9% risk. So how did Scott Burns do it? Looks like he got a good return on bonds which have lower volatility than stocks while also getting great returns on REITS and in the specific sector of energy. How did his portfolio do recently? Also, not too bad. As you see on the Lazy Portfolio Smackdown page, the portfolio dropped only -2.91% in January. Again, those bond funds helped cushion the blow.

The following comparison takes a look at the portfolios since August 2006. This places more heavy emphasis on the poor performance of REITS and small cap US stocks in 2007. Not fair to compare them on such a short time span, but there it is.

We can see the out-performance of Ted Aronson’s heavily-weighted emerging market portfolio. It gained 10.48% with 10.21% risk in the 1.5 recent years. He has 20% in VEIEX the Vanguard Emerging Markets fund. It gained 28.63% over the period.

You can see the components of all portfolios on the Lazy Portfolio Smackdown page.

Let’s say you have a $200,000 portfolio. This year alone you would save about $4,000 by becoming a Couch Potato investor rather than an investor in actively managed mutual funds. Over a few years, assuming you reinvested all of your savings, the difference would grow and grow, because the money you would be saving would compound on itself. Assuming typical rates of return, the money you would save by becoming a Couch Potato would be more than enough to buy you a luxury car in 10 years’ time even if you were never to invest another cent in your portfolio.

There are several links to click around to get the whole story, but they are worth a look. They compare the performance of the Couch Potato portfolio against the Canadian stock index. Hey, I gotta take a look at making sure I own some of that Canadian stock index! (Canadian stocks might NOT be a part of your international index fund!) Thanks James for the tip off.

Ted Aronson’s portfolio did well because it’s equity portion was composed of 25% emerging markets VEIEX which went up 39% in 2007. He only had 6% in Small Cap Value VISVS which went down 7.1%. His overall 13.6% return was pretty good for the year. 

Scott Burns’ portfolios came in 2nd and 3rd. His Margarita portfolio has only two equity funds split equally between Total Stock Market VTSMX and Total International Stock Market VGTSX which went up 5.5% and 15.5% respectively. This is the laziest of the lazy portfolios and amazingly did really well last year.

The worst performer? Ben Stein’s "safe" portfolio for retirees that relied on great dividends. But you know, if you didn’t sell, and instead reinvested the dividends, it might not be a bad deal in the long run because those reinvested dividends are buying stocks cheaply right now. As Jeremy Siegel says in his book The Future for Investors, dividends were one of the keys to big returns in stock investments.

Here’s the breakdown of the portfolios I created:

In 2006 we had a portfolio smackdown between a portfolio of Cramer’s recommended stocks that I selected vs. a basket of ETFs I bought and held. The ETFs won. In 2007 we featured a portfolio smackdown between Cramer’s recommended stocks that 20 volunteers selected vs. the IFA Indexfolio 100. It is neck and neck, meaning being lazy must win, right? So next year in 2008 I would like to create a new competition I’ll call the Mad Money Machine Lazy Portfolio Smackdown in which we pit all the various lazy portfolios against one another. We will be judging not only on return but also risk, as measured by standard deviation. The Mad Money Machine Lazy Portfolio Smackdown will of course feature the IFA Indexfolios, which are the gold standard of reward vs. risk portfolios. We will also include the other lazy portfolios that I have mentioned here previously. But also to make this fun and community-involved, I will include YOUR suggested lazy portfolio.

The rules are simple:
1. Create a portfolio of ETFs or Mutual funds (not individual stocks!) and indicate the percentage holding of each fund. Please limit the number of funds to 15 or fewer as anything more than that is not lazy.
2. Email the ticker symbols and percentages to me at Feedback AT MadMoneyMachine dot com.
3. I will calculate on a weekly basis the YTD return of the portfolio and the YTD standard deviation.
4. I may also try to go back in time with the portfolio to show its historical annualized return and annualized risk. Obviously, most ETFs don’t have any long history, so I may use substitute funds.
5. Three winning portfolios will be selected based upon closing prices December 31 2008 and will be the ones that have the highest reward vs. lowest risk for the year in each of three deciles: 0% to 8% risk, 8% to 16% risk, and 16+% risk.
6. Winners will receive a copy of Index Funds: The 12-Step Program for Active Investors by Mark Hebner of Index Funds Advisors at IFA.com, will be crowned Lazy Portfolio Manager of the Year, and other valuable awards to be determined!
7. Entries must be received before 2 January 2008 so act quickly.

The "Cost per $100k" column indicates how much each fund would cost you for every $100,000 in your total portfolio. For every $100k in the portfolio, this would cost you $1,226 per year. That is higher than a typical lazy portfolio which usually comes in at about half of that.

Results thru 11 December 2007 show a 14% annualized return and a 16% annualized risk.

Here’s the result, first sorted by annualized return over the nearly seven years:

Now, sorted by lowest risk:

You might enjoy seeing it as a scatter plot:

Now take a look at the same kind of chart only over a longer time span and INCLUDING THE DOW JONES 30 STOCKS!

Going farther to the right means you are taking on more risk. Basically, you want to find an investment at the upper left. The line that crosses from lower left to upper right is the “Efficient Frontier.” I think this is one of the most important concepts to understand in all of investing. That is why the icon for the Mad Money Machine incorporates it.

Note: I cannot guarantee the accuracy of these results. More likely, I might guarantee there is a mistake somewhere. But in general, the numbers give a good idea of the relative risk vs. reward results. No taxes or advisor fees were removed from the results.

NOTE THAT THESE ARE THE EQUITY ONLY PORTIONS OF EACH PORTFOLIO. I REMOVED THEIR BOND COMPONENT (IF ANY).

Sorted by long-term performance:

Now the short-term, YTD sort:

Here is the detailed holdings of each portfolio. The 3rd column is the original portfolio percentage including bonds. The last column shows the equity weightings without bonds.

Details of IFA IndexFolio 100 are here.

So, here’s the portfolio I constructed of Vanguard (and one Bridgeway) funds to try to match the IFA Indexfolio 100:

You can compare that against the IFA Indexfolio 100 to see how I tried to capture each asset class.

And here is how the performance compares:

The conclusion must be that when you allow Index Funds Advisors to help you, you get a twofer: help, and better returns.

NOTE THAT THESE ARE THE EQUITY ONLY PORTIONS OF EACH PORTFOLIO. I REMOVED THEIR BOND COMPONENT (IF ANY).

Here is the detailed holdings of each portfolio. The 3rd column is the original portfolio percentage including bonds. The last column shows the equity weightings without bonds.