Have you ever found yourself wondering which portfolios produce the highest returns? There are so many variations in portfolio construction that it can be hard to evaluate which portfolios make sense for your financial goals. We’ve spent the last five weeks analyzing safer investment strategies but now its time to talk about what’s probably the most popular portfolio in history. This portfolio has produced so much wealth that it basically has become the de-facto standard for investors who want to retire early. So stick around for a few minutes because today we are going to finally dig into the mighty, Simple Path to Wealth strategy.

Introduction

In the last episode of Portfolio Analysis we investigated the Boglehead 3-fund and Core Four Portfolios. Both of these portfolios use the index fund strategy pioneered by Jack Bogle. If you haven’t watched that video, please go check that one out first. The concepts in this video will make more sense after you watch that video.

In a nutshell, the balanced portfolios that Jack Bogle created using the index mutual funds he invented included asset classes such as bonds, international stocks, and real estate. Some investors started to think to themselves, hey international stocks and bonds haven’t really done very well in the last several decades so what would happen if I removed all these other asset classes and instead just invested 100% of my money in a Total US Stock Market Index or an S&P500 Index Fund.

And yea, if you go back to the 1970s and run the numbers this strategy beats pretty much every other strategy (well so long as you don’t need any of this money during the multiple times the market was crashing in that time period)

JL Collins created a blog which he later published as a book called, The Simple Path to Wealth. The ideas in Collins blog caught like wildfire. It captured people’s imaginations and today this strategy is basically the de-facto investing strategy for people in the FIRE (financial independence / retire early) movement.

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Simple Path Variations

Its important to understand that there are several variations of the Simple Path Formula. When advisors recommend the Simple Path to clients they are usually referring to an 80/20 or 75/25 version. For example, 80% Total US Stock Market and 20% Long Term US Treasuries. Balancing the portfolio with 20% or so bonds drops the standard deviation from around 14% to around 10% which changes this from a Very High Risk portfolio to just a High risk portfolio.

How the Simple Path Works

I want you to imagine a one year timeline. In this single year some stock pickers do really well and some stock pickers do really poorly. Stock picking is a zero sum game, for there to be a winner there must be a loser. When you average the returns of the winners and the losers you get the market average, or the return that index investors earn.

This is why index investing is called a “free lunch” and this is also why index investing is so hated by wall street investment firms. In any given year, you earn more money than 50% of all stock pickers for doing absolutely nothing.

Now lets add another year to our timeline. In the next year some stock pickers have a hot hand and they earn real good returns again the second year but many of the stock pickers that did well last year didn’t do so well this year. If we fast forward our timeline out 10 years or so we see that of all those stock pickers that were doing really great in the first year just a tiny handful of them are still in this winning category. If we assume we started with 100 investors just 7 of them have managed to beat this average return over 10 years and if we go out 30 years that number is just 2 out of 100. This 2% of investors are your Warren Buffetts and Ray Dalios of the world.

Its been said that you have just a 1 in 49,000 chance of beating the S&P500 over any given 30 year period. Are you still ashamed to be an “average” investor. Somehow, without picking a single stock or mutual fund you managed to beat 98% of fund managers, hedge funds, and stock pickers.

This is the power of ‘The Simple Path to Wealth’ strategy and its the reason this portfolio has created so many millionaires over the years.

Can You Really Pick Stocks?

When people chose not to invest in the index and instead pick stocks they are effectively saying that they believe they are better than 98% of all the people participating in the stock market.

Investors that pick stocks generally use two core techniques; Technical analysis and fundamental analysis.

These topics deserve their own videos so I’m not going to go too deep into these ideas but here’s a quick primer.

Technical Analysis

Technical analysis is based on Dow Theory and it tries to predict future price action based on patterns in previous prices. If you are interested in this, which I assume most people aren’t because its my worst performing video, I made a 10 minute primer that introduces Dow theory and in that video we write a computer program to perform automated trading just like the pros do.

Fundamental Analysis

Fundamental analysis is a process where investors analyse various factors pertaining to a company such as price to book ratio, price to earning ratio, return on equity, debt load and literally hundreds or thousands of other financial spreading data to try to find price bargains. Said anther way, the fundamental analyzer is looking for pricing inefficiencies in the market.

Speaking of price inefficiencies, there is a prevailing belief in academia called the Efficient Market Hypothesis. Long story short, the theory says that because all company information is equaliiy available to all investors any data that might give one investor an edge is no longer valuable because that information is universally known by all investors.

In earlier generations when Benjamin Graham was creating fundamental analysis it was hard to get all the relevent data about companies so anyone who knew how to get that data and more importantly, how to analyze it had a distinct advantage over other investors who were more or less just guessing which companies were going to make big moves. Times have changed and even graham himself was quoted before he died that he didn’t believe fundamental analysis would remain a valid strategy as access to technology and information continued to proliferate with new technology.

Let me just say that efficient market hypothesis doesn’t say that inefficiencies don’t exist or that its impossible to make winning bets, it just says that over long periods of time it is very, very difficult to outperform the market average.

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Simple Path Risks

At this point index investing has been around long enough and its results have been so impressive that most investors have more or less accepted the power and value of index investing.

Where investors run into real trouble today is when it comes to risk management.

This is a monthly chart of the S&P500 ETF SPY from 1992 to 2020. You can see that it took the S&P500 index 13 years to recover from the stock market crash of 2000 and it took 5 years to recover from the crash of 2008. If you were at the beginning of your investing journey then these crashes were a stroke of great luck for you but if you were at the end of your journey, nearing retirement or any other major lofe goal you were essentially wiped out.

This is the danger that everyone ignores when it comes to the Simple Path Portfolio.

As you get nearer and nearer to your financial goal its imperative that you reduce your risk by decreasing your stocks exposure. Once you’ve met your goal you can then slowly begin increaing your stocks exposure based on how the market is doing.

Final Thoughts

The Simple Path strategy is a great one and its longevity and popularity speak to its value. Investors just need to be sure that as each year passes they are properly accounting for risk so that a sudden market event doesn’t derail their timelines.

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