A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

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Boxtrap
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A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by Boxtrap » Tue Apr 24, 2018 1:35 pm

So I've been playing around with Portfolio Visualizer for a few days, just doing some comparative back testing of various portfolios...primarily the Two Fund, Three Fund, "Core 4", The Merriman Ultimate Buy & Hold, The Coffeehouse, and my own modified version of the Coffeehouse.

One of the things that is talked about so often here - and rightfully so - is the power of simplicity in investing. In particular, I have seen more and more here lately about how the Three Fund portfolio, consisting of Total Stock Market, Total International and Total Bond, captures the heart of diversification and simplicity. And by the way, I mostly agree with this - in fact, my current 401k is allocated in this exact 3 Fund portfolio.

But interestingly, when I compared all the different types of portfolios I mentioned at the top of this post in Portfolio Visualizer over the last 30 years in a 90% equities / 10% fixed income spread, the one that performed the best wasn't the Merriman UB&H (which I know Paul touts as being superior to simpler portfolios), it wasn't any version of Coffeehouse, it wasn't Core 4 or even the classic Three Fund.....it was good old fashioned 2 fund Total Stock Market and Total Bond market. It didn't outperform its nearest competitor by a ton, but it did outperform. If this isn't proof of the benefits of simplicity, I don't know what is. It did even better than a three fund that holds Total International.

Of course we have no idea if this will be true in the NEXT 30 years. Past performance doesn't predict future results. And I did not run comparisons with different spreads between equities and fixed-income (80/20, 70/30, etc), but I found it to be really eye opening nonetheless that in this particular simulation, the absolute simplest portfolio of all - Total US Stock Market and Total US Bond Market and nothing else - beat the rest.

Thoughts welcome!

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by Pajamas » Tue Apr 24, 2018 1:38 pm

How did a 1 fund portfolio of Total Stock Market compare to the 2 fund portfolio?

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by brother7 » Tue Apr 24, 2018 1:42 pm

Can you post numbers so we can get an idea of the degree of over/underperformance?

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by neurosphere » Tue Apr 24, 2018 1:49 pm

Boxtrap wrote:
Tue Apr 24, 2018 1:35 pm
It did even better than a three fund that holds Total International.
So what you are saying is, perhaps there is no need to hold international stocks? Adding international caused minimal difference overall?

Now you can search the forum for threads debating the best allocation to foreign stocks. There are passionate and well-reasoned arguments for anywhere between zero and 50%.

My take, is that it didn't make a difference in the past (subject to all the usual disclaimers about time periods studied, rebalancing, etc), but I'd rather have it for diversification. I'm happy with a 3-fund portfolio, and I allocate 40% of equities to international. If you want simpler than a three fund, you can always use a target date funds. Most (all?) target date funds have some international in them. If international doesn't make a difference in the future, it won't hurt you, and you'll still have the "simplest" portfolio, at least as measured by number of funds! :D
If you have to ask "Is a Target Date fund right for me?", the answer is "Yes".

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by Boxtrap » Tue Apr 24, 2018 1:57 pm

I actually prefer the 3 fund too. I don't like not having a little more direct international exposure. But it was just shocking to me that the 2 fund did better than the 3 fund over that 25 year period. Over the next 25 years, who knows? I'm very happy with the 3 fund and will probably leave it be, but it was just a very interesting exercise. I will try to post some actual numbers a little later so everyone can see the figures.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by GibsonL6s » Tue Apr 24, 2018 2:04 pm

Funny you should mention this, I was also looking at portfoliovisualizer and seeing how a "world allocation" portfolio did. There ware not a ton of funds going this far back, but it generally looked like the introduction of foreign debt instruments did not dampen volatility, they increased.

I could see holding a portfolio of total US stock and treasuries and be done.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by cfs » Tue Apr 24, 2018 2:05 pm

Simplicity?

Did you compare all of them with the ONE fund portfolio of Vanguard Balanced Index (VBINX/VBIAX)?

Good luck, y gracias por leer ~cfs~
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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by GibsonL6s » Tue Apr 24, 2018 2:42 pm

cfs wrote:
Tue Apr 24, 2018 2:05 pm
Simplicity?

Did you compare all of them with the ONE fund portfolio of Vanguard Balanced Index (VBINX/VBIAX)?

Good luck, y gracias por leer ~cfs~
Not sure if this was for me, but the Vanguard balanced fund generally provided the same general returns as some of the world funds, but with less volatility.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by Boxtrap » Tue Apr 24, 2018 2:56 pm

Here's one of the most interesting sets of figures I came up with. It's the contrast between Paul Merriman's Ultimate Buy & Hold - very extensive and 11 funds to manage - and the Ultimate In Simplicity of Total US Stock Market and Intermediate Term Treasuries.

For both of these it's a 23 year period, $40k initial balance, $720 monthly contributions, 90% on the equity side and 10% on fixed income side.

Merriman Portfolio (allocated as he lays it out in his podcast/articles):
Starting balance: $40,000
Ending balance: $933,860
CAGR: 14.51%
Standard deviation: 13.65%

Ultimate Simplicity of Total US Stock / Intermediate Term Treasuries:
Starting balance: $40,000
Ending balance: $932,843
CAGR: 14.51%
Standard deviation: 13.25%

RESULTS: Merriman's 11 Fund Ultimate Buy & Hold outperformed by $1,017. That's nothing. That's barely a blip. The CAGR is identical. The two funds did the exact same thing for all intents and purposes, but the simpler two fund portfolio actually had 40 bps reduced volatility.

I'm not knocking Paul, by the way. I really like his podcasts and articles and most of what he says I agree with philosophically. But when you compare his portfolio - and also factor in all the trouble and stress you'd probably have rebalancing it - with the simplicity and ease of Total US Stock Market and Intermediate Term government paper, why on earth would you not choose the latter?

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by Rick Ferri » Tue Apr 24, 2018 3:00 pm

The challenge isn't to compare one to another, the challenge is get people to do ANY of them and stick to the strategy long-term.

If two funds work for you, GREAT! Do it! If Core-4 is your thing, OUTSTANDING! Go for it! You like Taylor's three-fund portfolio, FANTASTIC! It's an excellent choice!

It's not the fund strategy that's important, it's the philosophy behind the strategy and the discipline to stick with it. We all believe in one philosophy and yet we can all have very different strategies. It's all perfectly fine. Whatever works for you and keeps you disciplined.

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The Education of an Index Investor: born in darkness, finds indexing enlightenment, overcomplicates everything, embraces simplicity.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by Boxtrap » Tue Apr 24, 2018 3:06 pm

Rick Ferri wrote:
Tue Apr 24, 2018 3:00 pm
The challenge isn't to compare one to another, the challenge is get people to do ANY of them and stick to the strategy long-term.

If two funds work for you, GREAT! Do it! If Core-4 is your thing, OUTSTANDING! Go for it! You like Taylor's three-fund portfolio, FANTASTIC! It's an excellent choice!

It's not the fund strategy that's important, it's the philosophy behind the strategy and the discipline to stick with it. We all believe in one philosophy and yet we can all have very different strategies. It's all perfectly fine. Whatever works for you and keeps you disciplined.

Philosophy - Strategy - Discipline
The Three Keys to Investment Success

Rick Ferri
Hi Rick - couldn't agree with you more. You're right, you could spend an eternity comparing every plausible portfolio. I just found this to be an interesting exercise. Admittedly I'm also looking for as much data justification for keeping it simple.

Absolutely loved All About Asset Allocation, by the way! The week I spent reading that book was enormously insightful!

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by nisiprius » Tue Apr 24, 2018 3:08 pm

I'd appreciate it if you'd post links to the actual portfolios you tested. You can get that here:

Image

The result will look something like this:

Code: Select all

https://www.portfoliovisualizer.com/backtest-portfolio?s=y&s=y&timePeriod=4&startYear=1985&firstMonth=1&endYear=2018&lastMonth=12&endDate=04%2F23%2F2018&initialAmount=10000&annualOperation=0&annualAdjustment=0&inflationAdjusted=true&annualPercentage=0.0&frequency=4&rebalanceType=1&showYield=false&reinvestDividends=true&sameFees=true&symbol1=VTSMX&allocation1_1=90&allocation1_2=70&symbol2=VGTSX&allocation2_1=0&allocation2_2=20&symbol3=VBMFX&allocation3_1=10&allocation3_2=10
1) You didn't say exactly what allocation you used for the 90/10 "three-fund."

2) I can't get thirty years of backtesting for "Bogleheads three-fund" portfolio: "The time period was automatically adjusted based on the available data (May 1996 - Mar 2018) for the selected asset: Vanguard Total Intl Stock Index Inv (VGTSX)." That's only 22 years.

3) I want to see the Sharpe ratio as well as the average (CAGR) return. One of the biggest issues in comparisons occurs when people only compare return without taking risk into account in any way. It is fairly easy for a portfolio with higher risk to outperform one with lower risk--and it doesn't mean much.
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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by Boxtrap » Tue Apr 24, 2018 3:14 pm

nisiprius wrote:
Tue Apr 24, 2018 3:08 pm
I'd appreciate it if you'd post links to the actual portfolios you tested. You can get that here:

Image

The result will look something like this:

Code: Select all

https://www.portfoliovisualizer.com/backtest-portfolio?s=y&s=y&timePeriod=4&startYear=1985&firstMonth=1&endYear=2018&lastMonth=12&endDate=04%2F23%2F2018&initialAmount=10000&annualOperation=0&annualAdjustment=0&inflationAdjusted=true&annualPercentage=0.0&frequency=4&rebalanceType=1&showYield=false&reinvestDividends=true&sameFees=true&symbol1=VTSMX&allocation1_1=90&allocation1_2=70&symbol2=VGTSX&allocation2_1=0&allocation2_2=20&symbol3=VBMFX&allocation3_1=10&allocation3_2=10
1) You didn't say exactly what allocation you used for the 90/10 "three-fund."

2) I can't get thirty years of backtesting for "Bogleheads three-fund" portfolio: "The time period was automatically adjusted based on the available data (May 1996 - Mar 2018) for the selected asset: Vanguard Total Intl Stock Index Inv (VGTSX)." That's only 22 years.

3) I want to see the Sharpe ratio as well as the average (CAGR) return. One of the biggest issues in comparisons occurs when people only compare return without taking risk into account in any way. It is fairly easy for a portfolio with higher risk to outperform one with lower risk--and it doesn't mean much.
Sorry, for the 90/10 3 funder my allocation was 72% S&P, 18% Total Int'l, and 10% Int. Term Treasury.

Yes, I meant to say that the back tests I did were roughly 23 years. I wasn't able to go back 30 years either.

Can you explain the Sharpe ratio a bit? Would love to understand that better.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by voodoo72 » Tue Apr 24, 2018 3:34 pm

GibsonL6s wrote:
Tue Apr 24, 2018 2:42 pm
cfs wrote:
Tue Apr 24, 2018 2:05 pm
Simplicity?

Did you compare all of them with the ONE fund portfolio of Vanguard Balanced Index (VBINX/VBIAX)?

Good luck, y gracias por leer ~cfs~
Not sure if this was for me, but the Vanguard balanced fund generally provided the same general returns as some of the world funds, but with less volatility.
Seems if you went back 30 years having only Vanguard Total Stock market index did even better returning a 9.49 % CAGR, gives me pause. The 2 fund did about 7.5%, and 3 fund 6.78%, hmmmmm. 8-)

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by Clever_Username » Tue Apr 24, 2018 4:02 pm

I am accidentally in a two-fund portfolio, sort of. Maybe. All my stocks are domestic (total domestic market for IRA shares, Vanguard institutional index (S&P500) for workplace account). My conservative portion is a mix of total bond, Series I Bonds, and CA Munis (Intermed. Term).

I used to have stocks in taxable and the total international was all in taxable. Then I went to cash as I was preparing to buy a home and never bothered to reallocate back to international.

IIRC, there's some high correlation of international to domestic, something like .85, so I'm not sure the extra expense and effort is worth the minor additional diversification.
"What was true then is true now. Have a plan. Stick to it." -- XXXX, _Layer Cake_ | | I survived my first downturn and all I got was this signature line.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by staythecourse » Tue Apr 24, 2018 4:07 pm

Rick Ferri wrote:
Tue Apr 24, 2018 3:00 pm
The challenge isn't to compare one to another, the challenge is get people to do ANY of them and stick to the strategy long-term.

If two funds work for you, GREAT! Do it! If Core-4 is your thing, OUTSTANDING! Go for it! You like Taylor's three-fund portfolio, FANTASTIC! It's an excellent choice!

It's not the fund strategy that's important, it's the philosophy behind the strategy and the discipline to stick with it. We all believe in one philosophy and yet we can all have very different strategies. It's all perfectly fine. Whatever works for you and keeps you disciplined.

Philosophy - Strategy - Discipline
The Three Keys to Investment Success

Rick Ferri
Great advice. The one default the OP GREATLY underestimates (just like most who do backesting) is MOST folks are not able to choose one plan and stick with it for 40+ years without changing (99% of the time when the "plan" is underperforming"). It interesting one of the BIG things about backtesting is it shows how much is lost with behavioral mistakes.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by chw » Tue Apr 24, 2018 4:33 pm

Totally agree with Rick regarding picking a strategy that works for you, and them implementing it and sticking with it. The 2 fund is basically the "Coach Potato" portfolio, which I believe was introduced to the masses by Scott Burns many years ago. I don't personally use it, and also seem to recall that it lagged the performance of many of the other portfolio strategies mentioned until recently. No one knows the future, and this particular strategy may underperform in the future as compared to the other portfolio strategies- no one knows.... It seems that once you compare all of these portolios over a 10 year time horizon or greater, generally the performance differences tend to flatten.

As Rick states, if the 2 fund portfolio works for you, and you feel you can stick with it for the long haul, it certainly is worth consideration.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by David Jay » Tue Apr 24, 2018 5:52 pm

Boxtrap wrote:
Tue Apr 24, 2018 1:35 pm
...primarily the Two Fund, Three Fund, "Core 4", The Merriman Ultimate Buy & Hold, The Coffeehouse, and my own modified version of the Coffeehouse.
I came to BH with a Coffeehouse portfolio, 80/20. I have been simplifying over time. All my US except SCV became Total Stock, I kept small cap value. I also kept both Ex-US and Intl. small cap so I am down to 4 stock funds with a minor tilt to small cap.
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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by nisiprius » Tue Apr 24, 2018 7:43 pm

The Sharpe ratio is one way to measure risk-adjusted return. I think it's a fairly good way. It starts by assuming that volatility, as measured by standard deviation, is a reasonable measure of risk. I posted about this once before: I believe it is a reasonable measure because I did some poking around and found that seemed to be a darned good relationship between standard deviation and a couple of other measures of "risk."
Image

Here is one way to interpret the Sharpe ratio. It makes the most sense if you assume that you want a moderate level of risk. I'll use round numbers that are roughly right. I'll also use the phrase "cash" to mean what is formally called "the riskless asset." It is riskless only in the sense of having no volatility, and it does have a positive return (it's in interest-bearing account). Traditionally Treasury bills are used as the riskless asset but I'll just say "cash."

The Sharpe ratio is defined as the difference between the riskless return and the portfolio return, divided by the portfolio's standard deviation. Remember, cash usually has a positive return... nowadays, maybe 2%. Cash gives you 2% return with zero risk-in-the-sense-of-value-fluctuation. So what is important is the excess return your investment delivers, the extra amount above the return from cash.

Suppose that 100% stocks has a standard deviation of 20% and you only want a standard deviation of 10%. One way you can get your desired level of risk is to hold half stocks, half cash. Let's also suppose that 100% stocks has a Sharpe ratio of 0.40. One of the things about the Sharpe ratio is that mixing cash into a portfolio never changes the Sharpe ratio because it cuts both return and standard deviation. So, the 50% stock/50% cash also has a Sharpe ratio of 0.40.

Now, suppose some other portfolio has a Sharpe ratio of 0.70. Remember, you can add any percentage of cash to this portfolio and it doesn't change the Sharpe ratio. So, you can add the right amount of cash to it to cut the standard deviation to your desired 10%. It will then have the same "risk" as your 50% stocks, 50% cash portfolio. Because it has a higher Sharpe ratio, it will have higher return. It is a better portfolio.

The Sharpe ratio isn't the be-all and end-all, but in comparing two portfolios to see which is better, it is far preferable to use the Sharpe ratio as the measure, than to use return without considering risk at all.

People sometimes say "you can't eat Sharpe ratio" but that is not true. If you can raise the Sharpe ratio, then you can always rejigger the portfolio allocations to give you more return for the same risk. There is one important limitation, though: it might require leverage to do this. This shouldn't be an issue for conservative investors.
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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by goblue100 » Tue Apr 24, 2018 8:17 pm

I've been using PV a lot lately. I found a great 2 fund portfolio. 33% small cap value and 67% Long bond. Too bad it's not 1974,

https://www.portfoliovisualizer.com/bac ... rpBond1=67
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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by heyyou » Tue Apr 24, 2018 9:34 pm

Long ago, when a computer filled an air conditioned room, an economist, perhaps Paul Samuelson, looked for the highest performing portfolio. It was either 93/7 or 87/13 stocks to bonds, rebalanced. (I can't remember which.) The rebalancing outperformed 100% stock portfolios due to buying more stock fund shares after market crashes.

Michael H. McClung was only concerned with retirement spending portfolios and his research showed 50/50 was a good starting point since his retiree was spending from the bond portion to let the equities grow longer, and to skip any sequence risk embedded in the first decade of retirement.

Currently in retirement, I will stay near a 60/40 allocation since that suits me, and with my slice and dice stock allocation which historically has done better at that ratio than the total market funds.
Another alternative is this link to Trev H's Ultimate B&H using only four VG funds
viewtopic.php?f=10&t=38374

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by harvestbook » Tue Apr 24, 2018 10:12 pm

I'm making a minor bet that the next 30 years won't be like the last. I'll stick with broad diversity even if the difference likely won't be great.
I'm not smart enough to know, and I can't afford to guess.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by PhilosophyAndrew » Wed Apr 25, 2018 8:09 am

If maximizing total return is your ultimate concern, why bother with bonds at all instead of a one-fund portfolio using a global or domestic total stock market index? As long as your investment horizon is long, it might be reasonable to expect an all-equity allocation to have a higher total return than a two- or three-find portfolio that includes bonds.

To me, the value of the three-fund portfolio lies neither in maximizing total return nor in minimizing number of finds, but rather is providing a straightforward and inexpensive means for investing according to my preferred equity/bond and US equity/international equity allocations. Being able to set those allocations gives me more control over the risk and diversity of my portfolio.



Andy.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by keystone » Wed Apr 25, 2018 8:55 am

harvestbook wrote:
Tue Apr 24, 2018 10:12 pm
I'm making a minor bet that the next 30 years won't be like the last. I'll stick with broad diversity even if the difference likely won't be great.
+1.

I adhere to the 3 fund portfolio to a great extent, but if I were to construct a 2 fund portfolio for the next 30 years I'd probably go with Total World Stock Index + Total Bond Market.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by buylowbuyhigh » Wed Apr 25, 2018 9:00 am

nisiprius wrote:
Tue Apr 24, 2018 7:43 pm

People sometimes say "you can't eat Sharpe ratio" but that is not true. If you can raise the Sharpe ratio, then you can always rejigger the portfolio allocations to give you more return for the same risk. There is one important limitation, though: it might require leverage to do this. This shouldn't be an issue for conservative investors.
Doesn't this work also the other way? That is, you can have the same expected return, but with a higher Sharpe ratio the lunch is more likely there at the exact moment you NEED to eat.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by Boxtrap » Wed Apr 25, 2018 9:17 am

PhilosophyAndrew wrote:
Wed Apr 25, 2018 8:09 am
If maximizing total return is your ultimate concern, why bother with bonds at all instead of a one-fund portfolio using a global or domestic total stock market index? As long as your investment horizon is long, it might be reasonable to expect an all-equity allocation to have a higher total return than a two- or three-find portfolio that includes bonds.

To me, the value of the three-fund portfolio lies neither in maximizing total return nor in minimizing number of finds, but rather is providing a straightforward and inexpensive means for investing according to my preferred equity/bond and US equity/international equity allocations. Being able to set those allocations gives me more control over the risk and diversity of my portfolio.



Andy.
Very much agree with that myself. That's basically why I will probably stick with a three-fund portfolio too. I just love these exercises one can do with Portfolio Visualizer. I find it eye opening to compare portfolios and learn about the different ways in which they can be compared.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by Boxtrap » Wed Apr 25, 2018 9:18 am

nisiprius wrote:
Tue Apr 24, 2018 7:43 pm
The Sharpe ratio is one way to measure risk-adjusted return. I think it's a fairly good way. It starts by assuming that volatility, as measured by standard deviation, is a reasonable measure of risk. I posted about this once before: I believe it is a reasonable measure because I did some poking around and found that seemed to be a darned good relationship between standard deviation and a couple of other measures of "risk."
Image

Here is one way to interpret the Sharpe ratio. It makes the most sense if you assume that you want a moderate level of risk. I'll use round numbers that are roughly right. I'll also use the phrase "cash" to mean what is formally called "the riskless asset." It is riskless only in the sense of having no volatility, and it does have a positive return (it's in interest-bearing account). Traditionally Treasury bills are used as the riskless asset but I'll just say "cash."

The Sharpe ratio is defined as the difference between the riskless return and the portfolio return, divided by the portfolio's standard deviation. Remember, cash usually has a positive return... nowadays, maybe 2%. Cash gives you 2% return with zero risk-in-the-sense-of-value-fluctuation. So what is important is the excess return your investment delivers, the extra amount above the return from cash.

Suppose that 100% stocks has a standard deviation of 20% and you only want a standard deviation of 10%. One way you can get your desired level of risk is to hold half stocks, half cash. Let's also suppose that 100% stocks has a Sharpe ratio of 0.40. One of the things about the Sharpe ratio is that mixing cash into a portfolio never changes the Sharpe ratio because it cuts both return and standard deviation. So, the 50% stock/50% cash also has a Sharpe ratio of 0.40.

Now, suppose some other portfolio has a Sharpe ratio of 0.70. Remember, you can add any percentage of cash to this portfolio and it doesn't change the Sharpe ratio. So, you can add the right amount of cash to it to cut the standard deviation to your desired 10%. It will then have the same "risk" as your 50% stocks, 50% cash portfolio. Because it has a higher Sharpe ratio, it will have higher return. It is a better portfolio.

The Sharpe ratio isn't the be-all and end-all, but in comparing two portfolios to see which is better, it is far preferable to use the Sharpe ratio as the measure, than to use return without considering risk at all.

People sometimes say "you can't eat Sharpe ratio" but that is not true. If you can raise the Sharpe ratio, then you can always rejigger the portfolio allocations to give you more return for the same risk. There is one important limitation, though: it might require leverage to do this. This shouldn't be an issue for conservative investors.
Thanks so much for this thorough primer on Sharpe ratio! I love learning about this stuff.

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by JoMoney » Wed Apr 25, 2018 9:18 am

Rick Ferri wrote:
Tue Apr 24, 2018 3:00 pm
... It's not the fund strategy that's important, it's the philosophy behind the strategy and the discipline to stick with it. We all believe in one philosophy and yet we can all have very different strategies. It's all perfectly fine. Whatever works for you and keeps you disciplined. ...
Good advice.

Philosophy Differs From Strategy
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MnD
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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by MnD » Wed Apr 25, 2018 9:43 am

keystone wrote:
Wed Apr 25, 2018 8:55 am
harvestbook wrote:
Tue Apr 24, 2018 10:12 pm
I'm making a minor bet that the next 30 years won't be like the last. I'll stick with broad diversity even if the difference likely won't be great.
+1.

I adhere to the 3 fund portfolio to a great extent, but if I were to construct a 2 fund portfolio for the next 30 years I'd probably go with Total World Stock Index + Total Bond Market.
Here's my entry:
Vanguard Total World Stock
Dodge and Cox Global Bond (I'm not a fan of "biggest debtor" approach to bond investing)

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Boxtrap
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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by Boxtrap » Wed Apr 25, 2018 9:50 am

nisiprius wrote:
Tue Apr 24, 2018 7:43 pm
The Sharpe ratio is one way to measure risk-adjusted return. I think it's a fairly good way. It starts by assuming that volatility, as measured by standard deviation, is a reasonable measure of risk. I posted about this once before: I believe it is a reasonable measure because I did some poking around and found that seemed to be a darned good relationship between standard deviation and a couple of other measures of "risk."
Image

Here is one way to interpret the Sharpe ratio. It makes the most sense if you assume that you want a moderate level of risk. I'll use round numbers that are roughly right. I'll also use the phrase "cash" to mean what is formally called "the riskless asset." It is riskless only in the sense of having no volatility, and it does have a positive return (it's in interest-bearing account). Traditionally Treasury bills are used as the riskless asset but I'll just say "cash."

The Sharpe ratio is defined as the difference between the riskless return and the portfolio return, divided by the portfolio's standard deviation. Remember, cash usually has a positive return... nowadays, maybe 2%. Cash gives you 2% return with zero risk-in-the-sense-of-value-fluctuation. So what is important is the excess return your investment delivers, the extra amount above the return from cash.

Suppose that 100% stocks has a standard deviation of 20% and you only want a standard deviation of 10%. One way you can get your desired level of risk is to hold half stocks, half cash. Let's also suppose that 100% stocks has a Sharpe ratio of 0.40. One of the things about the Sharpe ratio is that mixing cash into a portfolio never changes the Sharpe ratio because it cuts both return and standard deviation. So, the 50% stock/50% cash also has a Sharpe ratio of 0.40.

Now, suppose some other portfolio has a Sharpe ratio of 0.70. Remember, you can add any percentage of cash to this portfolio and it doesn't change the Sharpe ratio. So, you can add the right amount of cash to it to cut the standard deviation to your desired 10%. It will then have the same "risk" as your 50% stocks, 50% cash portfolio. Because it has a higher Sharpe ratio, it will have higher return. It is a better portfolio.

The Sharpe ratio isn't the be-all and end-all, but in comparing two portfolios to see which is better, it is far preferable to use the Sharpe ratio as the measure, than to use return without considering risk at all.

People sometimes say "you can't eat Sharpe ratio" but that is not true. If you can raise the Sharpe ratio, then you can always rejigger the portfolio allocations to give you more return for the same risk. There is one important limitation, though: it might require leverage to do this. This shouldn't be an issue for conservative investors.
So here's a follow up question for you, bearing in mind the crash course in Sharpe that you so kindly just provided...

Let's say I have two portfolios that hold a) the exact same funds and b) the exact same % allocations within each of the equity sides and the fixed income sides, and the only difference is that Portfolio 1 has an OVERALL portfolio weighting of 90% Equity / 10% Fixed Income while Portfolio 2 has an overall weighting of 60% Equity and 40% Fixed income. If you back test those two portfolios as I just did over about 25 years with all the same parameters in terms of starting balance, contributions, etc, you see that Portfolio 1 ends with a higher balance, a higher CAGR, a higher standard deviation but a LOWER Sharpe ratio. The Sharpe on Portfolio 1 is .55 and the Sharpe on Portfolio 2 is .68.

Am I correct in interpreting then that Portfolio 2 is therefore the "better portfolio" because it has a better risk-adjusted return, even though less money is made?

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by goblue100 » Wed Apr 25, 2018 11:08 am

Boxtrap wrote:
Wed Apr 25, 2018 9:50 am

So here's a follow up question for you, bearing in mind the crash course in Sharpe that you so kindly just provided...

Let's say I have two portfolios that hold a) the exact same funds and b) the exact same % allocations within each of the equity sides and the fixed income sides, and the only difference is that Portfolio 1 has an OVERALL portfolio weighting of 90% Equity / 10% Fixed Income while Portfolio 2 has an overall weighting of 60% Equity and 40% Fixed income. If you back test those two portfolios as I just did over about 25 years with all the same parameters in terms of starting balance, contributions, etc, you see that Portfolio 1 ends with a higher balance, a higher CAGR, a higher standard deviation but a LOWER Sharpe ratio. The Sharpe on Portfolio 1 is .55 and the Sharpe on Portfolio 2 is .68.

Am I correct in interpreting then that Portfolio 2 is therefore the "better portfolio" because it has a better risk-adjusted return, even though less money is made?
I am far from being nisiprius, but as a test to my own understanding of the material, I would answer that 2 is a better portfolio as far as providing returns for the risk being taken. Also, the lower the standard deviation the better.
Financial planners are savers. They want us to be 95 percent confident we can finance a 30-year retirement even though there is an 82 percent probability of being dead by then. - Scott Burns

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by abuss368 » Thu Apr 26, 2018 9:40 pm

Boxtrap wrote:
Tue Apr 24, 2018 1:35 pm
So I've been playing around with Portfolio Visualizer for a few days, just doing some comparative back testing of various portfolios...primarily the Two Fund, Three Fund, "Core 4", The Merriman Ultimate Buy & Hold, The Coffeehouse, and my own modified version of the Coffeehouse.

One of the things that is talked about so often here - and rightfully so - is the power of simplicity in investing. In particular, I have seen more and more here lately about how the Three Fund portfolio, consisting of Total Stock Market, Total International and Total Bond, captures the heart of diversification and simplicity. And by the way, I mostly agree with this - in fact, my current 401k is allocated in this exact 3 Fund portfolio.

But interestingly, when I compared all the different types of portfolios I mentioned at the top of this post in Portfolio Visualizer over the last 30 years in a 90% equities / 10% fixed income spread, the one that performed the best wasn't the Merriman UB&H (which I know Paul touts as being superior to simpler portfolios), it wasn't any version of Coffeehouse, it wasn't Core 4 or even the classic Three Fund.....it was good old fashioned 2 fund Total Stock Market and Total Bond market. It didn't outperform its nearest competitor by a ton, but it did outperform. If this isn't proof of the benefits of simplicity, I don't know what is. It did even better than a three fund that holds Total International.

Of course we have no idea if this will be true in the NEXT 30 years. Past performance doesn't predict future results. And I did not run comparisons with different spreads between equities and fixed-income (80/20, 70/30, etc), but I found it to be really eye opening nonetheless that in this particular simulation, the absolute simplest portfolio of all - Total US Stock Market and Total US Bond Market and nothing else - beat the rest.

Thoughts welcome!
Hi Boxtrap -

The Two Fund Portfolio is actually Jack Bogle's recommended investment portfolio in nearly everyone of his books. He will often recommend this simple but very effective strategy or simply a balanced fund.

Personally, I have family that has simplified their investment portfolio's with the Jack Bogle Two Fund Portfolio and could not be happier. The strategy works very well and they have rebalanced and stayed the course.

Best.
John C. Bogle: "Simplicity is the master key to financial success."

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Re: A Challenge To The 3 Fund Portfolio...The 2 Fund Portfolio

Post by abuss368 » Thu Apr 26, 2018 9:41 pm

Rick Ferri wrote:
Tue Apr 24, 2018 3:00 pm
The challenge isn't to compare one to another, the challenge is get people to do ANY of them and stick to the strategy long-term.

If two funds work for you, GREAT! Do it! If Core-4 is your thing, OUTSTANDING! Go for it! You like Taylor's three-fund portfolio, FANTASTIC! It's an excellent choice!

It's not the fund strategy that's important, it's the philosophy behind the strategy and the discipline to stick with it. We all believe in one philosophy and yet we can all have very different strategies. It's all perfectly fine. Whatever works for you and keeps you disciplined.

Philosophy - Strategy - Discipline
The Three Keys to Investment Success

Rick Ferri
Hi Rick -

Excellent thoughts and advice! More investors would be wise to follow. One strategy I have been continuing to learn is the older I get, the less funds I need! We value simplicity over time.

Best.
John C. Bogle: "Simplicity is the master key to financial success."

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