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Looking for a way to beat the S&P 500 (most of the time)?

In the past two weeks I’ve received an unusual volume of questions about an article I wrote recommending a simple portfolio of four U.S. asset classes.

So let’s tackle a few of the most common queries generated from that article, which you’ll find here.

This portfolio is a simple way to use just four index funds (or ETFs) to gain low-cost access to four of the most profitable asset classes over the past nine decades: large-cap blend stocks (the S&P 500
SPX,
-0.93%
,
in other words), large-cap value stocks, small-cap blend stocks, and small-cap value stocks.

Asset class

Vanguard fund

Fidelity fund

ETF

S&P 500

VFIAX

FXAIX

VOO

Large value

VVIAX

FLCOX

RPV

Small blend

VTMSX

FSSNX

IJR

Small value

VSIAX

FISVX

SLYV

This combination has outperformed the S&P 500 in six of the past nine decades, and it doesn’t involve any fancy footwork or difficult decisions.

Its power comes from pairing the familiar S&P 500 index with the historical performance advantages of value stocks and stocks of smaller companies.

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It’s more predictable and more diversified than most large-cap index funds, and it carries less long-term risk as well.

If this combination is so good, why wouldn’t every smart investor sell their holdings and use these four funds?

A: There are plenty of potential reasons.

For one thing, there’s no sales effort behind it. You won’t find any single fund offering this combination of four asset classes.

For another, it’s never a better performer than every one of its component parts. The reason for that is obvious when you realize this combination is an amalgamation of four things.

But I think the biggest impediment for most people is that it requires a long-term outlook and long-term patience. Those traits are often in short supply, especially with Wall Street and the financial media always touting what’s been most successful recently.

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Q: Are you saying this is not always the best strategy?

A: I guess that’s right. If you’re looking for the highest short-term performance, or even the highest medium-term performance, NOTHING is always the best strategy.

Many investors regard the S&P 500 as the Holy Grail of investing. In their view, anything that underperforms must be inferior.

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The good news about this portfolio is that it outperformed the S&P 500 in six of the last nine decades. The bad news is that sometimes it underperformed that index (or the total market index, which is similar) for as long as 15 to 20 years.

That doesn’t mean the four-part combination didn’t make money. It just didn’t make more than the S&P 500.

For investors with a short-term mentality, that bad news likely led them to abandon this strategy. But for those who could stick with it, the payoff could be great.

Over 90 years, the four-part combination made 5.7 times as much money as the S&P 500 by itself. (And remember, 25% of this portfolio consists of the S&P 500.)

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Q: What makes you believe this combination will produce better returns than the S&P 500 or the total market index in the future?

A: I believe this portfolio will produce superior LONG-TERM returns.

It’s well documented that over time, value stocks (which are over-represented in this combination) have outperformed growth stocks and that small-cap stocks (which are also over-represented) have outperformed large-cap stocks like those in the S&P 500.

I see no reason to think either of those longstanding relationships will change.

To clarify, I do not believe this combination will beat the S&P 500 or the total market index in every month, every quarter, every year or even every decade. History shows that has not been the case.

Q: How much more risky is the 4-Fund Combo compared with the S&P 500?

A: The answer to that is complex, because it depends entirely on how you define risk. In other words, what are you worried about?

The most basic definition of risk is that could you could lose money in a given period. Even though a single year is much too short to matter to long-term investors, it’s still the most common way that most people measure performance.

Looking at every calendar year from 1928 through 2019, we find the S&P 500 lost money 25 times, vs. 28 times for the four-fund combination. The average one-year loss of the S&P 500 was 13.2% vs. 13.6% for the combination.

That suggests the combination was somewhat more risky than the S&P 500. But here are a couple of “fun facts” uncovered by Daryl Bahls, my research partner.

• In seven of the 28 years when the combination lost money, the S&P 500 outperformed by an average of 5.9 percentage points.

• In four of the 25 years when the S&P 500 lost money, the four-fund combination outperformed by an average of 16.5 percentage points.

My conclusion: The overall risks of these two alternatives are fairly similar, but in calendar years when the S&P 500 loses money, investors should want the four-fund combination working for them.

Q: Should I be worried about something other than losing money in any given calendar year?

A: I think so. As I wrote in my earlier article, I believe it’s much more valuable to know how a portfolio holds up during a sustained market downturn.

By this measure, in the bear market from 2000 through 2002, the S&P 500 was definitely MORE risky than the four-fund combination.

In those three years, the S&P 500 had three successive annual losses that, if they were compounded, would have reduced $100 to a mere $62.38.

In those same three years, the four-fund combo had two years of gains followed by a losing year in 2002. Compounded, those returns would have turned $100 into $100.37.

In other words, you would have broken even with the four-fund combination or lost 37.6% in the S&P 500.

That very substantial difference was the result of one simple factor: diversification in the four-fund combination.

Q: I’m about to retire, and my portfolio is in the S&P 500. Does it make sense to switch to this four-fund portfolio?

A: That’s a very good question, and a tough one.

There’s no way to know the future, but an extensive study of returns from the past 50 years (1970 through 2019) suggests the answer depends on how long you’ll have your money invested.

Over 600 five-year periods (with a new one starting every month), the returns were about a tossup between the four-fund combination and the S&P 500.

In 15-year periods, the four-fund combination usually outperformed. And in every single 25-year period, the four-fund combination outperformed the S&P 500.

If you’ll have your money invested another 25 years, that seems pretty encouraging. However, there’s no guarantee about the next 50 years.

For more perspective on this topic, I recommend a terrific article by my friend and collaborator Chris Pedersen.

Richard Buck contributed to this article.


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