Complexity bias is the belief that complex solutions are better than simple ones. In investing, we know this all too well. From this, investors have embraced the opposite extreme by asking the question: what’s the most straightforward portfolio I can build and still achieve the same results? In life as in investing, we often overreact to things one way and the pendulum swings too far. Have we gone too simple?
“Things should be as simple as possible, but no simpler.” - Albert Einstein
The popular approach of the “three-fund” portfolio has gained a lot of steam in the past five to ten years. A recent report out by Institutional Investor discusses how a simple 60% stock and 40% portfolio outperformed almost all the Ivy Endowment Investment Strategies. The “smart” money of the Ivy league endowments is full of exclusive and sometimes exotic strategies most people will never access.
In part one of this blog series, we’ll look at the Boglehead Three Fund Portfolio and a brief history of how it got started. As we progress we’ll then look at some more evidence to question if it’s possible it is too simple.
How the Bogleheads Got Started
For Bogleheads, the idea of a three-fund portfolio is the ideal way to invest your money. It’s the lowest cost and simplest investment portfolio you can build. Rick Ferri, a Chartered Financial Analyst (CFA) and a vocal supporter of the three-fund portfolio explains, “The three-fund portfolio is composed…of a total stock market index fund, a total international stock index fund, and then a total bond index fund, which in a taxable account could be a municipal-bond fund. So, it's an intermediate-term bond fund instead of a total bond market fund, but its three funds total.” A more in-depth overview is here on the thought process of the justification for the approach. I’m not here to rehash the discussions that have explained above. If you are not looking to read those articles below are the holdings:
- A U.S. total stock market index fund – Ticker: VTSAX (mutual fund) VTI (exchange-traded-fund version)
- An International total stock market index fund – Ticker: VTIAX / VXUS (exchange-traded-fund version)
- A U.S. total bond market index fund – Ticker: VBTLX / BND (exchange-traded-fund version)
Additional evidence to support the validity of the strategy, the White Coat Investor (WCI) Blog had a post From 28 Funds to 3: Simplifying to a Three Fund Portfolio. The post was written by Physician on Fire (PoF) talking about helping someone who had 27 different mutual funds pair down to three using the Boglehead approach. The cost savings from an investment standpoint was significant. The individual also decided to self-manage and removed the asset-under-management (AUM) fee saving an extra $10,000. The post is full of links to evidence and arguments supporting the three- fund approach as well. The 27 funds seemingly were not improving returns or helping diversify that specific person. The investment funds looked to be randomly cobbled together and increased the complexity of the portfolio. Josh Brown from Ritholtz Wealth Management, (@ReformedBroker on Twitter) calls this a “mutual fund salad” investing strategy. The 28 funds is an example of an approach that’s too complex as it adds no value only complexity.
The WCI also shared a tweet link to If You Can: How Millennials Can Get Rich Slowly that covers the three-fund approach. That shows how it can make you a millionaire by investing 15% of your income and buying the same three funds. In a Morningstar article, Rick shares his thoughts, “I’ve been in the business now for 25 years--that the simplicity of a three-fund portfolio just makes more and more sense and becomes more obvious. And I’m not really convinced that having anything more than that is going to do anything more for you, except maybe make your life more complex.”
Alternatives to the Three Fund Portfolio
In the following writing, I will focus on the moderate 60% Stocks / 40% Bond approach. The late, great John “Jack” Bogle the founder of Vanguard and Rick Ferri, both are advocates for the mix. Rick's thoughts on the 60/40 portfolio, “Sixty-40 is sort of like Adam Smith’s ‘Invisible Hand,’…. We don’t know exactly why it works; it just always seems to work. In the end, when you look back over a 15-year period of time, it works.”
The allocation I've selected to review will be 40% to the US Stock Market, 20% International Stock, and 40% US total bond market. The majority of American investors have 70%-75% of their investments concentrated in the US per JPM Guide to the Markets. We will review an allocation which stays true to what most Americans own.
Financial advice should and is the majority of the reason anyone should hire an advisor. My previous work on dissecting and uncovering what is and is not advice is here. The vast majority of value an advisor offers is within the planning component. I will yet not say that investment management is not essential as well. It’s like the legs of a stool. The stool includes financial planning, investment management, and behavioral coaching. An advisor should bring all three to most efficiently achieve goals.
Asset allocation and investing is easy when times are good and returns are strong. Case and point comments from William Bernstein in his writings If You Can: How Millennials Can Get Rich Slowly. He writes, “Act like every broker, insurance salesman, mutual fund salesperson, and financial advisor you encounter is a hardened criminal, and stick to low-cost index funds, and you’ll do just fine.” In a small way, I find myself agreeing with him in a sense. The internet has brought transparency and more accountability, all positive things for consumers. I was once told at my first financial services position (within a large “wirehouse”) that CFP® stood for “CANNOT FU%KING PRODUCE” and to focus on sales Whoops! That was not the place for me. I do believe the hardened criminal comment is a bit extreme, but sometimes hyperbole is used to get a message heard. I doubt William Bernstein thinks that in every case. The WCI does advocate for real advice and advisors, so I do commend him for that stance. We share differences in opinions on some topics (investments are one), but I know the work he is doing for his followers is fantastic.
My goal is to get the message out for a subset of advisors and planners out there taking a high level of care of clients and taking the fiduciary duty to heart. Vanguard has put out a piece quantifying the value of advice at 3%. It’s possible then, that the issue falls into the total cost you’re being charged and the overreaction has gone too far. Let’s break down some simple math with simple assumptions to make my point.
Now the value of working with the advisor can create value in your annual return’s vs. working without one. Again, I make this claim for the Fee-Only and CFP® crowd, not the product salespeople. I’ve witnessed the Vanguard study being abused to twist and extort a higher fee or close a sale when not justified.
Okay, so back to the three-fund portfolio. I am not here to condemn a believer in the three-fund portfolio. My question is if I am a long-term investor are there some tweaks we could make to improve upon it? I want to take an academic and scientific approach to review the facts. Let’s look at what the evidence shows us and what we can take away from that while focusing on the question: “Are fees all that matter in investing?”
Fees Matter
"Morningstar, keepers of the keys to a financial goldmine, found that fees are the best predictor of fund performance. Not a Rockstar manager, not an empirically valid process, not an informational edge, but fees." - Dr. Daniel Crosby, PhD | The Behavioral Investor
Put that as one side of the evidence. Fees matter! Back in the late 90’s performance chasing was the hot thing. Investment managers who stuck to their guns about the process and the prices paid for a company mattered found themselves losing clients left and right. Today in 2019, we’re seeing a similar phenomenon take place. Only instead of investors performance chasing the new race seems to be in fee chasing. Examples: BlackRock cutting its fee for IVV which is an S&P 500 Index Fund by 0.000075% and Vanguard lowered its cost of VOO an S&P 500 Index Fund previously by 0.01% than IVV, and then proceeded to take in $4.3B in a week it’s biggest weekly increase ever.
Prominent critics of advisors and their investment decisions is it lacking evidence. For far too long I’ll agree we (the finance community) has built too much on “I think,” “I feel,” “The firm says,” or “We predict” amongst the hundred other bologna statements to justify investment decisions. As humans, we are full of behavioral biases, and we will discuss this in the next post. To combat biases, processes and checklist can help improve results. A popular book, The Checklist Manifesto shows how the use of checklists and systems in the business world and the medical profession improves outcomes. The book’s inspiration came from a physician that saved a young child’s life after relying on checklists.
I’m no different. Knowing a behavioral bias doesn’t make it go away. That’s why checklists and systems are so important. I know that the clients I serve and will serve have spent years educating themselves. Selecting a school involves a detailed vetting process. Then they must go through a rigorous education program to become a doctor. Whether it is through coursework and hands-on experience, academic research drives decisions. Our approach to an investment framework and review should be with the same evidence-based findings as in the medical field. The plan should be about what the research and facts show. Facts don’t have feelings, and that allows for better investing. Remove the hunches and feelings, and investment returns will improve.
So, what will the following posts hold? The work will be a process of reviewing the shortcomings of humans as long-term investors via behavioral psychology. Why the idea of an efficient market may be directionally correct but overpromised due to recency bias. A comprehensive review and deconstruction of the three-fund portfolio. Finally, what are persistent factors of returns in the market?
Conclusion: Financial Education and Evidence is Paramount
I will attempt to break the content down into layman’s terms. I will strive to bring in academic research while writing for all levels of knowledge. The goal is to empower and educate everyone, and then allow you can make a decision that works best for you. We all only live one life. If someone holds an investment philosophy that is sub-optimal and fragile, that's an issue. Often investors exposure to risks is far more than they understand. Not explaining that is unacceptable, and it’s reckless. After these posts, you can make a better decision on how to evaluate any investment process — the how and why academic research matters in investing like in dentistry.
I’ll swipe a great quote from James Clear in his book Atomic Habits. “Anything wise in these pages [blog posts] you should credit to the many experts who preceded me. Anything foolish, assume it is my error.”
Summary
- The Boglehead three-fund-portfolio has merits the biggest of which are simplicity and cost
- The three-fund-portfolio has performed exceptionally well the last ten years
- There are genuinely good financial advisors and planners in the US
- The goal of this writing is to look at investing through an academic lens with a rigor-like that of the dental profession.