A revolution is spreading across the American investing scene. The proponents of this new way of thinking claim that investing has become far too complicated, too fast paced and too infatuated with complex trading ideas. According to its fans, the best strategy for most ordinary investors is to invest using Lazy portfolios, simply constructed, using basic investment theory that’s built around the cornerstones of modern asset allocation theory and portfolio analysis. It's all about cheap, simple, easy to understand, long-term investing made simple.
"Investing should be dull. It shouldn't be exciting. Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas... it is not easy to get rich in Las Vegas... or at the local Merrill Lynch office". That's Paul Samuelson, the Nobel economist quoted at the beginning of American investment writer Paul Farrell's excellent book, "The Lazy person's Guide to Investing". It pithily sums up the view of most professional economists - modern investing has become too complex for ordinary investors to really understand and profit from.
The idea behind investing made simple is that you buy a smallish number of well diversified equity and bond funds at low cost and stick with them over the long term, only switching between risk profiles as you grow older. To understand why this idea makes sense, you first need to understand our collective failings as investors.
1. We all collectively over-trade
There's a mountain of investment research on this subject but Farrell quotes one study by University of California behavioural finance researchers Terry Oldean and Brad Barber who researched the portfolios of 66,400 investors at brokers Merrill Lynch between 1991 and 1997. The professors concluded there were 2 very specific factors that hugely reduced returns – lousy stock picking and transaction costs ie the cost of over-trading.
In fact the most active traders averaged 258 per cent portfolio turnover annually and earned 7 per cent less annually than buy and hold investors who averaged 2 per cent turnover. The moral of story – trading costs money, while long term buy-and-hold investing by contrast delivers greater results because it's a consistent, coherent strategy designed to capture long-term trends.
2. We constantly try to market time
Calling the market high or low is almost impossible for the average investor – hugely experienced hedge fund managers poached from the trading desks of investment banks find it equally baffling. Again Farrell quotes another US study – by the Charles Schwab Center for Investment Research – that looked at three buy and hold investors who each received $2,000 annually for 20 years – a total of $40,000. Over the next two decades they then compared three different investment strategies.
The first was the Perfect (Foresight) Timer, the investor who puts their money into the market at the monthly low point every year - their lump sum after 20 years amounted to $387,120. The next investor was terrified of risky equities and only puts their money into Treasury Bills (our version of gilts) – their lump sum at the end was $76,558. The 'auto-pilot Investor' simply invested the money evenly spread over the year on an autopilot basis, just using a specified date every time. Their lump sum amounted to $362,185.
The bottom line - even if you're gifted with perfect foresight, you'd still only have made an extra $25,000 or so over the best ever market timer, while also taking on huge extra risk – the results in this scenario would have much worse if you're timing had been only 50 per cent accurate.
3. We chase momentum... in the wrong way
Chasing momentum really can deliver brilliant results – that's the radical conclusions of Professors Elroy Dimson, and Paul Marsh at the London Business School in their annual Global Investment Returns Yearbook, published with ABN Amro. The secret - buy the most popular and successful shares as rated by their relative strength rating against the market. Over the period between 2001 and 2007 for instance they found that the winner-minus-loser return from a carefully constructed strategy called "12/1/1" would have amounted to an extra 1.77 per cent extra performance per month.
This 12/1/1 strategy involves buying a portfolio at the beginning of February on the basis of previous 12 months returns and holding the portfolio only for a month. They even kindly displayed a table for what you'd buy in 2008 comprised of 20 shares valued at more than £100m.
The difficulty is that this strategy actually involves buying 20 shares, and a large amount of trading – which eats into returns of course – as well as strict adherence to the rules of the game.
4. We're not really diversified
Diversification, sensibly applied, produces spectacular gains yet we British don't actually seem to have learnt the lesson. Far too many of us stuff our portfolios with blue chip high street bansk and the off mining company but not what it should be – a globally diversified list of stocks and funds. And according to stockbroker Selftrade, the average holding of shares in a portfolio is just five companies – that's not even five diversified funds, but five specific (blue chip) individual shares.
5. We're dazzled by experts and it costs us money
We're confused by the huge choice of shares and investment ideas out there and like all humans we react in a number of ways. The first is that comfort ourselves with familiarity – if we've heard of it, used it and like its products, we buy the shares, thus our bias towards blue chip consumer brand names.
The Lazy Alternative
The main essentials of this lazy, simple, easy strategy are as follows:
1. Use funds. According to fans of the Lazy approach, it makes sense to run a portfolio that captures the broadest markets trends simply – capturing beta as it’s called – and the simplest way to do this is via a fund.
2. Simplicity wins out. You should aim to have enough funds to capture diversity but not too many to confuse and dilute your ability to capture that beta we mentioned earlier. Analyst Paul Merriman of US outfit FundAdvice says just four funds, tracking just four indices isn’t diversified enough – his research based on a huge database provided by Eugene Fama at Dimensional Fund Advisors suggest that owning 10 asset classes increases your total return to the sensible maximum.
3. Capture those broad market trends/beta cheaply. US fund manager Bill Miller at Legg Mason is legendary for consistently beating the S&P 500 index - he did for 16 years, until it all went a bit pear shaped two years ago when his magic started to fade. He may well recover his legendary touch but if even he can fail, in relative terms, you can bet that the other 99.99 per cent of fund managers out will do much, much worse. By and large this logic suggests that the safest way to capture the market is to do so efficiently – by using index tracking funds – and cheaply, by lowering the cost of fund management.
4. Diversify in a smart way. In the latest annual Barclay's Equity Gilt Study economist Kevin Kneafsy draws attention to the four demons of modern investment, and in particular to the most heinous, what he calls 'asset class focus'. Like many he's worried that professional investors are increasingly wising up to the power of diversification and that means they try to include lots and lots of different asset classes in their portfolios – this explains the fascination with ever more wonderful and complex indices measuring every conceivable asset known to mankind. But although investors may be tracking lots of different indices these exotic indices used by this myriad of funds are actually all driven by our collective exposure to the broader economic risk in the US economy and sub-prime – that explains why so many markets and so many global indices have collapsed in a synchronised way. True diversification means investing in markets and assets that move entirely independently of the key US market.
5. Don't rebalance your portfolio. IFAs in particular love to boast about complex software that 'tactically re-allocates' your portfolio on a monthly/quarterly/annual basis – the software acts as a surrogate for the huge 'asset allocation committees' currently popular at the huge fund of fund managers. According to economist and Barron's columnist Ben Stein, it's all guff. "The financial services industry loves to tout portfolio rebalancing as a value-adding strategy" says Stein in a recent book on investment where he set out to find out if rebalancing works. "The idea is that every year we should sell a little of that 12 months' winners and use them to buy the current losers so that we bring our portfolios back into alignment with their original specs. We looked at 10,000 Monte Carlo simulations involving complex, seven-asset-class portfolios. We experimented with several calendar-based strategies, rebalancing the portfolios monthly, annually, or never... We also looked at tolerance-based rebalancing approaches: rebalancing when the portfolio wandered 10, 15, and 20 percent from its original allocations." The results over a 25 year back test (involving a notional $1000)? Monthly rebalancing delivered the worst results while never rebalancing delivered the best results.
6. You can reflect your attitude to risk in a lazy portfolio. This is an idea most clearly picked up on by a variant of Lazy investing called Lifecycle funds (see bow below).
Some Practical Ideas for Lazy Portfolios
Hopefully by now, you've got the message. Keep it simple, cheap and stick to the plan through thick and thin. But where do you start – how do you actually go about building these Lazy portfolios?
Farrell starts his Lazy Investing book off with two tried and tested strategies worth looking at.
Couch Potato Portfolio.
This was developed by Scott Burns, an investment columnist on the Dallas Morning News. His 2-Fund Lazy Portfolio is as simple as it gets and has worked a treat – it was launched in 1991 but it’s been back-tested to 1973, delivering returns of 10.29 per cent per annum.
1.50 per cent main market domestic equities (in this case an index fund called Vanguard / S&P 500 Index) . This tracks the S&P 500
2.50 per cent in bonds and government securities (again in another Vanguard fund called Vanguard Total Bond Market Index Fund – this tracks the Lehman Brothers Aggregate Bond Index of treasury bonds and corporate bonds)
So, if you want to copy this, you could put 50 per cent into the broadest domestic equity index (in our case the FTSE All Share) and another 50 per cent in an index that broadly captures bond/gilt returns such as iShares FTSE All Stock Gilts fund with a smaller percentage in their Sterling Liquid Corporate Bonds fund.
The CoffeeHouse Portfolio
A few years back Bill Schulttheis – a former Salomon Smith Barney broker turned financial adviser - wrote one of the most successful investment books of recent times, the Coffeehouse Investor. He built his Lazy, coffee fuelled Portfolio around seven funds, all equally weighted (they're also all Vanguard unit trust mutual funds again - they're very, very cheap, easily accessible and they're hugely efficient in capturing the underlying indices):
• Main domestic US (or UK) market – in this case the S&P 500
• Value orientated domestic large caps – the Vanguard Large Cap Value
• Small caps - Vanguard Small Cap Index
• Small cap value stocks - Vanguard Small Cap Value
• International excluding the USA - Vanguard International
• Property funds - Vanguard REIT Stock Index
His 7-fund Coffeehouse portfolio has averaged an annual return of 11.42 per cent although an even simpler version involving absolutely no annual rebalancing at all delivered 11.79 per cent.
William Bernstein, a leading investment columnist and writer, has crated two model portfolios of his own - his No Brainer Basic portfolio of just four funds and his slightly more complicated No Brainer Cowards.
William Bernstein's Basic No-Brainer Portfolio
• 25 per cent in the main S& P 500 index (Vanguard 500 Index (VFINX))
• 25 per cent in the main US Small Cap index (Vanguard Small Cap (NAESX) or (VTMSX))
• 25 per cent in a diversified international index (Vanguard Total International (VGTSX) or (VTMGX))
• 25 per cent in a US bond fund (Vanguard Total Bond (VBMFX) or (VBISX) )
William Bernstein's No-Brainer Coward's Portfolio:
• 40 per cent in Short Term Investment Grade funds (VFSTX)
• 15 per cent in Total Stock Market (VTSMX)
• 10 per cent in (US) Small Cap Value (VISVX)
• 10 per cent in a Value Index (VIVAX)
• 5 per cent in Emerging Markets Stocks (VEIEX)
• 5 per cent in European Stocks (VEURX)
• 5 per cent in Pacific Stocks (VPACX)
• 5 per cent in real estate trusts or a REIT Index (VGSIX)
• 5 per cent in Small Cap Value (NAESX) or (VTMSX)
Bernstein's run the Cowards portfolio for five years now, and it's produced an annualised return of 9.37 per cent per annum (compared to 6.19 per cent for the benchmark S&P index), and 11.35 per cent over the last five years (compared to 10.44 per cent for the S&P 500), all done by using simple tracker funds that cost less 0.4 per cent per annum in management fees.
Another Lazy portfolio worth checking out comes from David Swensen, the chief investment officer of Yale Universities' hugely successful endowment fund. This comprises just five indices, all using vanguard index tracking funds.
David Swensen's Lazy Portfolio:
• 30 per cent in Total Stock Market Index (VTSMX)
• 20 per cent in REIT Index (VGSIX)
• 20 per cent in Total International Stock (VGTSX) or (15 per cent in VDMIX and 5 per cent in VEIEX)
• 15 per cent in Inflation Protected Securities (VIPSX)
• 15 per cent in Short Term Treasury/Gilt Index (VFISX)
Again this Lazy portfolio has beaten its benchmark by a considerable margin – delivering five year annualised returns of 11.54 per cent compared to 6.19 per cent for the S&P 500 main American market index.
