I’ll tell you how I’ve invested most of my career.
S&P 500 index fund. That’s it.
But, shouldn’t I be able to do better than that?
This post will show you a data-proven way to boost your index fund returns.
Paul Merriman is a believer in index fund investing. Additionally, he is a nationally recognized authority on mutual funds, index investing, asset allocation, and ran his own investment advisory firm since 1983. Paul has been on Wall Street since the 1960’s.
He’s been preaching something called the ultimate buy-and-hold portfolio for the past 20 years. His ideas aren’t revolutionary. It’s very similar to Larry Swedroe’s research on small value stocks and their superior performance over long periods of time. Moreover, he believes in the work of Dr. Fauna and Dr. French in regards to diversification to increase returns without adding risk.
With the ultimate buy-and-hold portfolio, we are going to keep the S&P 500 index, but only 10% of the portfolio, and then give 10% each to 9 other asset classes.
Most people say nothing outperforms the S&P 500 index over the long term. Well, that’s not exactly true.
Over the long term, 8 of the 9 asset classes we’ll be diversifying with have outperformed the S&P 500. Consequently, the risk is also roughly the same.
So the main ingredient in this portfolio is still the S&P 500 index. According to Merriman’s research, it has compounded at 9.3% between the years of 1970 to 2016.
Personally, that feels a bit high, but we’ll stick with his numbers today. I’m more comfortable claiming a historic 7% rate.
THE ULTIMATE BUY-AND-HOLD PORTFOLIO
For the sake of explaining this portfolio, think of the S&P 500 index as Portfolio 1. To start, we will invest $100,000 into our portfolio today between the dates of 1970-2016 to illustrate the growth that would have occurred with each step of diversification over that period.
At 9.3%, $100,000 would have grown to $6.5 million. No way I can live off that! We’ve got to do better!!
Compound return: 9.3%
Growth: $6.5 million
The first step is to add U.S. large-cap value stocks, which gives us Portfolio 2. These are larger companies that are regarded as relatively underpriced (that’s what value means). Although only 10% of the portfolio has changed, the 47-year return takes a good jump.
The 9.7% return of Portfolio 2 turns $100,000 into $7.8 million. Now I’m a little more comfortable.
That’s a 19.3% increase from that one small change. This diversification business is no joke people!
Compound return: 9.7%
Growth: $7.8 million
Portfolio 3 comes from adding 10% into U.S. small-cap blend stocks, decreasing the weight of S&P 500 index to 80% in our portfolio (it get decreased by 10% with each addition). Small cap stocks (small companies) have a long history of higher returns than the S&P 500 index. This applies not only domestically, but internationally as well.
Compound return: 9.9%
Growth: $8.3 million – an increase of $1.84 million (28.4%).
A good start!
Next, we have U.S. small-cap value stocks for Portfolio 4, reducing the weight of S&P 500 index to 70%. These have historically been the most productive asset class:
Compound return: 10.3%
Growth: $10.1 million – double digits baby!
Portfolio 5 is near and dear to my heart, real estate. REITs or Real Estate Investment Trusts. It’s like investing in real estate through a mutual fund.
Talk about diversity!
Compound return: 10.4%
Growth: $10.6 million
- Portfolio 5’s impact on returns was minimal, but you can see it still meant $500,000 over the long term. With these numbers, small differences are worth looking for.
- Portfolios 2 through 5 had a lower standard deviation, or risk, than just the S&P 500 index. That means average higher returns with average lower risk. That’s a no-brainer!
The rest of this portfolio will use international stock to boost returns. You could stop here, if you’re not cool with that. Nothing wrong with the returns we already have!
If you are greedy, and want to make more money like I do, read on.
In Portfolio 6 we will add four international asset classes in 10% increments reducing the S&P 500 index contribution to only 20%:
- International large-cap blend
- International large-cap value
- International small-cap blend
- International small-cap value
Compound return: 11.1%
Growth: $14.1 million – Now I’m sleeping a little more comfortably at night
The final step, which is Portfolio 7, is adding 10% in emerging market stocks. These represent companies in countries with expanding economies and prospects for rapid growth.
Compound return: 11.3%
Growth: $15.3 million – Hell yeah!
Emerging markets is slightly more volatile than S&P 500 index.
Keep in mind, we’ve went from $6.5 million to $15.3 million. Not bad for a little diversification!
The interesting thing about these numbers is that Paul Merriman assumed 1% was paid as a management fee. I’m not a believer in paying management fees. You could easily build this portfolio on your own, so your returns would be 1% higher.
DISCLAIMER TIME: I am not a financial advisor and cannot predict the future. Index investing is based on a belief these trends seen in the past will continue into the future. That is likely, but there is no guarantee. This portfolio could lose more than the S&P 500 index in a bear market. Choose your investment strategy at your own risk.
Paul Merriman points out the following guidelines. Most academics agree stocks will have higher returns than bonds, small-cap will perform superior to large-cap, and value stocks will have superior returns to growth. I tend to agree.
However, as the old saying goes:
It is difficult to make predictions, especially about the future.
Ok, this isn’t your only choice in the world for a portfolio. If you are interested in shopping through samples of several different types of portfolios with explanations see:
You can find a way to build this portfolio, or something close to it, with the mutual funds or ETFs available at many mutual funds companies. Paul Merriman actually has recommendations for mutual funds for Fidelity, Vanguard, Charles Schwab, and T. Rowe Price.
Many of my readers (maybe 10 people) are in the military. We have the thrift savings plan (TSP). Unfortunately, this doesn’t really lend itself well to this portfolio because of a lack of variety of choices including value stock options, which is the strongest performer in the portfolio.
This is not a good method for use in a TSP, as the options available can’t utilize the variety of asset classes employed here.
This is meant for a normal brokerage account or an IRA.
Here is what the TSP funds are:
C fund: S&P 500 index clone
S fund: all funds not in the S&P 500 index, so mid-cap and small-cap
I fund: International stocks in 21 developed markets excluding the United States and Canada
F fund: index of world-wide bonds, both government and corporate
G fund: short-term U.S. Treasury securities
Really, all you can do is mix C, S, and I to try to mimic something similar to what we talked about above, but it will be a lot less diversified.
Were you surprised how much more money you can make by increasing the return a small amount? You’d be surprised what a massive effect fees can have on a portfolio! You can read about this here:
What did you think of this portfolio?
Do you buy it?
I think it’s awesome. Am I right or wrong? Why?
Rich on Money