Magic formula for wealth building

Signal From Static: Magic Formulas and Portfolio Rainbows

Magic Formulas and Portfolio Rainbows

What would you say to a magic formula for wealth building that beats the pants off a traditional 60/40 stock/bond portfolio while performing almost on par with the S&P 500? Oh, and did I mention there’s less risk? According to a series of articles on MarketWatch, the magic formula is yours for the taking.

This isn’t the first “easy path to investing success” that I’ve come across, but it caught my eye as a case study because of its simplicity and the relentless promotion of the strategy over the past year or more.

Its creator refers to it as the “All Asset No Authority” portfolio, but I call it the “7-asset portfolio,” or 7AP for short. Here’s the secret sauce: Hold equal weights of large and small U.S. stocks, 10-year Treasury bonds, U.S. real estate investment trusts (REITs), foreign stocks, commodities and gold. Rebalance annually.

Sounds easy, but does it deliver?

I put the 7AP to the test by going back 50 years, and the end-to-end results seem to match the headline promise: Since the end of 1971, the 7AP compounded at 10.0% per annum compared to the stock market’s 10.5%. And the strategy’s worst drawdown was a 36% drop—that compares well to the stock market, which fell by more than 40% on three occasions over the past five decades.

This is promising at first glance, but look a little closer and the rainbow starts to fade.

First, consider the relative performance of the 7AP and the S&P over the past 50-plus years (in the chart below). When the line is rising, the S&P is outperforming; when the line is falling, the 7AP is outperforming. Those are some big swings.

Yes, the 7AP has, at times, generated an enviable string of returns. For instance, over the nine or so years from the end of 1971 through January 1981, the 7AP returned an annualized 19.9% gain compared to the S&P 500’s 5.8%. Then there’s the period from June 1999 through February 2009, almost 10 years, when the 7AP compounded at a 4.4% rate while the S&P declined 4.6% per year.

However, the 7AP also lagged the stock market substantially from January 1981 through June 1999 (more than 18 years) and from February 2009 through December 2021 (almost 13 years). During those much longer periods, the 7AP gained 10.2% and 10.4% per annum while the S&P was compounding money at 17.5% and 18.0%.

Source: Bloomberg, Morningstar, Adviser Investments

My first takeaway is to remember the human element. Sure, the 50-year results look good in aggregate. But do you think investors would have stuck with the strategy during those long periods when the 7AP was lagging by 7% to 8% a year? I suspect most investors would’ve thrown in the towel.

Another major stumbling block: This truly is a magic portfolio because no investor would have been able to actually buy and trade the 7AP in the 1970s, 1980s or 1990s. At the time, owning physical gold, futures on gold and various commodities, or a basket of real estate investments would have been practically impossible for the average investor—and that’s before considering the costs of the rebalancing necessary to follow the strategy.

Indeed, only with the advent of easily traded ETFs covering commodities, gold and REITs has a 7AP actually been obtainable and tradable. And that means you can only look back as far as mid-2006 to capture the performance of a real, honest-to-goodness, tradable 7AP. Why? It took that long for someone to come up with a viable ETF that tracks commodity prices.

With that in mind, I backtested the 7AP using seven well-known and liquid ETFs—the kind your typical investor might use. As you’ll see in the chart, except for a brief period from about mid-2007 through early 2009—the approximate dates of the bear market driven by the global financial crisis—the S&P 500 has put the 7AP to shame. Over the entire period presented here, the 7AP generated a return of about 5.2% while the S&P 500 almost doubled that—up an annualized 9.0%.

Source: Bloomberg, Morningstar, Adviser Investments

How’d the 7AP do against a 60/40 portfolio? Vanguard’s Balanced Index (VBINX) fund compounded at 6.8% over the period. So, even a simple stock/bond portfolio outperformed the 7AP by a goodly amount.

The illusion of a magical portfolio—whether it’s the 7AP or something else—is shattered by the realities of real-world investing. My advice is to tune out the static of articles purporting to offer easy fulfillment of all our investing dreams. If the strategies were really as good as advertised, the creators would be sipping daquiris on a private island, and they wouldn’t be sharing their secrets.

Every investor follows a unique path to financial prosperity. Navigating the supposed magic of a simple portfolio can make finding and staying on that path difficult. At Adviser, we have the resources and expertise to help build a plan for you and guide you through unpredictable markets and life events. No magic necessary.

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