“Eat your Brussels sprouts,” I used to hear when I was a kid, “and you’ll grow into a big, strong boy.”

So I ate a bowl of Brussels sprouts for breakfast, a plate of Brussels sprouts for lunch, and a casserole dish of Brussels sprouts for dinner—seven days a week.

If that were true, I’d probably resemble a green, leafy ball with legs by now. Brussels sprouts might be good for you, but you need to eat more than a bunch of tiny cabbages if you want to be healthy.

In the same vein, a total stock market index fund might be good for you as well, but it doesn’t represent a balanced portfolio.

If that were all you bought, your portfolio would gyrate wildly with the stock market. If the market dropped 20 percent, so would your overall portfolio. If the market dropped 50 percent, so would your total investments.

This isn’t good for any investor, especially those approaching retirement and needing more stability. If a 60-year-old plans to use her portfolio as a nest egg, she’s not going to be comfortable seeing all of her hard-earned money plunge into what might look like a bottomless crater during a sharp market decline.

Only an irresponsible portfolio would fall 50 percent if the stock market value were cut in half. That’s because bonds become parachutes when stock markets fall.

What Are Bonds?

Bond is a secret British agent with a license to kill. He sleeps with multiple women, never dies, and every 15 years or so, gets a body transplant to look like a completely different guy.

Financial bonds are just as riveting.

Bond Index Funds Are the Winner

In case you’re tempted to buy an actively managed bond fund, remember this: bond index funds beat them silly. Costs matter even more in the world of bond funds.

Figure 5.1 reveals that from 2003 to 2008, the average actively managed government bond fund with a sales load (that crafty commission paid to advisers) made 3.7 percent annually and the average actively managed bond fund without a sales load made 4.9 percent annually. As with actively managed stock market mutual funds, those without sales-load fees outperform, on average, those with sales-load fees.

During the same period, a US government bond index averaged 7.1 percent annually.

The SPIVA Persistence Scorecard measures what percentage of actively managed bond funds beat their bond index counterparts. When measuring three categories of government bond funds (long term, intermediate term, and short term) they found that just 17.67 percent of them beat their index fund counterparts during the 10-year period that ended December 31, 2015.¹

Whether you’re buying stock indexes or bond indexes, active management puts a drag on your returns because of the extra fees.

If your account has a bond index, a domestic stock index, and an international stock index, you’ll have a good chance of success.

Profiting from Panic—Stock Market Crash, 2008–2009

When stock markets fall, most people panic, sending stocks to lower levels. Calm investors, however, can lay seeds for future profits. My personal portfolio was far larger just one year after the financial crisis compared with its level before the crisis scuttled the markets. It helped that I kept a constant allocation of stocks and bonds. As I mentioned in the previous chapter, I started 2008 (before the stock market crash) with a bond allocation at roughly 35 percent of my total portfolio, as shown in Figure 5.2

Then the stock markets started to fall, giving me a disproportionate percentage in bonds. I invest monthly, so when the markets fell—to keep me close to my desired stock/bond allocation—I bought nothing but stocks and stock indexes. But no matter how much money I was adding to my stock indexes, the markets continued to drop until March 2009.

Figure 5.3 shows how my portfolio looked during the first few months of 2009.

Despite my monthly stock market purchases, I couldn’t get my stock allocation back to 65 percent of my total. As a result, I had to sell some of my bonds in early 2009 to bring my portfolio back to my desired allocation.

Naturally, I was hoping the markets would stay low. But they didn’t. As the stock markets began to recover that year, I switched tactics again and bought nothing but bonds for more than a year. I was low on bonds because I had sold bonds to buy stocks, and my stocks were rising in value.

This kind of rebalancing is common practice among university endowment funds and pension funds.

Usually investors don’t need to address their stock/bond allocation more than once a year. But when the stock markets go completely nuts—dropping by 20 percent or more—it’s a good idea to take advantage of it if you can.

Having a Foreign Affair

Americans should have a nice chunk of money in a US index; Canadians should have a good-sized chunk in a Canadian index; and so it should follow for Australians, Brits, Singaporeans, or any other nationality with an established stock market. An investor’s portfolio should always have the home country index represented. After all, it makes sense to keep much of your money in the currency with which you pay your bills.

After adding a government bond index to your portfolio, you really could stop right there.

But many investors (me included) like having an international component. The US stock market makes up about 50 percent of the world’s stock market exposure. There are also stock markets in Canada, Australia, England, France, Japan, and China, just to mention a few. Investors can increase their diversification by building a portfolio with global exposure. A total international stock market index would fit the bill.

There are many trains of thought relating to how much of your stock exposure should be international. To keep it simple, you could split your stock market money between your home country index and an international index.

In that case, a 30-year-old American investor (without an upcoming pension) could have a portfolio that looks like the one on Figure 5.4

If you’re making monthly investment purchases, you need to look at your home country stock index and your international stock index and determine which one has done better over the previous month. When you figure it out (hold on for this!) you need to add newly invested money to the index that hasn’t done as well. That should keep your account close to your desired allocation.

What do most people do? You guessed it. Metaphorically speaking, they sign long-term contracts to empty their wallets into the toilet—buying more of the high-performing index and less of the underperforming index. Over an investment lifetime, behavior such as this can cost hundreds of thousands of dollars.

Over my lifetime, the total US stock market index and the total international stock market index have performed similarly. There has been about 1 percent compounding difference between the two since 1970.² But there are times when one will lag the other. Take advantage of that.

Please note that I’m not talking about chasing individual stocks or individual foreign markets into the gutter. For example, just because the share price of company “Random X” has fallen doesn’t mean that investors should throw good money after bad, thinking that it’s a great deal just because it has dropped in value. Who knows what’s going to happen to “Random X?” It could vaporize like a San Francisco fog.

Likewise, you take a large risk buying an index focusing on a single foreign country, such as Chile, Brazil, or China. Who really knows what’s going to happen to those markets over the next 30 years? They might do really well, but it’s better to diversify and go with the total international stock market index (if you want foreign exposure). Within it, you’ll have exposure to older world economies such as England, France, and Germany, as well as the younger, fast-growing economies of China, India, Brazil, and Thailand. Just remember to rebalance. If the international stock market goes on a tear, don’t chase it with fresh money. If your domestic stock index and the international stock index both shoot skyward, add fresh money to your bond index.

If that sounds too complicated, Scott Burns has popularized an even simpler strategy.

Introducing the Couch Potato Portfolio

A former columnist with The Dallas Morning News, Burns now works with AssetBuilder, a US-based investment company that manages money with indexed strategies. Recognizing that actively managed mutual fund purchases didn’t make sense (thanks to high fees, high-tax consequences, and poor performance), he popularized a simple investment strategy called the Couch Potato Portfolio.

It’s comprised of an equal commitment to a US total stock market index and a total bond market index. In other words, if you were investing $200 a month, you would put $100 a month into the stock market index and $100 a month into the bond market index. You don’t even have to open your investment statements more than once a year.

After one year is up, look at your investment account and figure out whether you now have more money in stocks or bonds. If there’s more money in the bond index, sell some of it to get equal weighting in your portfolio, buying the stock index with the proceeds. If there’s more money in the stock index, sell some of your stock market index and buy the bond index with the proceeds.

Without allowing yourself to fall victim to the market’s crazy “ups and downs,” you would be buying low and selling high once a year.

With a 50 percent bond component, this would be a pretty conservative account. If the stock markets fell by 50 percent in a given year, your account would fall far less than that and you would have a chance to even out your account 12 months later by buying the underpriced stock index with proceeds from the bond index.

Such a strategy, despite its very conservative nature, would have averaged 10.96 percent annually from 1986 to 2001.³

This would have turned $1,000 into $4,758.79 over that 15-year period.

But a drunken monkey tossing darts at the stock market page could have made decent money from 1986 to 2001, because most of the world’s stock markets rose like a hot air balloon. How did the indexed couch potato strategy perform when stock markets went through their gut-wrenching dives and rises (and dives again) during the next 10 years—a decade that many stock market investors have coined “the lost decade?” For starters, the indexed couch potato strategy let investors sleep more soundly during market drops, thanks to the large bond component.

During 2002, the US stock market was hammered. The average US stock market mutual fund declined 22.8 percent in value. In other words, an investment of $10,000 would have fallen to $7,723. But during that devastating year, the markets were able to knock the couch potato strategy down only 6.9 percent. A $10,000 investment would have dropped to $9,310.⁴

Between the beginning of 2003 and the beginning of 2008, the US and international stock market indexes rose dramatically, gaining 91 percent and 186 percent, respectively.⁵ If you had money in the markets during these five years, you probably would have increased your portfolio size a lot, no matter who was managing it. But let’s have a look at one of the ugliest years in modern financial history: 2008.

With the global economic crisis, world stock markets took a beating. Of course, long-term investors should have gleefully rubbed their hands. They could take advantage of lower prices. But let’s see how the average US mutual fund and the couch potato portfolio would have fared during that falling market.

If you thought the average professional could have weathered the storm, you’d be disappointed. Table 5.1 shows that the average actively managed stock market mutual fund (comprised of stocks, without bonds) dropped 29.1 percent in 2008, compared to a drop of 20.4 percent for the indexed couch potato portfolio. And how about the average actively managed balanced fund? Balanced funds don’t have the same kind of exposure to the stock market that regular stock market mutual funds have. Balanced funds are usually comprised of 60 percent stocks and 40 percent bonds. When stocks fell dramatically in 2008, the bond component of the average actively managed balanced fund should have cushioned the fall. But that wasn’t the case. The average actively managed balanced fund dropped a whopping 28 percent during 2008.⁶ Why did the average balanced fund manager lose so much money even though 40 percent to 50 percent of their funds’ assets were in bonds? The only explanation is that they were afraid, and they sold stocks when the markets fell. As mentioned in my previous chapter, nobody can predict the short-term movements of the stock markets. Following a disciplined couch potato strategy is likely to be far more profitable than allowing a fund manager to mess with your money.

Another nice thing about using the couch potato portfolio strategy is that (despite the market crash of 2008–2009) you would have still made money from 2006 to 2011. During this five-year period—when many actively managed balanced mutual funds lost money—a $10,000 investment in the couch potato portfolio would have grown to more than $12,521.56. That’s an overall gain of 25.2 percent.⁷

As an investor, I loved the stock market decline of 2008–2009. But as a consultant, it was disheartening. Many people brought their portfolios to me during the economic crisis, revealing investments that had collapsed 40 percent or more in value.

When I looked at their investment holdings, I found something pretty shocking: their investment advisers obviously had little respect for bonds. Most of the people who showed me their statements were older than me, so they should have had bond components that equaled or exceeded mine. But none did. In some cases, they had no bonds at all! Their accounts fell far further than mine when the markets declined and they couldn’t take advantage of cheap stock market prices because they didn’t have any bonds to sell.

Investors in their 50s and 60s, especially, require bonds in their portfolios. It would be tough to find an investment book that didn’t include this fundamental principle. But many of the accounts I saw were fully exposed to the market’s gyrations without a protective bond component.

I taught with one fellow whom I refer to as a “cowboy investor.” He’s in his mid-50s and won’t have a pension because he spent his career teaching in private schools overseas. He says bonds are for wimps, so he doesn’t own any. Instead, he buys whatever rises in value (after it rises) and he sells whatever falls (after it falls). This gives him the distinction of a cowboy who’ll never have enough money to leave the ranch.

Combinations of Stocks and Bonds Can Have Powerful Returns

Even when stock markets are rising, a portfolio with a bond component isn’t the “party pooper” most cowboy investors think it is. Financial author Daniel Solin notes that from 1973 to 2004, an investor with an allocation of 60 percent in a US stock market index and 40 percent in a total bond market index would have earned an average return of 10.49 percent annually.

An investor taking much more risk and having 100 percent of their portfolio in a stock index would have returns averaging 11.19 percent annually during this period.⁸

The cowboy investor would have taken more risk, and for what? An extra 0.7 percent annual return? He would have needed a strong stomach. His worst year during this 31-year time period would have seen his account plunge by 20.15 percent. In contrast, an account with 40 percent bonds and 60 percent stocks wouldn’t have fallen further than 9.15 percent during its worst 12 months.⁹

Using portfoliovisualizer.com, we can see how different Couch Potato portfolios would have performed between 1986 and 2016. The Classic Couch Potato portfolio, 50 percent stocks, 50 percent bonds, would have averaged a compound annual return of 8.04 percent. That would have turned $10,000 into $105,374.

Investors who wished to take a bit more risk may have chosen 60 percent stocks, 40 percent bonds. Such a portfolio would have been slightly more volatile. But it would have earned a higher average return, gaining an average of 8.82 percent during the same time period. That would have turned a $10,000 investment into $116,171.

Those choosing a portfolio with 70 percent stocks, 30 percent bonds would have seen even better long-term results. They would have averaged a compound annual return of 9.16 percent. That would have turned a $10,000 investment into $126,941.

Higher allocations of stocks in the portfolio increase returns over long time periods, as you can see in Table 5.2. But such portfolios fall further when markets fall. And there will always be periods (sometimes years at a time) when bonds beat stocks.