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.