Investing basics: the virtues of a minimalist portfolio

Can investors reasonably employ a minimalist all-index fund portfolio and call it a day? Financial blogger and author Jim Dahle thinks so. Dahle, a US-based physician, oversees the popular “White Coat Investor” website, where he advocates for low-cost investing, a long-term approach to asset allocation, and a disciplined plan for saving and spending.

On a recent episode of Morningstar's “The Long View” podcast, Dahle discussed why he thinks a utilitarian approach to investment selection and portfolio construction is best and whether investors should brace themselves for meagre returns from stocks and bonds in the decade ahead.

Christine Benz: When it comes to portfolio management, you like to keep things simple and you like to focus on index funds. What about index funds resonated with you? Was it simply the evidence-based focus?

Jim Dahle: I think a lot of it came out in the writings of John Bogle, William Bernstein, Rick Ferri, Larry Swedroe. I read these books and time and time again the evidence showed that index funds were outperforming, depending on the timeline, 70 per cent, 80 per cent, 90 per cent of actively managed funds. And I looked at myself and said, “Self, what makes you think you're in the 10 per cent that can pick the winners?” Number one. And number two, “If you can't even pick a winning manager, what makes you think you can be a winning manager yourself picking individual stocks?” When I realised that you could get exposure to these asset classes, to US stocks and international stocks and bonds and real estate and so on and so forth, through index funds for essentially free - 2, 3, 4, 5 basis points a year for these mutual funds, and you never had to worry about manager risk - you didn't have to really follow the investments because you knew that they were going to perform as well as the asset class performed. And you could then concentrate on the other things in your life that you cared about, whether it was your hobbies or whether it was your practice, your family, or whatever. I found that very attractive.

The other thing I realised early on was that my crystal ball was very cloudy. I needed a plan that would not require me to be able to predict the future because I realised early on that my ability to predict the future was very limited. And anybody who thinks they can do this I think should try an exercise where they take a notebook and they write down what they think is going to happen--which asset classes are going to outperform, which stocks are going to do well, what interest rates are going to do, what's going to happen in the political sphere, etc. I think after a year or two of doing this, you will convince yourself that your crystal ball is also very cloudy and that you really need something that's going to work in a wide range of future economic outcomes and not require you to be able to predict the future in order to be successful. I think that's really why I found the idea of investing in a static asset allocation of low-cost, broadly diversified index funds was a very attractive way to invest. It is highly unlikely to be unsuccessful over the long term. If I can stick with the plan and stay disciplined with it, each of those asset classes are going to have their day in the sun.

Jeffrey Ptak: So, the corollary to that is that when - and I would imagine you did read some of these texts, Buffett's letters, Peter Lynch's books, Hedge Fund Market Wizards, just to give examples of managers that have been quite, quite successful - you read those and you came to the conclusion that while maybe it worked for them, it wasn't right for you. How did you come to that conclusion?

Dahle: Mostly, I listen to their advice. If you ask Warren Buffett how he thinks a typical person should invest, he will tell you: Go buy index funds. I tried to do what they said, not necessarily what they did, because I saw that they had a different skill set than I did. And the reason we know these names and we use these names over and over and over for decades is because they were so successful and so unique. But the question isn't what about Warren Buffett. It's why aren't there more Warren Buffetts? Because, statistically, there should be a lot more than they are, even with random chance. I think, when I realised that, I realised that I make enough money that if I just save a decent portion of it, and I invest it in some reasonable way, I'm going to have more money than I ever need to spend, and I'm going to be able to use the excess to benefit my heirs and my favourite charities. I don't need to crush the market in order to meet my financial goals. I already have a high income and the ability to have a high savings rate. I need an investment plan that's highly likely to work, that is unlikely to blow up, and that is relatively easy for me to follow for decades. And that's what I found with a Boglehead-style portfolio.

Benz: You're a proponent of maintaining a fixed asset allocation as opposed to one that changes on the road to one's goal. But that runs counter to conventional asset-allocation prescription where you take on less risk as you age. Can you discuss your thinking on maintaining that static asset.

Dahle: When I talk about a static asset allocation, I'm mostly not referring to that aspect of making it less risky as you approach retirement, and I actually think it's probably a good idea to reduce your sequence-of-returns risk within the first five years of retirement and maybe the last five years of your career. I think that's probably a good idea and probably a wise thing to do.

When I say I prefer a static asset allocation, what I'm talking about is not using a tactical asset allocation, not looking at current market events, putting your finger up into the political winds and trying to decide which is going to outperform over the next year or five years or 10 years. I really have no idea whatsoever whether US stocks are going to beat international stocks this year. I really don't know. I try to use an asset allocation that doesn't require me to know that. I set these percentages back when my wife and I drafted up our financial plan in 2004 and wrote out what our asset allocation was going to be--we set fixed percentages for US stocks and international stocks. In some years, international stocks do better, and we end up selling some international stocks and buying more US stocks. Other years, the US stocks do better, and we do the opposite.

But what that allows me to do is not have to know what the future holds in advance in order to be successful. By owning all of these asset classes, I'm going to own them when they have their day in the sun and over the long run it's all going to even out. Whereas I think if I was trying to predict the future, if I was trying to move these asset allocations around based on what I thought was going to do well over the next short term, what I was much more likely to do, I felt, was to chase performance and end up buying high and selling low repeatedly between these asset classes. It just seemed much wiser to me to set it up as a static asset allocation from the beginning and rebalance back once a year or every couple of years, or whatever, back to that static asset allocation. But as far as over the years reducing risk, particularly around the time of retirement, I'm certainly not against that. I think that's probably a wise move for the vast majority of investors.

Ptak: I suppose a unique issue, maybe not a unique issue, but a remarkable issue that some subscribers to the approach that you just describe - which is having a relatively static asset allocation, not trying to guess about asset class returns in the future - is that US stocks and bonds have done quite well and valuations are high, yields are very, very low. I suppose as we gaze forward you would legitimately raise questions about what the potential return of the traditional US 60/40 portfolio would be. Do you think it behooves investors who maybe in the past were more prone to just going with that 60/40 to be asking themselves, “Maybe we should be inching up the international equity exposure; perhaps we should be owning more equity than we did before just because fixed income has so little to offer right now?”

Dahle: I think it's absolutely fascinating to talk about. If I had to put money down in Vegas on whether I thought international stocks and small-value stocks were going to outperform US large-growth stocks over the next decade, I certainly would bet that way. But I think it's important to divorce how you feel about the market from what you actually do with your investments, and to be very, very rational and very intentional and stay the course with your financial plan when it comes to actually doing things with your investments. And I'll give you an example why.

If you go back to Internet forums and you go back to financial publications in 2010, you will see that people were saying, “Get out of bonds, they're going to have terrible returns; interest rates have nowhere to go but up.” And that has basically been the tune for the last decade. Meanwhile, what has happened? Well, interest rates have stayed low. They've even fallen. Bonds have had excellent returns over the last decade, and it's one of those things that everyone felt had to be true that turned out not to be true, and I kind of feel the same way today. Yes, I expect that international stocks are going to outperform US stocks, but the market can remain irrational for longer than I can remain solvent. I think the most important thing about a plan, especially if you have written up a reasonable plan, is to stick with it through thick and thin, because there are going to be times where you feel like this can't possibly happen, and then it happens again and again and again for several more years. And you want to be able to make sure that you get those gains when that does happen even though you didn't expect the gains.