Two-Fund Solution

Charles Ellis’s article “The Loser’s Game” compared investing to tennis.  He said that the markets had become so efficient that it was unlikely that even professional investment managers could consistently earn above-market returns.  The amateur tennis player’s winning strategy is to just get the ball over the net and let his opponent make a mistake.  Similarly, according to Ellis, investing had become a game of earning market returns and letting someone else make the mistake of timing the market.

So what is an amateur or do-it-yourself investor to do?  He or she can build a well-diversified stock and bond portfolio that is built to earn market returns (for a given risk level and minus fund fees) using two Vanguard funds.  The first is the Vanguard Total World Stock Index (ticker: VTWSX) and the Vanguard Total U.S. Bond Index (ticker: VBMFX).  We call this two fund portfolio the Two-Fund Solution.  Building this portfolio requires that one determines their unique need and ability to take the risk of loss in pursuit of portfolio growth.

The following table summarizes an analysis of the risk and returns of 3 portfolios using indexes that approximate the returns of the two Vanguard funds in the Two-Fund Solution.  The analysis spans the time period from January 1, 1970 through July 31, 2014, a little longer than 44.5 years.  0.25%/year has been subtracted from the annual returns to account for the fund fees in the Two-Fund Solution.  The portfolio was rebalanced once a year.  Since stock and bond prices move throughout the year, the stock to bond mix can, and usually does change.  At the end of each year, these portfolios were restored to their original stock to bond ratios (i.e. 40/60).  With the caveat that past performance does not guarantee future results let’s review the analysis.

from 1/1/1970-7/31/2014 • all figures annualized

from 1/1/1970-7/31/2014 • all figures annualized

To build the Two-Fund Solution, the first item to focus on is the worse one year loss row.  Note that the 80/20 portfolio had a 1 year loss that was more than twice the the one year loss of the 40/60 portfolio.  The Two-Fund Solution has to ask themselves this crucial question, “When my portfolio has lost 40% of its value in less than a year, could I sell bonds to buy stocks?”  Keep in mind that this is exactly what is required to rebalance the portfolio to its original allocation.  If the investor cannot stand such a loss (and research shows that few amateur investors have this emotional strength) then the investor should choose a lower stock allocation in their portfolio.  They cannot take the risk of an 80/20 portfolio.

Once the risk level has been determined the do-it-yourself investor can build the Two-Fund Solution with the stock and bond mix that is consistent with the acceptable level of risk.  For example, if the investor can stand a 30% loss in a year, the 60/40 portfolio may be an acceptable allocation for them.  Keep in mind we have only explored the ability to take risk and have ignored the need to take risk.  The need to take risk requires an analysis that is more complex and is beyond the knowledge base of most do-it-yourself investors.  

We’ve discussed the do-it-yourself investment process and portfolio.  How does the professional financial advisor approach investing?  We’ll discuss that topic next week.