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IN AN EFFORT TO identify the simplest, most resilient lifetime investment portfolio, author and investment analyst Chris Pedersen concluded that a minimum of two funds is required. His recent book, 2 Funds for Life, summarizes his back-testing study to find a simple yet effective portfolio. The book is available free at PaulMerriman.com.
Pedersen found that a 90% allocation to a Vanguard Group target-date fund coupled with a 10% allocation to a small-cap value fund provides meaningful diversification across stocks and bonds, allows investments to be easily managed, and has a high probability of enduring over 30 years of retirement withdrawals.
Vanguard’s target-date funds are broadly diversified among U.S. and international stocks and bonds. As you’ll see from the funds’ so-called glide path, bond allocations automatically increase after age 40, while stock allocations decline.
Age 40 seems early to me. My wife and I were essentially all-in on U.S. stocks during our working years. Still, as Pedersen points out, if we’d wanted to own a target-date fund, we could have achieved a higher stock ratio by investing in a fund with a retirement year later than our actual one—the 2040 fund, for example, rather than 2020.
Don’t like the idea of 90% in a target-date fund and 10% in small-cap value? Petersen also tested a portfolio of 90% S&P 500 and 10% short-term government bonds. He labeled this the “Buffett strategy” since Warren Buffett has recommended this mix for his wife after he dies.
Pedersen calculates that the more stock-heavy Buffett strategy might wind up with a higher ending value than his two-fund strategy. The two-fund portfolio is more widely diversified, however, and hence less volatile, which risk-averse investors may find comforting.
In his book, Pedersen also recommends that retirees reduce portfolio withdrawals during market downturns. This allows for somewhat higher withdrawals during most years. Pedersen estimates that his method would have a 100% chance of success in carrying a retiree through a 30-year retirement, versus 98% for the Buffett strategy.
To me, the more interesting piece of Pedersen’s portfolio puzzle is the recommendation to supplement target-date funds with small-cap value funds. He works with the Merriman Financial Education Foundation, whose research indicates that small-cap value has handily out-legged the returns of the S&P 500. According to the foundation’s studies, the S&P 500 had a compound average annual return of 9.7% from 1928 through 2016, while small-cap value stocks grew at 13.5% over the same period. Merriman’s studies also suggest that the small-cap value sector tends to perform well when other market sectors are underperforming.
Which investing path should I follow—Buffett’s or Pedersen’s? Well, I have historically been more of a Buffett strategy investor, in part because the S&P 500 was one of only seven 401(k) investment choices during my 40-year career.
But while an S&P 500 focus has served me well, Pedersen’s book and the Merriman research are making me consider supplementing almost any portfolio with a small-cap value allocation. This may sound like heresy, but perhaps I can take Buffett’s investment strategy and improve upon it by adding a sliver of small-cap value shares.
Another strategy is the Bogleheads 3-fund portfolio. Simple, diversified, and you can trim or add as you please. With a target date fund you are stuck with the good, the bad, and their idea of allocation changes in the portfolio, which I believe is overly skewed towards bonds as you get closer to the maturity date.
Even the Target-Date retirement income portfolio is over skewed towards bonds. As far as the % of stocks in a retirement portfolio, I use the (120 – your age) formula as the benchmark and will only change it every five years. So, at age 70, it’s minimum 50% stocks.
Here’s the Vanguard Target Retirement Fund asset allocation (Not even 30% stocks):
Vanguard Total Bond Market II Index Fund 8 – 37.30%
Vanguard Total Stock Market Index Fund Institutional Plus Shares – 17.40%
Vanguard Short-Term Inflation-Protected Securities Index Fund Admiral Shares – 16.90%
Vanguard Total International Bond II Index Fund – 16.30%
Vanguard Total International Stock Index Fund Investor Shares – 12.10%
Respectfully, I take a wee bit of issue with statements in the last couple of comments here. Saying SCV “has been terrible for many years” is very vague and not universally true. And alluding that SCV outperformance may be an artifact from “way back when” is also not necessarily true.
Not to appear a Merriman doppelgänger, but some of his charts, created via DFA analysis, may be worth a look.
For example, these are representative, though not updated through the pandemic and 2022:
https://paulmerriman.com/wp-content/uploads/2021/01/2020-Year-End-Podcast-Charts.pdf
Of course, nobody has to trust either Merriman or DFA…
Also, well chosen small allocations, 10% or so, if made carefully, could each potentially make incremental improvements in returns, leading to better overall returns, which is what counts over time, no?
That has to be balanced against the stability engendered by a really simple portfolio, which is where psychology and predispositions come into play.
Along the same line, some are fond of saying that total market funds have the greatest diversification, but do they? Aren’t they actually very heavily weighted toward the greatest market cap companies? And so wouldn’t adding an increment of, say, SCV or another asset class actually increase the real diversification and reduce long-term volatility?
If you have confidence in an investment, why only a 10% allocation? To me, adding 10% seems less like investing and more like dabbling. We know moving in and out of positions will on average reduce returns, so why allocate to something in such a way that it clearly indicates a lack of commitment?
Small cap value has been terrible for many years. Long term performance may make it seem better, but that also may be influenced by a period way back when. A small exposure won’t hurt you, but Merriman is in love with small value, but I wouldn’t put more than 10%
Not a fan of Merriman portfolios, too many tiny allocation slices. A 10% allocation to anything isn’t going to provide any practical difference compared to not having it. There is also plenty of research showing target date funds, specifically due to the declining equity allocation, are a suboptimal strategy. I also greatly respect Buffett, but fully disagree with his 90/10 portfolio. Anyone familiar with Japan 1989-2019 knows putting a majority of investments into a single country’s total market index is a bad idea.
That said, portfolio fund selection may not even be the biggest problem to solve. Withdrawal strategy has a much greater impact on portfolio survival. Specifically, following the 4% rule is basically guaranteed to fail once even one assumption turns out sufficiently different than expected. Variable withdrawal amount methods are far more resilient, such as even the simple fixed percentage of current balance method. Track expenses as either required or discretionary, make sure the required expenses are covered, and otherwise embrace variability.
I wouldn’t use a target-date fund for retirement income. When held in tax deferred all withdrawals are taxed as ordinary income. If held in taxable then tax planning is impossible due to manager shenanigans, forced redemptions, and mandated recharacterizations. Never mind the inability to rebalance.
Dos pesos worth of misc. thoughts:
I read “Two Funds for Life.” It’s a fine book, better than I expected, and having good info about more than its title subject.
I started learning about investing from Paul Merriman’s work. I admire and am grateful to him. In any event, Paul is sort of the Billy Graham of small cap value. But he all-too rarely acknowledges that value funds, small or large, can underperform the broad market for very long periods in between the times when they “kick booty.” Accordingly, large and/or initial investments in SCV or even LCV should be VERY carefully thought through for anyone (or any investment purpose/plan) with less than about a twenty year time horizon. That doesn’t mean it might not be a good idea if you’re well into retirement, depending on your age and whether you expect your investments to outlive you for the benefit of heirs. Many variables, and everybody’s mileage may vary…
I think it is Johnathan Clements who uses five years of projected withdrawals in a short-term treasury fund and the rest in a total world stock market index fund.
IMHO choosing one of Vanguard’s LifeStrategy funds with their set bond:stock ratio makes more sense than the target retirement date funds but in either case only in tax-deferred accounts since all of these are tax-inefficient. But a classic three-fund portfolio is far more tax-efficient and low cost – or better still go the Jonathan Clements route with as big a slug of VT (total world stock market) as your risk tolerance can handle plus half-each VGSH (short-term Treasury ETF) and VTIP (short-term TIPS) and call it a day.
Merriman has been touting SCV for years and rightly so, but for a broader view of small-cap value in context I highly recommend this post from the wonderful Portfolio Charts site (which contains a wealth of info on the best lazy portfolios, including Merriman’s “Ultimate.”
https://portfoliocharts.com/2021/12/16/three-secret-ingredients-of-the-most-efficient-portfolios/
One thing bad about target date funds is that you can’t pick particular allocation(s) to sell when you need cash.
Exactly.
Of course, a significant problem with back-testing is that it flies in the face of “past performance may not be indicative of future performance.” John Bogle was extremely cautious about applying “to the future inductive arguments based on past experience, unless one can distinguish the broad reasons for why past experience was what it was”. For much of the 50 year period since Bogle founded Vanguard, “the returns provided by the stock market exceeded the returns by businesses by among the highest margin in any period of such length in the entire history of the U.S. market.” (Both quotes are from Bogle’s “The Little Book of Common Sense Investing.”) Many pundits will assert they know exactly why past experience was what it was but they don’t.
The presence of institutional investors has changed the equation. In the 60s they owned about 10% of market cap. Now it is closer to 80%. They tilt large cap.
Secondly, is the small cap value premium a real thing or a proxy for other factors?
https://aswathdamodaran.blogspot.com/2015/04/the-small-cap-premium-fact-fiction-and.html
Hi Purple Rain – I may have it wrong, but I believe the article you reference refers to the general premium on small cap stocks. For example, the Russell 2000 has a current Price\Earnings ratio of about 35. The Merriman folks refer to small-cap value funds as those that include only those small-caps that are underappreciated and underpriced. As comparison, the Vanguard small-cap value ETF – VBR has a current Price\Earnings ratio of about 9.5.
I think you’ll find plenty others who utilize small cap value tilts in their portfolios.
On one hand, it’s hard to argue against 100 years of data. Clearly small cap value has been a winning strategy.
On the other, look at the last ten years and you’ll see the broader US stock market beating small cap value by about 1.5% annually.
One could easily say reversion to the mean is due for small cap value, but I can’t help but wonder if it’s harder to find “value” in 2023, with the abundance of information made readily available to the entire world in real time.
I don’t think I’m going to chance it. I’ll stick with Buffett and Bogle on this one and take my fair share of market returns.
I also chose the Vanguard S&P 500 fund in my previous 401(k) investment options primarily due to unreasonably high expense ratios on the offered TDFs. I am delaying rolling my 401(k) balances to my IRA over until there appears to me to be less market volatility. When I took my RMD earlier in 2023 I was disappointed in the time the fund custodian took to process my request.
I would like to know whether the small-cap value advantage is true over more recent time periods. I have seen suggestions that its value has diminished as it has become better known. I also prefer to make my own decisions on asset allocation rather than leaving them to a target-date fund manager. And well into retirement I am certainly not holding 90% stocks.
Kathy – Over the last five years, the S&P 500 with it’s mega-cap tech stocks has handily beaten small-cap value funds\ETFs. However, from the 2008-9 financial downturn until about 2018, small-cap value outperformed the S&P 500. The enticing diversification benefit of the author’s study is that small-cap value tends to perform better when other market segments are underperforming. I don’t own any small-cap value yet, but the spread to the S&P might be worth watching.
Thanks, I definitely belong to the KISS school, so am more likely to stay with total market.
John, I enjoyed this and your many prior articles. I recall the annual letter in which Buffett described his simple investing advice for his wife, should she survive him. The thing which is rarely discussed in the press is that 10% allocation to short term treasuries. I suspect that will amount to some $100 Million, which means she’ll never need to touch the equity portion. Meanwhile, a 10% cash allocation for me might last 4-5 years. Such is the power of large numbers.
Exactly. Readers here should ask themselves “What is my time line?” and “What is my ratio of expenses to assets?”. $50K expenses in $1M acct over 30 years is completely different from $100K spent from a $10M acct. As they say, “Your results may vary….”
Thank you Mr. Yeigh. While I’m very familiar with Buffett’s 2 fund portfolio, I’m not familiar with either of these 2 folks you mention. I do feel it’s helpful to remember that not all target date funds are created equal. For example, T Rowe Price’s 2050 has 4% – 5% points higher equity allocation in their 2050 target date fund vs both Vanguard and Fidelity’s 2050 funds. If that 4% – 5% points difference continues over an entire period from, say, 2023 until 2050 as the funds slowly become more conservative that would result in a huge performance difference.
Anyway, Thanks again. I look forward to reading the book.
Thanks for bringing us Pedersen’s simple, helpful solution to the portfolio question.
As followup, their informative website shows returns of 10.2% for the S&P 500 and 13.4% for small-cap value through 2021. Also, you will have to sign up to receive the free book.
I didn’t need to sign up to download the .pdf file.