Paul Merriman is something of a legend on Wall Street. Not only was he the founder of a brokerage and investment advisory firm bearing his name, since his retirement he has continued to contribute to the market news and analysis site MarketWatch, acting as an educator to the financial industry.
Moreover, the famed financial advisor established the Merriman Financial Education Foundation in 2014, an organization dedicated to providing quality financial education to investors. He’s also the author of several books.
It only makes sense that investors would be interested in an investment portfolio Merriman designed, and one of his most popular is the 4 Fund Portfolio.
What Is the Paul Merriman 4 Fund Portfolio?
Merriman’s 4 Fund Portfolio was meant to provide the ultimate level of simplicity, built as a 4-fund combo, with each fund in the portfolio receiving equal allocation at 25%. Due to the buy-and-hold nature of the portfolio, it’s not only simple to set up, but extremely easy to manage.
Interestingly, the strategy is a 100% equity portfolio, which doesn’t take asset class diversification into account. As a result, it comes with elevated risk because there are no safe havens to limit the pain caused by a market correction or bear market.
Nonetheless, the portfolio is known to consistently outperform the S&P 500 by giving significant weight to investments that offer a significant risk premium (covered in more detail later). While it’s definitely not a one-size-fits-all portfolio strategy, it is an attractive option for younger investors and those who have a high tolerance for risk.
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Portfolio Asset Allocation
As mentioned above, the portfolio’s asset allocation is about as easy as it gets, with equal investments in four highly diversified funds. Here’s how the allocation breaks down:
- 25% in the S&P 500. The first quarter of the portfolio is geared toward a large-cap tilted blend of U.S. stocks. One of the best ways to get this exposure is by investing in an S&P 500 index fund because it covers well over half of the United States’ total market cap.
- 25% in Large-Cap Value. The portfolio calls for a fund that provides exposure to large-cap value stocks, ditching the concept of investing in large-cap growth and focusing on where long-term returns will likely be larger.
- 25% in Small-Cap Value. The portfolio also contains a heavy allocation to small-cap value stocks.
- 25% in Small-Cap Blend. The portfolio also gives exposure to small-cap blend stocks. This includes smaller stocks from various sectors that offer a mix growth, value, or income characteristics.
The Investment Thesis Behind the Portfolio
As with the Alexander Green Gone Fishin’ Portfolio, this portfolio is centered around factor investing, also simply known as factoring. Factoring takes index investing, or indexing, to the next level.
Instead of simply investing in a group of investment-grade funds that track specific market indexes, factor investors look for factors that pay a risk premium — higher potential gains in exchange for a higher level of risk.
There’s only one asset included in the 4 Fund Portfolio that doesn’t fall in line with factors that pay risk premiums: the S&P 500 index fund. This fund offers an important level of stability considering the lack of fixed-income investments in the strategy. Here are the factors behind the rest of the portfolio:
Large-Cap Value (The Value Factor)
The larger the company you invest in, the more stable it is likely to be, but that has nothing to do with the risk premium. The risk premium here is in the value factor.
Historically, large-cap value stocks are known to outperform large-cap growth stocks, and often by a wide margin. By avoiding the allure of growth stocks and investing in their value counterparts, you may be taking on the risk of investing in a company that’s undervalued for a reason, but this is offset by the potential that the undervaluation is coincidental and that significant gains are ahead.
Small-Cap Value (The Small-Cap and Value Factors)
Smaller companies aren’t quite as stable as larger companies, increasing the risk associated with investing in them. Investing in small companies with value characteristics comes with two key factors that produce risk premiums.
While larger, blue chip companies offer stability, they’ve already addressed a large portion of their audience, often being household names. Small companies typically haven’t done so, setting up for a long runway of growth ahead. So, that growth becomes a premium.
Also, as with their larger counterparts, small-cap companies that display value characteristics have historically outperformed small-cap growth companies. There’s an added premium in focusing on the value side of small-cap investing.
Small-Cap Blend (The Small-Cap Factor)
As described above, small companies may be more volatile, but they often have much more of a runway and larger opportunities for growth than larger companies. As a result, investing in small-caps pays a risk premium, generally resulting in more potential for gains than investing in larger companies.
Pros and Cons of the 4 Fund Portfolio
There’s no such thing as a portfolio that’s perfect for everyone. Any prebuilt portfolio comes with pros and cons to consider, and this particular portfolio is no different. The most exciting benefits and most significant drawbacks are as follows:
Merriman isn’t just an expert, he’s an investing mogul. Over the years, he has reached a level of success in the market only matched by a minuscule percentage of investors. It’s only natural that following a portfolio of his design comes with its perks. Some of the most significant advantages include:
- Stellar Past Performance. Throughout history, a portfolio following Merriman’s strategy would have been a top performer all the way back to 1928. In the 91-year period from 1928 to 2019, the portfolio generated an average annual return of 11.8%, while the S&P 500’s return averaged at 9.9%. Who doesn’t like higher returns?
- Simplicity. This particular portfolio is one of the laziest in the “lazy portfolio” category. With only four assets included in the strategy, all of which given equal weight, there’s not much work to set up or maintain, making this a great option for the busy investor.
- Small-Cap-Tilted. Investors are often fans of portfolios that have a tilt toward small-cap assets. Once again, this points to the strong return potential of the portfolio because small companies have a long history of outperforming large companies.
- Value-Tilted. The portfolio also tilts heavily toward stocks with value characteristics. This also increases the potential returns of the portfolio because value stocks have a long history of outperforming their growth-centric counterparts.
Although there are plenty of reasons to be excited about this portfolio strategy, there are some serious drawbacks that should be considered before employing it. Some of the most important include:
- A Single Asset Class. The portfolio involves investing in four different types of exchange-traded funds (ETFs), all focused on investments in equities. Most financial advisors will tell you that a portfolio made up of 100% equities doesn’t represent sound investing because it opens the door to substantial volatility risk.
- Risk Added to Risk. Factor investing is exciting because investors accept risk factors in exchange for a risk premium, or the potential to generate returns that outpace the market averages. On the other hand, the portfolio adds risk onto risk by investing in high-risk, high-return equities while completely avoiding safe-haven investments that could balance things out a bit.
- No International Holdings. The fact that Merriman left international stocks out of the equation is surprising. Emerging markets often outperform the domestic market, creating further growth potential. However, this portfolio doesn’t allocate a penny to international stocks.
Who Should Use This Portfolio Strategy?
If you’re looking for a one-size-fits-all portfolio strategy, you’ll be looking for quite a while, because there simply isn’t one. Every investor has a unique tolerance for risk, unique goals, and a specific time horizon.
While most investors can be categorized based on risk tolerance and their methods of working in the market, there’s no way to address the needs of everyone with a single portfolio strategy.
In the case of the 4 Fund strategy, it was designed for a very specific set of investors and is far too risky for most. The perfect candidate to use this portfolio strategy is:
- Young. Investing experts often point to the fact that younger investors should be more willing to accept higher levels of risk, as long as the potential payoff is worth it. After all, they have their whole lives to recover should a correction or bear market take place. On the other hand, investors nearing retirement simply can’t absorb large drawdowns and should avoid this strategy at all costs.
- Risk-Tolerant. There are few investing experts who would suggest the average investor of any age should consider a portfolio made 100% of equities. That’s a dangerous notion, and one only the most risk-tolerant investors should consider.
- Busy. Even if you’re young with a healthy appetite for risk, this might not be the best option for you. Simplicity often comes at a cost, and taking more time to find even better-performing assets based on the level of risk in the portfolio is something worth considering. However, if you’re a busy investor who doesn’t have time to adequately research opportunities and maintain balance in a more complex portfolio, this may be the perfect fit.
How to Duplicate the 4 Fund Portfolio
If you’d like to give the portfolio a try, duplicating it is easy through the use of ETFs with low expense ratios. Also, even if the portfolio strategy isn’t a good fit for your investing style, you may be able to follow along the same lines of the strategy while making simple adjustments so it fits your needs.
Here are a few different ways to go about building your portfolio based on this strategy:
The Traditional 4 Fund Build
The portfolio can be duplicated relatively quickly using a group of four low-cost funds. Here’s how it’s done:
- 25% in Vanguard S&P 500 ETF (VOO). The VOO fund offers exposure to a large-cap blend consisting of 500 of the largest companies in the U.S. by market cap. With an expense ratio of just 0.03%, it’s also one of the lowest-cost funds on the market.
- 25% in Invesco S&P 500 Pure Value ETF (RPV). The RPV fund offers a diversified portfolio of large-cap value investments. To provide this exposure, the fund invests in S&P 500-listed companies that display value characteristics.
- 25% in Vanguard Small-Cap Index Fund ETF (VB). The VB fund offers diversified exposure to domestic small-cap stocks that display value characteristics. These stocks are spread across a wide range of sectors and regions within the U.S.
- 25% in Vanguard S&P Small-Cap 600 Value Index Fund ETF (VIOV). The VIOV fund gives investors access to a highly diversified group of small-cap domestic stocks that come with value characteristics. Like all other funds on this list, VIOV is heavily diversified across sectors and regions within the U.S.
Pro tip: You don’t have to build this portfolio in your brokerage account yourself. If you use M1 Finance, you can simply load the Paul Merriman’s 4 Fund Portfolio prebuilt expert pie to gain access to a curated allocation of securities that follows this strategy.
The 4 Fund Portfolio With an International Twist
One of the biggest problems some investors have with this portfolio strategy is the lack of international stocks. Historically, international stocks — particularly those in emerging markets — have performed overwhelmingly well, and avoiding investing in them is akin to leaving money on the table.
If you’d like to add a little international flavor to your portfolio, doing so is quite simple, but it will require expanding the fund count from four to six. Here’s how it works:
The first thing you’ll need to do is cut your investments in the VB and VOO funds in half, allocating 12.5% of your portfolio to these. Then add the two following international funds to your portfolio:
- 12.5% in iShares MSCI Emerging Markets Small-Cap ETF (EEMS). With the EEMS fund, you can add international exposure that’s specifically focused on small-cap companies in emerging markets. With small-caps traditionally outperforming their large-cap peers and emerging markets known for generating compelling opportunities, this is a great way to gain exposure to the best of both worlds.
- 12.5% in Vanguard Total International Stock Index Fund ETF (VXUS). The VXUS fund includes a diversified list of international stocks in both emerging and developed markets. The fund invests in a wide range of market caps, sectors, and regions, giving you widespread exposure to international markets.
Safe(r) Versions of the 4 Fund Portfolio
The traditional portfolio leaves you exposed to significant risk due to a lack of fixed-income allocation. To protect yourself from bear markets and corrections, it’s relatively easy to build a safer portfolio using the same concepts, but mixing in one extra fund to make it a five-fund portfolio.
To do so, reduce all holdings in the portfolio to 20%, which will result in 20% left for fixed-income investing. This 20% allocation can be invested in the Vanguard Long Term Treasury Index Fund ETF (VGLT).
The assets in the fund are protected by the full faith and security of the U.S. government. At the same time, the long-term nature of the Treasury debt securities the portfolio invests in makes them even more stable. These factors are important because 20% holdings in fixed-income is still a relatively light allocation, so it should be invested in the safest of safe-haven assets.
Another option for those looking to invest in a safer portfolio is to consider the Paul Merriman Ultimate Buy-and-Hold Portfolio, developed by the same financial expert behind the 4 Fund Portfolio strategy but inclusive of safer investment vehicles.
Maintain Balance in Your Portfolio
As with any investment portfolio, it’s important to maintain balance with this one.
Prebuilt portfolios are designed to balance risk by choosing assets for specific characteristics during specific market conditions. As time passes, the prices of every asset in your portfolio will change, some faster than others. As a result, equal exposure among four assets will fall out of line, with some assets over-allocated and some receiving too few of your investment dollars.
To combat this, investors should rebalance their portfolios regularly. As a lazy portfolio, this investment option doesn’t require weekly or monthly rebalancing, but it is important to take time to do so on a quarterly basis.
While the 4 Fund Portfolio investing strategy is exciting, it’s also inherently risky. As a result, only young investors with a healthy appetite for risk should follow the portfolio in the traditional sense.
On the other hand, due to the limited number of funds involved in the portfolio, it’s very easy to customize to fit your needs. By mixing in a fixed-income asset or two, you can follow the same principles of the portfolio without exposing yourself to significant amounts of volatility.
As is always the case, before making an investment, it’s important to do your research and get an understanding of just what you’re buying and what it might mean for your portfolio.