Everyone loves a good cup of coffee. It’s one of the most popular beverages in the world, and if one were to poll a random group of passers-by on the street it’s very likely they’d find a good percentage of people who identify as frequent coffee drinkers. But offer those biggest fans a free cup of home-brewed coffee, and there’s no guarantee they’ll like it. While people often talk about coffee in universal terms, everyone has a specific type and combination of ingredients that they like best and a caramel macchiato with extra foam tastes much different than a strong coffee served black. The devil is in the details.
Stocks are kind of like coffee in that regard. Lots of people love them and sing their praises, but that doesn’t mean that all types of stocks are equally appealing to all people. Walking into a fancy coffee shop with a big menu and just asking for “coffee” may not necessarily yield the results you will like, and walking into your brokerage and announcing “I’d like some stocks, please” might elicit a few funny looks. What types of stocks? The ones you choose may drastically change your portfolio outcome, and lumping them all together as a single homogeneous entity sorta misses the point. In coffee and in stocks, it’s important to be specific.
There’s a new portfolio on the site by a financial adviser named Bill Schultheis — appropriately named the Coffeehouse Portfolio — that is a nice illustration of this phenomenon. I’ve read several sources refer to it as a 60-40 stock/bond asset allocation, which is technically true. However, the Coffeehouse portfolio divides the stock portion equally into six very specific types of stocks: large cap blend, large cap value, small cap blend, small cap value, total international and REITs. Referring to it colloquially as a 60-40 portfolio tends to imply that all 60-40 portfolios are pretty much the same. Well are they? Let’s take a look.
First, here’s the Classic 60-40 portfolio that is generally what most people think of and what most studies referencing stock/bond blends are actually referring to. It uses the total stock market for stocks and the total bond market for bonds.
And here’s the Coffeehouse Portfolio.
While the standard deviation, best year, and worst year are pretty much the same, the returns are a lot different than you might expect. In fact, this portfolio with only 60% stocks had the same CAGR since 1972 as the total stock market alone. Pretty impressive!
Also, note the difference in longest drawdowns — you can see that not only in the numbers on the right but also intuitively in the patterns of red pixels. The Coffeehouse portfolio performed remarkably well in the 70’s and 2000’s when other 60-40 portfolios notably struggled. In the worst case, ten years is a long time to wait to see any returns on your investments and a lot of people might change strategies at exactly the wrong time. But seven might be a bit more palatable, potentially making the difference between a long-term gain and a multi-portfolio loss.
And then there’s retirement. Seemingly hundreds of papers have been published about the right percentage of stocks in a retirement portfolio, yet the vast majority don’t go into much detail on the composition of the stocks themselves. Can two 60-40 portfolios really be all that different?
With higher returns at the same volatility and less severe prolonged down periods, the long-term Coffeehouse withdrawal rates were a full percent higher than the Classic 60-40 portfolio. Not all stocks are created equal, and not all 60-40 portfolios perform the same in accumulation or in retirement.
Now admittedly deconstructing stocks into their component types takes a bit of financial education. However, you don’t need to spend a fortune on a degree or an expert to get on the right track. The Assets section here can help you explore different types of stocks in more depth, the Portfolios (including the new Coffeehouse Portfolio) will show you just how differently various combinations can perform, and the Calculators can crunch the numbers for your own experiments. Even if you ultimately do settle on a single total stock market fund (a very fine choice), understanding the various sub-components will make you a more intelligent investor and help you feel comfortable your decision.
So the next time you hear someone discuss the percentage of stocks in a portfolio, take a moment to dig a little deeper. What specific stocks are they talking about, and how might a different stock fund affect the results? It’s not simply a matter of market timing or of getting lucky with a hot index — it’s an issue of fundamental differences between different types of stocks and how they combine together to affect an overall portfolio. It could be that, behind the generalizations, the specific portfolio being discussed may not actually be the cup of coffee you expected. But learn how the components work, and you’ll be making your own version in no time that suits your personal tastes.
UPDATE: The charts were updated on 9-28-2016 with up-to-date data and modified withdrawal terminology.