When it comes to investing, I’ve been an outspoken advocate of keeping things as simple and as cheap as possible. Namely, to own the entire stock market using a Total Stock Market index fund with a rock bottom expense ratio. But recently I’ve decided to add some complexity into my investing portfolio. Let me tell you why.
First, what the heck is The Simple Path to Wealth (SPTW)? The SPTW was introduced by J.L. Collins of jlcollinsnh.com in his famous Stock Series and in his similarly titled book. This strategy is centered around the following:
- Don’t seek to beat the market. Rather, seek to match the market’s returns
- Minimize Fees
- Avoid actively managed funds
- Avoid being our own worst enemy
To do this, J.L. Collins recommends buying every stock in the U.S. stock market with a total stock market mutual fund or exchange-traded fund (ETF) with a rock bottom expense ratio, such as Vanguard’s Total Stock Market mutual fund (VTSAX) or similar. Additionally, if you feel you need to help smooth the ride (i.e. reduce volatility) then add in a total bond market fund or ETF. Doing so means that you no longer have to pick winners or losers. You have them all.
Let me be clear: I am a huge fan of this approach. I believe it is likely the best approach for the vast majority of investors. And, as you will see later, I’m not stepping too far out of line.
Then why am I deviating?
Diversification
I do not have a Total Stock Market index fund as an investment option within my 401k account. Rather, I have the Vanguard 500 (VFIAX) fund, which tracks the S&P 500. Within it are 511 of the largest companies in the U.S. In comparison, the Total Stock Market fund (VTSAX) holds 3,624 companies. That’s quite a difference.
The Vanguard 500 fund excludes companies with small and mid-sized market capitalization (i.e. small and mid cap). To me, this is a lost opportunity to capture returns and diversify risks.
Further, within our household’s combined portfolio there are absolutely ZERO international stocks. I side with J.L. Collins in that U.S. returns have the best bet to continue to outpace the international scene. Personally, I feel it’s our country’s geographical advantages (navigable rivers, defend-able borders, petroleum reserves, and ample cropland) that set the U.S. up for long term.
However, that doesn’t mean there won’t be hugely successful foreign companies with spectacular growth. To put my mind at ease, it would be nice to be able to tell myself: “Hey, I have a piece of that”. Basically, international stock exposure increases my diversification and reduces my FOMO – Fear of Missing Out.
Similarly, we don’t have any exposure to Real Estate Investment Trusts (aka REITs) which invest, surprisingly enough, in real estate. REITs have a track record of solid returns, and are less correlated to the stock market performance, which can provide some protection against market volatility.
Historical Returns
I’ve been looking into the historical performance of the various asset classes (i.e. small, mid and large cap, international, growth and value). The SPTW approach is a market-weighted one, meaning the larger companies, such as Amazon, Facebook, Alphabet (Google) and Microsoft, absolutely dominate the holdings. As such this approach can be classified as a Large Cap Blend.
This asset class has performed very well over time. But it has not been the best. That honor appears to go to Small Cap and Small Cap Value (value companies are those that have a low ratio of stock price to book value… think of them as out of favor or discounted).
Paul Merriman, the originator of the Ultimate Buy and Hold Portfolio, is a raving fan of Small Cap Value as an asset class. His site presents an Asset Class Comparison chart that details the performance of each asset class over various time periods.
To me, this chart was eye-opening. Small Cap Value was the best performing asset class an average of 53.7% of the time over periods ranging from 1 to 40 years from 1928 through 2017. The next in class asset was Small Cap Growth. Large Cap Blend (aka the SPTW approach) performed best an average of 5.6% of the time.
Conversely, Small Cap Blend performed the worst only 0.1% of the time over the same periods. Small Cap Value performed worst 2.8% of the time. Small Cap Growth as a comparison, fared worst 23% of the time. Large Cap Blend was the worst performer an average of 8.4% of the time.
I know, I know… past performance doesn’t guarantee future results. But it is VERY hard to ignore data like this.
So What Did I Do?
First off, I looked at my 401k options and found that I have two low cost small cap index funds. Vanguard’s Small Cap and Small Cap Value funds (VSMAX and VSIAX, respectively). Additionally, there is a Total International Stock Market fund (VTIAX) and a Real Estate Fund (VGLSX).
I then summarized the expense ratio (ER), number of companies held, and return since inceptions and compared them to the VFIAX fund I was already in. Here is what I found:
| Fund | ER % | # Companies | Return since inception |
| VFIAX | 0.04 | 511 | 5.16% |
| VSMAX | 0.05 | 1382 | 7.32% |
| VSIAX | 0.07 | 859 | 10.43% |
| VTIAX | 0.11 | 7128 | 3.33% |
| VGLX | 0.12 | 183 | 8.41% |
I am always drawn to the fees first. VFIAX (aka the S&P 500 tracker) has a rock bottom 0.04% ER, but the remainder of the funds are actually not that bad. For full disclosure, when I was invested with Edward Jones I had multiple funds that with ER’s of 0.50% to 1.00%+. Yikes! In comparison, these all look like bargains.
Going back to diversification, again, there are several thousand companies I would be missing out on if I stuck with just the S&P 500.
Last, and certainly not least, look at the returns! Most of these are 19-year returns. These are returns accounting directly from Vanguard’s website accounting for taxes, distributions, etc. Every fund, with exception of the international stock fund has outpaced the good ol’ S&P 500 over this time. This is consistent with the research at Paul Merriman’s site.
I started tinkering with asset allocations and settled with the following breakdown.
| Fund | % |
| VFIAX | 50.00% |
| VSMAX | 10.00% |
| VSIAX | 20.00% |
| VTIAX | 10.00% |
| VGLX | 10.00% |
What Does that Give Me?
This gives me more complete exposure to the U.S. stock market with a slight emphasis on small cap value (the best performing asset class thus far).
It broadly diversifies my 401k portfolio from 511 companies to 8,693!! (I didn’t count the VSIAX companies since they are part of the 1,382 companies held by VSMAX). It also includes an asset class with less market correlation, which can reduce some market volatility.
Looking back, this portfolio would have outperformed my S&P 500 approach by 1.41% (I ran a weighted average of the returns based on the % portfolio allocation). Putting that into a dollars perspective… over 20 years it would have outperformed the S&P by $71,000 (based on my current 401k balance). Over 40 years the difference grows to $272,000!
You might be asking: “If the numbers are so compelling, why don’t I go all-in?” It comes back around to knowing thyself. While I love the prospect of higher returns offered by the Small Cap and Small Cap Value asset classes, I just don’t know how I will respond to the higher volatility associated with them. We have not had a bear market or major correction since I’ve started heavily investing. Dipping my toe in here allows me to run an experiment of sorts to check the strategy and check my mental fortitude.
Lest you think I am shunning the SPTW, the remainder of our family’s portfolio is held in a Total Stock Market index fund (VTSAX or similar). My break from the SPTW accounts for a whopping 7% of our portfolio. I’m really living on the edge here. This portion will grow with future contributions maybe up to about 20% of the portfolio.
Photo by Pedro Sandrini from Pexels