This 4-fund combo wallops the S&P 500 index
Reprinted courtesy of MarketWatch.com
Published: March 18, 2015
To read the original article click here
U.S. equity investors typically concentrate their money in large-cap blend funds and so-called total market funds, all of which more or less move in step with the Standard & Poor’s 500 Index.
But for investors who are willing to venture into value stocks and small-cap stocks, there’s much more money to be made.
In the most recent articles in this performance-oriented series, we’ve looked in some detail at the long-term track records of the S&P 500 plus three other major asset classes: large-cap value stocks, small-cap blend stocks and small-cap value stocks.
Each of those three significantly outperformed the S&P 500 index SPX, +1.49% over the past 87 calendar years, the longest period for which we have data. Yet each of those three has been more volatile than the S&P 500, making each one riskier.
The good news, which I’ll demonstrate with historical performance numbers, is that there’s an easy way to harness the returns of these three asset classes while limiting their volatility. That happens when you allocate your U.S. equity assets equally into all four of these asset classes.
Follow along as I present the historical results of a hypothetical portfolio invested equally in the S&P 500, the large-cap value index, the small-cap blend index and the small-cap value index.
Although one-year returns aren’t meaningful for long-term investors, they must inevitably be part of any comparison like this. So we’ll start there:
Summary of 1-year period results (1928-2014)
| Large-cap blend | Large-cap-value | Small-cap blend | Small-cap value | Four-way combo | |
| $100 grows to: | $346,261 | $971,683 | $2,223,809 | $6,563,730 | $1,793,238 |
| 87-year avg. CRR | 9.8% | 11.1% | 12.2% | 13.6% | 11.9% |
| Best 1-year return | 54.0% | 92.7% | 110.0% | 125.2% | 96.0% |
| Worst 1-year return | -43.3% | -62.0% | -48.0% | -54.7% | -51.8% |
Data Source: Dimensional Fund Advisors; CCR – Compound Rate of Return
As you can see, in the 87 years from 1928 through 2014, the four-way combination had an average gain of 11.9%, versus 9.8% for the S&P 500. The best one-year returns both occurred in 1933; the worst ones were both in 1931.
Although the table doesn’t show it, the four-way combo had 62 profitable years with gains averaging 26.8% and 25 losing years with losses averaging 14.8%.
The S&P had 63 profitable years with gains averaging 21.5% and 24 losing years with average losses of 13.6%.
More meaningful are 15-year periods (there were 73 of them). Every such period was profitable both for the S&P 500 and for the four-way combination. (All the multiyear performance figures in this article assume annual rebalancing.)
These 15-year periods are summarized below:
Summary of 15-year period results (1928-2014)
| Large-cap blend | Large-cap-value | Small-cap blend | Small-cap value | Four-way combo | |
| Avg. $100 grows to: | $474 | $641 | $699 | $943 | $686 |
| Avg. 15-year CRR | 10.9% | 13.2% | 13.8% | 16.1% | 13.7% |
| Best 15-year CRR | 18.9% | 21.7% | 23.1% | 26.4% | 22.1% |
| Worst 15-year CRR | 0.6% | -1.4% | 1.6% | -1.6% | 0.5% |
Although the returns of the four-way combo were generally higher, we need to evaluate their risk. The most widely used measurement of investment risk is volatility, or unpredictability. That’s measured by standard deviation.
This statistical measure has to be taken with a grain of salt, because it doesn’t measure risk the same way a human being would. For example, a gain of 75% is regarded as just as “risky” (and thus presumably dangerous) as a loss of 75%.
Still, standard deviation tells you how much an investment’s returns were “all over the map” as opposed to steady and predictable.
By themselves, standard deviation measurements don’t mean a lot. But they are good for making comparisons, because lower standard deviations mean lower volatility — thus lower risk.
For all the 15-year periods from 1928 through 2014, the S&P had an average standard deviation of 18.2%. The four-fund combination’s average standard deviation was 22.5%.
Now let’s look at this four-way combination over 40-year periods from 1928 through 2014:
Summary of 40-year period results (1928-2014)
| Large-cap blend | Large-cap-value | Small-cap blend | Small-cap value | Four-way combo | |
| Avg. $100 grows to: | $6,287 | $15,621 | $17,072 | $40,413 | $17,275 |
| Avg. 40-year CRR | 10.9% | 13.5% | 13.7% | 16.2% | 13.7% |
| Best 40-year CRR | 12.5% | 15.8% | 16.7% | 18.9% | 15.9% |
| Worst 40-year CRR | 8.9% | 8.3% | 10.7% | 11.8% | 10.7% |
There were 48 such periods, and in every one, the combination portfolio had a compound return of more than 10%. (The S&P 500 had four 40-year periods with returns less than 10%.)
In general, the 40-year risk comparison between the S&P and the four-way combo was similar to that for 15-year periods.
Enough numbers! What should you make of all this? I think you should use it to make more than twice as much money!
Based on the average 40-year return, an initial $5,000 investment in the S&P 500 would grow to about $2.8 million. In this four-fund combination, the same $5,000 would grow to about $6.1 million.
The four-way combination provides a good means of capturing the higher returns of three asset classes beyond the S&P 500. The combination’s volatility was somewhat higher, but not drastically so — certainly not enough to dismiss the possibility of making twice as much money.
You can learn more about this four-way combination from this table and my podcast, “The Four-Fund Solution.”
There’s more good news to come.
Diversification doesn’t have to stop with these four asset classes. In my next performance articles we will look at real-estate investment trusts and international asset classes and see how they can improve on what we have covered so far.
Richard Buck contributed to this article.
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