Generating accurate and intuitive charts to help you navigate the professional asset allocation landscape is pretty darned rewarding, and I take a lot of pride in contributing to everyday asset allocation discussions in my own data-driven way. I also spend a lot of time reading those same discussions online, as not only does it help inspire new ideas but it also helps me understand what drives people. Everyone’s motivations are different, and when you put your life savings on the line the stakes are also quite high so people tend to really tell you what they think.
While that variety of strong opinions makes the financial blogosphere particularly difficult to navigate for new investors, I personally find the abundance of different perspectives a fascinating design challenge. That’s because beyond simply crunching numbers like a good engineer, I’m also a designer at heart and love solving complex problems and bringing new ideas to the table. The Golden Butterfly is one such example, but I don’t believe there’s one perfect way to invest and my problem-solving circuits are always scanning for new ideas to help people find an asset allocation that resonates. So in that spirit, today I want to talk about a new portfolio idea that based on all I’ve read I think a lot of people may find helpful.
Any self-respecting design solution is only as good as its stated goals, so before we get started let’s talk about who this new portfolio is intended to help. Summarizing a perspective that I think many investors can relate to, here’s the problem statement.
What portfolio would you recommend to someone who:
- Very rationally wants to diversify their wealth broadly across all four core asset types — domestic stocks, international stocks, bonds, and real assets
- Is uncomfortable with high percentages of unconventional assets found in many modern portfolios and desires a more traditional foundation
- Remains open to improving risk-adjusted returns in a simple and sustainable way, but prefers to stick to one best-in-class supplement for each asset type rather than getting carried away with slicing & dicing
Does that sound like you? If so, you’ve come to the right place. It occurred to me that a few portfolios on the site come close but none really hit the mark, and after thinking about it a while I have a potential solution I’d like to share. In recognition of the colorful diversification and familiar symmetry, I call it the Pinwheel Portfolio.
- 15% Total Stock Market
- 10% Small Cap Value
- 15% World Total Stock Market
- 10% Emerging Markets
- 15% Intermediate Term Bonds
- 10% Tbills / Cash
- 15% REITs
- 10% Gold
The foundation of the Pinwheel Portfolio consists of the four most common assets found in many professionally-recommended portfolios — the total domestic stock market, total international stock market, intermediate term bonds, and real estate. In fact, about half of the portfolios here on the site include all four of these assets. Rick Ferri goes as far as to call them the “Core Four” assets in portfolio construction and David Swensen, when he’s not managing billions at Yale, also recommends the same basic assets for investors like you and me. So when looking for the most widely-accepted place to start an asset allocation, building on these four assets is well-supported in the industry.
Rather than messing with fine-tuning percentages, the Pinwheel Portfolio starts with these four assets in equal proportions very similar to the Swensen Portfolio. The idea is to balance the risk of different economic outcomes rather than fuss with optimizations based on sheer economic guesses for what the future might look like. With fully 60% of the portfolio equally weighted in the four most common portfolio assets, you’re well-positioned to confidently start your portfolio on solid ground no matter what the future holds.
This fundamental foundation already satisfies our first two design goals of broad asset class diversification using traditional investment vehicles. So now we get to the fun part. If you were to limit yourself to only one best-in-class additional asset in each category to improve the risk-adjusted returns of the portfolio, what would they be? Here are my four choices — two chosen to improve returns and two chosen to mitigate risk.
Small Cap Value
The investing world is always looking for an edge in the markets, and smart researchers have looked into dozens if not hundreds of different “factors” with the potential to improve returns. For the uninitiated, a factor in index investing is basically just a filter to help you identify a subset of stocks with superior performance. There’s a huge amount of research on this topic (read this book by Larry Swedroe for an excellent summary), but let me make it simple for you. Of all of the different investing factors out there that you might choose to improve returns over a common cap-weighted total market fund, the two most measurably significant and consistent options are small and value.
Purchasing smaller undervalued companies does not always produce better returns than the cap-weighted market as a whole, but more often than not it does help. There’s a reason so many portfolios on the site include small cap value stocks, and it seems like a natural choice for the domestic stock portion of our portfolio.
While it might make sense to apply the same small cap value filters to international markets, you may notice that international SCV funds are not very common. When thinking globally, you have to change your perspective a little from company-based to country-based. Small startups relative to their developed peers, emerging markets are the widely-traded small cap value equivalents in global markets.
That said, while they have often posted tremendous returns they can also be wildly volatile and generally are not weighted too heavily in most portfolios. But a performance enhancing supplement is exactly what we’re looking for, and in the right proportion it makes a lot of sense. Mix in the fact that many broad World funds only include developed markets, and an emerging market fund is the easy choice to supplement international stocks.
Wait — what? Yes, you read that right. If you’re looking for one additional bond asset to best complement the intermediate bonds you already hold, properly invested cash is definitely the most under-appreciated asset out there.
Cash serves two very important roles in a portfolio. First, contrary to most “common knowledge” based on a very myopic recent-history view of the markets, T-bills have historically been the single most consistent inflation hedge money can buy (Don’t believe me? Read this). And second, cash is extremely helpful for simple day-to-day spending needs which is why almost every financial professional recommends you save up an emergency fund before messing with the stock market.
Do you not consider your emergency fund part of your overall portfolio? Why not? Look at the big picture rather than separating your savings and investments and you may already have this part covered. So let’s set aside artificial mental buckets and start thinking about cash in the overall investing context it deserves.
There’s probably no single investing asset that inspires as much passion as gold. Many people either love it or despise it. Play with the My Portfolio tool for long enough and you’ll eventually see for yourself the financial benefits of adding gold to a portfolio, but that will never satisfy the doubts of people who simply don’t understand it.
So what is it good for? Gold is like portfolio insurance — there will be times when you feel like you wasted your money on it for years, but when the financial world blows up you’ll be incredibly thankful you bought it. I like to think of gold as an “adversity asset” that’s there to carry the day when times are tough for everything else. And since REITs are highly correlated to stocks during poor markets, supplementing our real assets with gold makes a lot of sense and has a demonstrably positive effect on limiting the downside of a portfolio.
That said, I still totally understand how people might have a tough time putting a large percentage of their hard-earned money into a shiny metal. Even if you’re uncomfortable with putting 20-25% of your money into gold like Golden Butterfly or Permanent Portfolio investors, in my experience a modest 10% stake is much easier to handle while still noticeably improving risk-adjusted returns.
In summary, the Pinwheel Portfolio contains 60% conventional assets that virtually everyone recommends and 40% performance-enhancing tilts to improve risk-adjusted returns without over-committing to any one new asset. In addition, it is intentionally balanced not only across stocks and other assets but also across all four high-level investing categories. It’s an intelligently constructed outlook-neutral portfolio designed to do well in all types of economic environments.
Now that sounds great, but talk is cheap. How has it performed? Here are a few comparisons to other portfolios mentioned above that share the same common four-fund foundation — the Rick Ferri Core Four and the Swensen Portfolio. I’m going to focus here on US returns, but international readers can directly translate the numbers to their own home currency using the interactive tools in the Portfolios section.
As you can see, all three portfolios had very similar median returns. Like so many asset allocations, the big difference was not in a single long-term average but in the range of outcomes. Pay particular attention to the minimum and baseline returns, and you’ll quickly see the difference in terms of realistic performance when things didn’t go as planned.
Speaking of downside, the Drawdowns chart shows how the additional assets in the Pinwheel Portfolio helped take the edge off of the longest drawdown and Ulcer Index. It’s a little counter-intuitive that adding highly volatile assets like small cap value, emerging markets, and gold can actually reduce the overall volatility of a portfolio, but that’s the great benefit of modern portfolio theory for those willing to give intelligent asset allocation a try.
And finally, few metrics measure the long-term reliability of a portfolio better than withdrawal rates. Here you can see that simply varying the percentages of the exact same domestic stocks, international stocks, intermediate bonds, and REITs even somewhat drastically between the Rick Ferri Core Four and Swensen Portfolios had only a negligible effect on withdrawal rates. But supplementing those four base assets with a few smart additions raised the safe and perpetual rates by a full percent.
Of course there are many other portfolio options than just the Ferri and Swensen recommendations, so allow me to save you a little time and cut to the chase. Of all the portfolios on the site, the Pinwheel Portfolio trails only the Golden Butterfly in baseline return and withdrawal rates and stands a respectable 7th in ulcer index. So for people attracted to the performance of the Golden Butterfly but who struggle with the specific holdings, the Pinwheel Portfolio is worth your attention.
With a solid foundation of conventional investing ingredients complemented by a handful of strategically picked seasonings, I believe the Pinwheel Portfolio can be an appealing asset allocation recipe not only for traditional investors looking to build upon what they already own but also for experienced DIY investors looking for ways to simplify their portfolios. Only you can decide how to best invest your own life savings, but it’s my pleasure to add another option to the discussion and no matter how you invest I hope you find it insightful.