How to Make a Two-Fund Portfolio

On this episode of The Long View, Scott Burns, syndicated personal finance columnist and author, talks about two-fund portfolios, retirement planning, the bond market, and more.

Here are a few excerpts from Burns’ conversation with Morningstar’s Christine Benz and Jeff Ptak:

Couch-Potato Investing

Christine Benz: Thanks for being here. We wanted to start by discussing your evolution toward what you have called Couch Potato Investing, something that you’ve become kind of famous for. And it’s an ultra-minimalist buy-and-hold index fund strategy. You’ve talked about how earlier in your career watching so many smart, articulate fund managers fail or just sort of flame out and never really deliver on their previous outperformance. That contributed to your change in thinking about how we all ought to be investing. Can you discuss that?

Scott Burns: Happily. I didn’t start out to be a minimalist at all. I started out in Boston. Boston is the major mutual fund headquarters that has Fidelity, Mass Financial Services, and probably a dozen others, plus a whole bunch of insurance entities. I thought at that time that, well, smart people are here, and smart people can probably do well. I was totally impressed over at Fidelity. As soon as the Apple II appeared, all of the offices on Devonshire Street for Fidelity were littered with Apple II computers. People were running the spreadsheets and doing all kinds of very interesting work. They presented well. They were all smart guys or women and yet the results weren’t there. And then, a little later, Morningstar, a company you should be familiar with, introduced through Businessweek—you’re too young to remember this—but the first mutual fund screener was introduced by Morningstar and was distributed through Businessweek. And I treasured those discs because they allowed me to screen and rank and sort and do different studies related to mutual fund performance. And what I started finding again and again and again is that the only major variable on mutual performance that was predictive was the expense ratio. It kind of gives you a message that brains don’t count for that much.

I could have made a very easy living in Boston by ignoring those results and arranging nice lunches with the portfolio manager of my choice. There were plenty of portfolio managers. They were all articulate. They all had good stories. But the statistics were starting to show that it didn’t make much difference how articulate anyone was or whether they’d gone to Harvard Business School or whatever. There was a funny day when a public relations guy from a major insurance company did confess that one of his jobs was to make sure that some of his vice presidents never saw the light of day. So, not all of the investment firms have a brain trust the way Fidelity had or Mass Financial Services.

Couch Potato Portfolios

Jeff Ptak: You have a couple of Couch Potato portfolios. One that’s total stock market, total bond market and another one that’s better diversified. It includes non-U.S. stocks and so on. You’ve discussed how the simpler one has outperformed the better-diversified one. Should most investors buy a two-fund portfolio and just call it a day?

Burns: I think so. There are a bunch of reasons for that. For me, I drank the diversification Kool-Aid and tried to do an optimized distribution of asset classes. And it did better than the Couch Potato for maybe 18 months. And then, all of a sudden, it reversed, and it wasn’t producing and has yet to produce. And the longer I’ve been writing, the more I have learned that the number of people who actually want to deal with investments and think about them is really small. And if I wanted to reach a broad audience, I had to find a simple way for people to invest that didn’t involve a whole bunch of numbers and got them away from what I call the numerical precision illusion, which intimidates a lot of people. And the Couch Potato divide by two, with the aid of a calculator, if necessary, is the way to do that. And interestingly, the results were positive both in up markets and down markets. And there was a lot of backup for it, including from the lord of all indexing, John Bogle, but also there were some Nobel laureates that did the same thing.

But this thing about the numerical intimidation, let’s think about that for a minute. Most mutual funds, their returns, whether short-term or long-term, are expressed in two-digit numbers. That return is a hundredth of 1%. That’s a tiny number in a world that has difficulty figuring out whether it’s plus or minus. And yet, the people who are not math-facile, which is the majority of the population, are intimidated. They see those numbers and they think, “Well, boy, if they can calculate in two digits like that in the past, they must know something about the future.” Well, it ain’t so.

Should Investors Tune Out the Non-U.S. Market?

Benz: Just to follow up on that ultrasimple portfolio, I think there’s a lot to like about that intuitively. But in a lot of ways, I would say the current environment reminds me a little of the late-1990s period where we had the large technology stocks at the top of the U.S. market and really driving great returns for broad U.S. index funds. And then, we had a lost decade for the U.S. market and value stocks and small caps and international performed better during that period. So, is there a risk there that if investors just hitch their whole future to the U.S. market and tune out, say, non-U.S. stocks especially, do they potentially miss out quite a bit?

Burns: I think the evidence is no, in part because the S&P 500 and smaller companies all derive a significant portion of their earnings from overseas. So, we are earning money and we have capital throughout the world. So, that’s one very big reason. The other reason, if we look around the world as desolate, as people appear to feel about the United States at this moment, we look pretty good compared with others. For instance, if you look at the other wealthy nations in Europe, their demography is terrible. They have declining populations in Italy with very low birthrates throughout the region. And that is a very big headwind to run against. Even in emerging-markets stocks, the demography is not favorable. It’s turned unfavorable in China. It’s been unfavorable in Japan for years. And in other areas, it’s problematic like the Middle East. So, I just don’t feel there’s a compelling reason to do it.

How to Make a Two-Fund Portfolio

Ptak: Maybe back to the two-fund portfolio. Clearly, you’re predisposed to index. But what about the stock/bond split and how one should go about setting that? How do you think somebody should approach that? They say, “I’m going to pick up my two funds—one is a stock fund, the other a bond fund.” How should they set the mix?

Burns: It all depends on the inclinations of the person. If the person is aware of and considers their human capital, I think that the theory of human capital is very useful. And if you have a secure job, you can invest very aggressively when you’re young and become less aggressive as you get older. If you don’t have a secure job, which is a more common condition, you might just start 50/50. Or you can just pick a number that you feel comfortable with. I like 75/25 for younger workers. But again, it depends on where they’re employed and how it’s going to change. I have a younger brother who’s a university professor and he’s been quite secure. So, his employment is a bond, so he can afford to invest aggressively.