When I interviewed the late John Bogle two years ago, he emphasized his belief that most investors are often best served by a simple plan they will stick with for the long term, even though a more complex and challenging plan may be likely to make them more money.
Bogle wove that point of view into the fabric of The Vanguard Group, of which he was the founder and longtime chief executive.
Though Vanguard investors can build complicated portfolios, the company offers simple options that do a fine job of getting good results with relatively little effort.
That Bogle interview inspired me to search for a simpler way to implement an asset allocation strategy I’ve been recommending for the past quarter of a century.
Unfortunately, there’s never been a way to implement my Ultimate Buy and Hold Strategy in just one mutual fund, and there may never be one.
That’s a shame, because this strategy, which makes up the bulk of my own retirement investments, has a long-term track record of producing significantly higher returns than the S&P 500 index, with little if any additional risk.
But could investors get the major benefits of this portfolio with only two funds?
I think the answer is yes. My two-fund solution comes from research and analysis done by my friend and colleague Chris Pedersen, who is devoting a good part of his life these days to helping investors.
Leaving out some important details, here’s the broad outline of my two-fund strategy, in three bullet points:
- Use a target-date retirement fund as the “base” of your portfolio for controlling risk and producing reasonably good long-term expected returns.
- Use a “booster” fund that invests in value stocks to improve your long-term return.
- The booster fund should make up the majority of the portfolio for young people, then gradually give way to the target-date fund as retirement approaches.
Chris did lots of research on ways this two-fund combination could be put into practice. He and I have come up with two variations.
Protocol 1: For maximum simplicity, you can make a single lifetime decision and let the results play out. For example, a 25-year-old with presumably 40 years until retirement could allocate 90% of his retirement savings to a target-date fund and the other 10% to a small-cap value fund.
That’s it — an asset allocation that doesn’t need to be rebalanced, ever. Based on the historical data we have, that is likely to produce 30% more money after 40 years than the target-date fund alone.
Protocol 2: To take much fuller advantage of the long-term premium expected return of value stocks, here’s a more aggressive variation.
Multiply your age by 1.5. That tells you what percentage of your portfolio should be in the target-date fund. Keep the rest in a value fund. Adjust this allocation periodically as you age, and your portfolio will automatically shift more and more to the target-date fund.
For your “booster” fund you can choose small-cap blend (conservative), large-cap value (moderate), or small-cap value (aggressive).
Recently I’ve been talking to lots of investors about this strategy, and I have had lots of questions. Here are a few of them:
Question: My 401(k) plan doesn’t offer small-cap value but they do have target-date funds and a small-cap fund that is balanced between growth and value companies. What should I do?
Answer: You have described a small-cap blend fund, and it certainly can work as a “booster” to complement a target-date fund.
Studies of 40-year periods in the past suggest that if you use a small-cap blend fund in what I described above as Protocol 1, you could wind up with 20% more money than if you used only the target-date fund. If you used a small-cap value fund instead, the additional return could be 45%.
Either way, you can expect the booster fund to produce a very significant improvement. But I think the difference between 20% and 45% is worth the extra trouble of adding small-cap value.
If you can’t get small-cap value in your 401(k), you certainly can get it in an IRA.
My advice: First, contribute enough to your 401(k) to get the maximum employer match. Then, use an IRA to gain access to a small-cap value fund. If you include a target-date fund in your IRA, you’ll be able to rebalance when you need to.
Question: How can you be so confident that small-cap value stocks will keep producing higher returns?
Answer: Obviously, I cannot know the future. But I can know the past, and I can know what academic researchers believe. That knowledge gives me confidence (although not assurance) that small-cap value investing will continue to be very worthwhile for long-term investors.
One study tracked the performance of various asset classes in all 40-year periods since 1927. In 94% of those periods, small-cap value had the highest return of all the asset classes under study.
The S&P 500 index — the major equity holding of target-date funds — was the top performer in only 4% of the 40-year periods.
Many people have found this statistic equally interesting: The worst 40-year return for small-cap value was almost as good as the best 40-year return for the S&P 500.
The academics generally agree on two points:
- Over the 51 rolling 40-year periods since 1927, small-cap value has produced about 5 additional percentage points of compound return compared with the S&P 500.
- Small-cap value is likely to significantly outperform the S&P 500 in the future.
Question: I’m young and not interested in owning bond funds or international stock funds. Can I skip the target-date fund and substitute a U.S. total market fund or an S&P 500 index fund?
Answer: Yes. As a young investor you don’t need bonds, and international stocks won’t make a life-changing difference. But as you age you should add a bond fund to reduce risk. That gives you three funds for life — still very manageable.
Question: You say young investors shouldn’t have bonds, yet many target-date funds include 10% bonds even for very young investors. Why recommend those funds?
Answer: If I were designing a target-date fund, it wouldn’t include bonds for investors in their 20s. Some families already do this, which I prefer. But expenses, turnover, and equity exposure also matter — and the two-funds-for-life strategy improves all target-date funds regardless.
Later this year I’ll compare these funds from the major companies to help investors choose wisely.
For more on this strategy, check out the video and two podcasts here.
Richard Buck contributed to this article.