Author’s Disclaimer

Past performance of the 7Twelve portfolio is not a guarantee of future performance. This book does not represent investment advice nor is it an investment solicitation.

ACKNOWLEDGMENTS

I appreciate the help of Meg Freeborn, Bill Falloon, Tiffany Charbonier, and Chris Gage of John Wiley & Sons in getting this book produced in a timely fashion.

My deepest appreciation will always be reserved for my eternal companion Tammy. I love her. And just as important, I trust and respect her. Our children are great, too, and I love them each in a very individual way: Sara and Jon, Andrew and Shannon, Heidi, Mark, Nathan, Emma, and Jared.

My parents, as well as Tammy’s parents, have provided a lifelong example of integrity and endurance that has blessed our lives and the lives of our children.

Thanks also to Bob Vaughan, Robert Katz, Bryce Kurfees, and Andy Martin—each helpful in the early development of the 7Twelve portfolio.

Anciently, and almost cross-culturally, most numbers had an assigned symbolic meaning. So when people heard or read the number seven, for example, they were reminded of ideas of fullness and completion.

—Gaskill, Alonzo, The Lost Language of Symbolism (Deseret Book)

CHAPTER 1

A RECIPE FOR SUCCESS

A wise chef follows a good recipe. Likewise, wise investors should have a good recipe they follow when building a portfolio. The 7Twelve Portfolio is that recipe. By following it, investors will build a diversified, multi-asset portfolio.

The 7Twelve portfolio invests in “7” core asset classes (or investment categories) by utilizing “Twelve” underlying mutual funds—hence the name 7Twelve. The 7Twelve portfolio has both depth and breadth. 7Twelve has diversification depth within each separate mutual fund, and diversification breadth across seven core asset classes.

The 7Twelve Portfolio Recipe

7Twelve represents a complete portfolio by itself because it incorporates 12 different mutual funds. Alternatively, 7Twelve can be used as the starting point, or core component, in virtually any portfolio. The success of the 7Twelve portfolio is not the result of special skill. Rather, the success of the 7Twelve portfolio is the result of genuine diversification across multiple asset classes. The various mutual funds within the 7Twelve portfolio complement each other because they behave differently—the essential benefit of diversification.

Achieving diversification is critical to success in so many aspects of life. For example, only by combining a wide variety of very different instruments can an orchestra produce beautiful music. In the world of sports, the analogies abound. Teams combine players with different talents in order to maximize their chances for success.

Likewise, only by combining a wide variety of asset classes can an investment portfolio produce superior performance with lower levels of risk. Better risk-adjusted performance is the benefit from building broadly diversified investment portfolios.

The 7Twelve Recipe

Think of the 7Twelve model as a recipe for building a broadly diversified investment portfolio with 12 different mutual funds—where each mutual fund is itself a diversified investment product.

For those new to investing, a mutual fund is a collection of stocks, bonds, or any other investable asset. Mutual funds are purchased in shares, just as stock in a company is purchased in units called shares. The difference being that mutual funds represent a diversified collection of “stuff,” whereas a single issue of stock is not diversified. Building a portfolio using a wide variety of mutual funds is an ideal way to achieve maximum diversification. The trick is putting the right types of mutual funds together so that redundancy is avoided and diversification is maximized. Welcome to the 7Twelve portfolio “recipe”—your guide to building a portfolio that provides an ideal blend of risk-controlled performance.

As shown in Figure 1.1, each mutual fund has an equal share in the 7Twelve recipe, meaning that each mutual fund is equally valued for its specific contribution to the overall portfolio’s performance.

7TWELVE

The 7Twelve is a diversified portfolio of 12 different mutual funds—where each mutual fund is itself a diversified investment product.

Figure 1.1 Two-Fund Portfolio versus Twelve-Fund Portfolio

The pie chart on the right (the multi-asset 7Twelve portfolio) is far more diversified than the pie chart on the left (a typical balanced portfolio that has a 60 percent stock allocation and a 40 percent bond allocation). The 7Twelve portfolio utilizes 12 different mutual funds to gain exposure to a wide variety of investable asset classes. The typical “balanced” portfolio utilizes only U.S. stock and U.S. bonds. As will be shown in this book, the broadly diversified 7Twelve portfolio provides better performance with less risk than the typical two-asset balanced portfolio.

Throughout this book, the words “stock” and “equity” will be used interchangeably. A stock mutual fund is the same as an equity mutual fund. Likewise, bonds can also be referred to as fixed income products. So a bond mutual fund might also be called a fixed income fund. Of course, there are many different kinds of stock funds and many varieties of bond funds.

Salsa Anyone?

The 7Twelve portfolio is a recipe for combining 12 asset classes that optimizes performance and minimizes risk. It’s not complicated, but it does require more asset classes than typically used. It’s like making salsa with 12 ingredients instead of salsa with just two ingredients. Salsa with two ingredients won’t cut it.

Just as new recipes often call for unfamiliar ingredients, the 7Twelve portfolio recipe will integrate investment asset classes that may seem exotic. Remember that some recipes call for ingredients that we would never eat individually (say, Tabasco sauce). However, when combined with other ingredients the exotic ingredient is magically integrated in a way that enhances the overall dish . . . or portfolio.

It is the diversity of the ingredients that makes salsa taste great. It’s just hard to imagine great salsa that has only two ingredients. Even if you use the best tomatoes and onions available, having only two ingredients will not produce great salsa. How about using a wide variety of tomatoes and a wide variety of onions? Nope, doesn’t solve the problem. Even though you have diversity within the two ingredients, you still have only two ingredients—and that ain’t salsa.

The salsa metaphor describes the approach many investors (and mutual fund companies) use today when building what they claim to be a diversified portfolio. Here is a common approach: A stock mutual fund that contains 500 U.S. stocks is combined with a bond mutual fund that contains several hundred bonds. The resulting portfolio is referred to as a diversified balanced portfolio—the classic 60/40 model, with 60 percent of the portfolio allocated to large-cap U.S. stocks and 40 percent of the portfolio allocated to bonds.

With so many individual stocks and bonds, it appears that a diversified portfolio has been created. Wrong. No matter how much diversification there is within each ingredient, this supposedly diversified portfolio still has only two different ingredients (or asset classes): large-cap U.S. stock and U.S. bonds. Variety within specific asset classes is very important, but variety among asset classes is just as important—perhaps even more important.

Variety within an asset class represents “intra-asset” diversification, whereas variety among asset classes represents “inter-asset” diversification. Both forms of diversification are important. Nearly all mutual funds provide intra-asset diversification. Very few provide inter-asset diversification. The 7Twelve portfolio provides both.

7TWELVE

The classic 60/40 balanced fund is 60 percent allocated to large-cap U.S. stocks and 40 percent allocated to bonds.

Very simply, more types of ingredients are needed to create a truly diversified portfolio (or great tasting salsa). Investment portfolios with genuine diversification have variety within and among asset classes, just like a good salsa that has a variety of tomatoes and onions and a wide array of other ingredients, such as peppers, lime juice, cilantro, salt, vinegar, and so on. Similarly, a great recipe for a diversified investment portfolio calls for 12 diversified ingredients, not just two.

In broad terms, the 7Twelve portfolio has an allocation of about 65 percent (66.6 percent to be exact) that is devoted to “Equity and Diversifying Funds” (U.S. stock, non-U.S. stock, real estate, resources) and about a 35 percent allocation (33.4 percent to be exact) to “Fixed Income Funds” (U.S. bonds, Non-U.S. bonds, and cash).

This two-thirds/one-third allocation pattern between stocks and bonds represents a classic “60/40 balanced” model, where 60 represents a 60 percent allocation to stocks (or equity investments) and 40 represents a 40 percent allocation to bonds (or fixed income). This general 60/40 allocation pattern is a useful starting point when building investment portfolios. However, the 7Twelve portfolio represents a much-needed diversification “upgrade” to the generic 60/40 model. In fact, the 7Twelve portfolio will be compared to the classic 60/40 portfolio throughout this entire book.

The seven core asset classes in the 7Twelve portfolio include U.S. stock, non-U.S. stock, real estate, resources, U.S. bonds, non-U.S. bonds, and cash. Underneath the seven core asset categories are 12 specific mutual funds. You can also use exchange-traded funds (ETFs) instead of mutual funds. An exchange traded fund is a mutual fund that trades like a stock.

7TWELVE

The seven core asset classes in the 7Twelve portfolio include U.S. stock, non-U.S. stock, real estate, resources, U.S. bonds, non-U.S. bonds, and cash.

The 12 different mutual funds represent the specific ingredients in the 7Twelve recipe. Let’s take a look at the ingredients in first four broad asset classes, namely, U.S. stock, non-U.S. stock, real estate, and resources.

The first asset class to examine is U.S. stock. U.S. stock is often considered to be the “core” of many investment portfolios.

U.S. Stock

The 7Twelve portfolio utilizes three specific mutual funds in the U.S. stock asset class:

• Large-cap companies

• Midcap companies

• Small-cap companies

Each mutual fund has an 8.33 percent weighting (or allocation) in the 7Twelve portfolio; thus the U.S. stock “asset class” has a total allocation of about 25 percent in the 7Twelve portfolio—which is the largest allocation to any of the seven core asset categories. In other words, the 7Twelve portfolio’s largest single commitment is to the U.S. stock asset class.

Let’s talk first about large-cap U.S. stock, the first mutual fund in the U.S. stock asset class. Examples of large-cap U.S. stock (i.e., companies) are ExxonMobil, Microsoft, General Electric, Procter & Gamble, Johnson & Johnson, and the list goes on. Companies are classified as large cap (or midcap or small cap) based on their market capitalization (or “cap”), which is simply the current price of their stock multiplied by the number of shares of their stock that have been sold to investors. Large-cap stocks have a market cap of something over $8 billion. Small-cap stocks are market cap below about $1.5 billion. Midcap stocks are in between. These market cap boundaries are flexible, but these figures are general guidelines.

A well known collection of large-cap U.S. companies is the Standard & Poor’s 500 Index (or S&P 500). There are dozens of mutual funds that mimic the S&P 500 Index. Such funds are referred to as “index” funds, and index funds can mimic any index they choose. The most popular index to mimic is the S&P 500 Index. Funds that attempt to replicate the performance of the S&P 500 Index are referred to as S&P 500 Index funds (weird, huh?). More generally, they are simply referred to as index funds. But it’s important to remember that there are other indexes that can be replicated by “index” funds. (This may come as a shock to the good folks at Standard & Poor’s.)

Investing in the S&P 500 Index (by selecting an index fund) is a logical and appropriate way to invest in large-cap U.S. stock. Other large-cap U.S. stock indexes include the Russell 1000 Index or the Morgan Stanley U.S. Broad Market Index. Each of these indexes is investable via an appropriate index fund that has been chosen to mimic that particular index.

Let’s assume an investor chooses to invest in an index fund that mimics the S&P 500 Index. The good news is that the investor has instant diversification across 500 large-cap U.S. stocks. But that’s all they have—a diversified fund that invests in only one specific subasset class, namely, large-cap U.S. stock. Our diversified portfolio recipe calls for 12 ingredients—there are eleven other ingredients missing.

Creating an investment portfolio by using only one mutual fund (using an S&P 500 Index fund, for example) would be comparable to making salsa using tomatoes only. However, being clever, you diversify and use five (or 500!) kinds of tomatoes. Sure, you have diversification among tomatoes, but diversified tomatoes doesn’t create salsa! You need salt, cilantro, onions, peppers . . . and whatever else turns you on.

What I’m describing here represents a very common misunderstanding of diversification. Many investors believe they are diversified if they have a mutual fund that includes 500 different large-cap U.S. stocks. True, they have a diversified mutual fund. But it represents diversification only within one specific investment category, and there are many investment categories needed within a diversified portfolio.

The 7Twelve recipe creates a diversified portfolio using diversified individual ingredients (actual mutual funds). A mutual fund that mimics the S&P 500 Index represents only one diversified ingredient within a broadly diversified multi-asset portfolio. If we’re making salsa, we need more than tomatoes. If we’re making a diversified portfolio, we need more than 500 large-cap U.S. stocks. As of late 2009, there were about 750 large-cap stocks in the U.S. stock market (using data from Morningstar Principia).

There are two additional mutual funds we need to obtain to complete the U.S. stock category, namely, a mutual fund that invests in midcap U.S. stocks and a mutual fund that invests specifically in small-cap U.S. stocks.

Midsized and small U.S. companies are not as well known but often have more growth potential than large-cap U.S. companies. Think of large-cap U.S. stocks as adults, midcap U.S. stocks as teenagers, and small-cap U.S. stocks as children. Children have the most growth potential, but they also present more risk (use your imagination here). Teenagers also have growth potential but also present more risk than most adults (no imagination needed here).

Examples of midcap U.S. stocks are Ross Stores (“Do these Bermuda shorts make me look skinny?”), Chipotle Mexican Grill (“Three cheesy encharitos to go, please!”), Aeropostale (a retailer of casual clothing, but as my children will confirm I’m waaaay too old to go there), and Kansas City Southern (look both ways before you cross the tracks). According to Morningstar, there were about 980 midcap U.S. companies in late 2009. The performance of midcap U.S. stock is captured by several different indexes: S&P Midcap 400 Index, Russell Midcap Index, Morningstar Mid Core Index, and others. Mutual funds and ETFs that mimic the various midcap indexes are widely available.

Small-cap U.S. companies are like small fish in the ocean: abundant, but at risk. If, however, they make it past puberty they stand a chance of becoming a midcap fish, or possibly even a big fish. That’s where the growth potential comes from. Investors love to invest in little fish that become big fish.

The obvious challenge is selecting the little companies that will survive. As of late 2009, there were about 5,100 small-cap stocks in the U.S. market (at least that many were included in the Morningstar database). Many of those companies won’t exist two years later. Therefore, the only sane way to invest in small-cap stock (or any stock for that matter) is by investing in a mutual fund that purchases hundreds or thousands of small companies (or midcap stock or large-cap stock). This approach represents the central tenet of diversification: spread risk across multiple investments. It is a principle that applies to mutual funds as well as portfolios that utilize multiple mutual funds—such as the 7Twelve portfolio.