Nearly everything you read about making money in the stock market points to the fact that significant research is necessary. But what if you’re a newcomer or you simply don’t have the time or desire to research each and every company you invest in? What if you’re not even sure where to start when it comes to building an investment portfolio?
Thankfully, there are several prebuilt portfolios that make use of investment-grade funds to provide heavy diversification while giving you access to the wealth-building power the market has to provide.
One of the most popular of these portfolios is known as the Pinwheel Portfolio.
What Is the Pinwheel Portfolio?
The Pinwheel strategy was developed by the investing expert known by the name Tyler, who contributes to Portfolio Charts. He’s also the creator of the Golden Butterfly Portfolio and a highly respected expert among the investing community.
When developing his Pinwheel Portfolio strategy, Tyler focused heavily on diversification through asset classes in an attempt to provide exposure to the growth the market has to provide while offering up protections from significant downside risk, much like the David Swensen Portfolio.
While the portfolio offers heavy diversification across a wide range of assets, it’s a member of the lazy portfolio category, meaning it was designed for simplicity, both in terms of setup and management.
Importantly, the portfolio allocates funds to the four key asset classes, including United States equities, international equities, bonds, and real assets. In fact, there’s so much diversification in the portfolio that its pie chart looks like a pinwheel, which is what gives the strategy its name.
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Portfolio Asset Allocation
The Pinwheel strategy points to setting up an eight-fund portfolio, inclusive of the following investment vehicles:
- 15% in U.S. Stocks. The first fund in the portfolio should offer exposure to a diversified group of domestic stocks ranging in market cap, sector, and region in the U.S. This can be done by investing in a total U.S. stock market fund like the one described in the exact portfolio build below.
- 10% in U.S. Small-Cap Value Stocks. Next up should be a diversified group of domestic small-cap value stocks. These stocks represent relatively small companies that come with valuation metrics that suggest they trade at a discount.
- 15% in the Total International Stock Market. The next fund should offer exposure to the global stock market as a whole. These funds invest in a wide range of market caps, sectors, and regions around the world.
- 10% in Emerging Markets Stocks. Emerging economies like China, Brazil, and South Africa are all developing, and as a result, they are known to experience significant growth. The portfolio’s asset allocation taps into this growth by investing in a fund that invests in companies in emerging economies.
- 15% in Intermediate-Term Bonds. The next 15% of the prescribed allocation should be invested in intermediate-term bonds. The portfolio strategy doesn’t specifically point to whether these should be government or corporate bonds, so that choice is up to you.
- 10% in Cash. While not all portfolios include cash holdings, the Pinwheel strategy calls for 10% of your portfolio’s value to be held in cash or cash equivalents like short-term Treasury bonds and Treasury bills.
- 15% in Real Estate. The portfolio calls for investing in real assets, but you won’t have to go buying houses, apartment buildings, or strip malls. Instead, invest in a fund that offers exposure to real estate investment trusts (REITs). These funds pool money from a large group of investors to buy and manage rental properties, dividing the income they produce among their shareholders.
- 10% in Gold. Tyler has long been a proponent of gold as a safe-haven investment option. Gold features prominently in his Golden Butterfly Portfolio too, so it’s not surprising that it’s among the safe-haven holdings in this portfolio as well. To invest in gold, it’s best to choose a fund that focuses on buying physical gold bullion.
The Investment Thesis Behind the Portfolio
The portfolio may seem complicated at first glance, but rest assured, the thesis behind it is relatively simple. By investing across a wide range of assets, the portfolio takes an all-weather approach designed to perform well regardless of the economic cycle, an idea that was introduced by Ray Dalio with his All Weather Portfolio.
These four cycles are addressed in the following ways:
- Inflation. There are multiple assets that act as a hedge against inflation in this portfolio strategy. These include gold, real assets, and equities. Intermediate-term bonds and cash are both subject to inflation-related blues, but should be balanced by the other assets in this portfolio should heavy inflation take place.
- Deflation. Both bonds and cash are great options when deflation sets in. As prices fall, the stock market, real estate, and gold will all experience headwinds, but cash and bonds will generally experience growth in value, helping to lighten the blow should these headwinds take place.
- Economic Expansion. The economic expansion cycle is addressed with a heavy allocation in stocks with a tilt toward small-cap value plays. Moreover, real assets will generally experience growth in value during economic expansions.
- Economic Contraction. Gold, cash, and bonds are excellent hedges against declines that take place in the stock and real asset markets when economic contractions take place.
As you can see, the portfolio was designed to limit drawdown risk and exposure to volatility regardless of the state of the economy or market.
Unlike the Permanent Portfolio and the Golden Butterfly models, which allocate more than 20% in gold, the Pinwheel strategy limits exposure to precious metals while focusing on other safe havens — a move many financial experts are happy to get behind.
There’s more to this portfolio’s success than a focus on fixed-income securities and real assets. There’s also a bit of factoring at play here.
Factoring is much like indexing, but when choosing the index funds you invest in, you’ll pay close attention to factors that pay a risk premium, resulting in a slightly riskier portfolio but a much higher return potential. The active factoring in the Pinwheel strategy includes:
- The Small-Cap Factor. First off, 10% of the allocation strategy is tilted toward exposure to small-cap opportunities. This is important because small-cap stocks, although notoriously volatile, have a long history of outperforming their blue chip and large-cap counterparts in the long run.
- The Value Factor. Famed investor Warren Buffett has long been a proponent of the value investing concept, and for good reason. Historically, value stocks perform better than growth stocks, adding in yet another factor that pays a risk premium.
- The Emerging Economies Factor. Emerging economies are known for producing exceptional growth. While there’s increased risk investing in regions and economies that aren’t completely developed, that risk results in a premium that has the potential to significantly boost your investments’ earnings.
Pros and Cons of the Pinwheel Portfolio
Whenever you’re deciding to make a financial move, it’s important to consider the pros and cons. After all, you’ve worked hard for your money; why risk it on a poor financial decision?
If you’re considering following the Pinwheel strategy, chances are you’re on the right track when it comes to your investing activities, but you’ll want to consider the following pros and cons:
Pinwheel Portfolio Pros
Tyler has become somewhat famous in the investing community, and for good reason. His strategies have proven to be successful options, helping countless people build wealth in the market. Naturally, his Pinwheel Portfolio comes with some pretty significant perks. Some of the most important include:
- Strong Average Returns. While the safe-haven assets in the portfolio limit its ability to consistently outperform the market as a whole, tilts within the portfolio to factors that pay a risk premium help to balance this out. The end result is performance that has historically been pretty similar to that of the S&P 500 market index.
- Limited Drawdowns. With 35% of the portfolio’s assets invested in safe-haven assets and another 15% in real estate, the drawdown risks are limited even when economic and market conditions are concerning.
- Simple Setup and Management. Sure, there are other portfolios — like the Bogleheads Three-Fund Portfolio and Paul Merriman 4 Fund Portfolio — that take simplicity to the next level. However, the Pinwheel strategy is also relatively easy to set up and manage, making it a great option for new investors or those who simply don’t have the time to manage a more complex investment portfolio.
- Factoring Use. The use of factoring in the portfolio sets the stage for performance, even though much of the portfolio’s assets are nested in safe-haven investment options.
Pinwheel Portfolio Cons
There are plenty of reasons to be excited about taking advantage of the Pinwheel strategy. However it’s not made up of 100% butterflies and rainbows — there are drawbacks to consider before diving in. Some of the most significant are:
- Intermediate Maturities. The bonds in the portfolio come with intermediate maturities, meaning that they’ll mature in three to 10 years from the date of inception. Some argue that these bonds don’t provide enough protection, especially when only 15% of the portfolio is nested in fixed-income assets.
- You Won’t Beat the Market. While the use of factoring in the portfolio greatly increases your ability to generate strong returns, don’t count on beating the market when using this portfolio strategy. The increased earnings potential is offset by the 35% allocation to slow-growth, safe-haven assets like cash, gold, and bonds.
- Cash Holdings. Many finance experts point to a savings account as the parking spot for cash, not your investing account. After all, cash provides no hedge against inflation and greatly limits your earnings potential. While cash only represents 10% of the portfolio’s asset allocation, that 10% allocation could be more effective elsewhere.
Who Should Use the Pinwheel Portfolio?
There’s no such thing as a one-size-fits-all investment portfolio strategy. In fact, most prebuilt portfolios are actually designed to address the needs of a relatively small group of like-minded investors.
This particular portfolio is unusual in the large number of people who would benefit from it.
The portfolio is highly versatile due to its use of factoring to offset the slow growth of the safe-haven side of the portfolio, delivering returns similar to that of the overall market without having to take on the risk of a portfolio that’s 100% invested in equities.
So, who exactly should use it?
Investors With Mid- to Long-Term Time Horizons
Your time horizon should always be considered when choosing an investment strategy. Younger investors with long time horizons should be more risk tolerant because they have plenty of time to recover should the market correct or a bear market take hold.
As you age or your time horizon shortens, your tolerance for risk should become limited because you won’t have as much time to recover if something goes wrong.
In the case of the Pinwheel, long-term and intermediate time horizons will work perfectly. However, investors entering or in retirement or who have a short time horizon for another reason should avoid the strategy.
While the portfolio’s drawdowns will be relatively limited in poor market conditions, they’ll still be too significant to recover from in a short period of time. If you’re living off your investments or plan to do so soon, the increased earnings potential isn’t worth the risk.
Investors Who Like the Concept of Investment-Grade Funds
Any time your portfolio is made up of investment-grade funds rather than individual stocks, REITs, and other investment vehicles, you’re giving up your control in two key ways:
- Control Over Stock Picks. Some investors would rather research and get a full understanding of each stock they buy rather than investing in a bucket of diversified holdings. If that’s you, this isn’t going to be a good strategy to follow.
- Voting Rights. When investing in an individual stock, you’ll have the right to vote when the company makes big decisions. When investing in investment-grade funds, you’re essentially handing your voting rights to the fund manager and won’t have any say when shareholder votes take place. If you want your opinion heard during these votes, you’ll need to own stock in the company directly, meaning this portfolio strategy won’t be a good fit.
There’s a tradeoff however. Giving control over to the fund managers also means the work involved with maintaining a quality investment portfolio is also taken off of your shoulders. That’s why so many investors like investment-grade funds. In fact, passively managed funds make up more than half of the entire stock market’s capital.
How to Duplicate the Pinwheel Portfolio
If you think the Pinwheel strategy is a good way to go for your portfolio, you’re in luck. It’s a relatively simple strategy to duplicate.
Before doing so, it’s important to decide whether you want to move forward with the traditional Pinwheel Portfolio or if you want to make adjustments like changing the term of bonds to add further stability or cutting cash out of the equation. Here’s the build in all three renditions:
The Traditional Pinwheel Portfolio
The traditional Pinwheel Portfolio is easy to duplicate using a list of eight low-cost exchange-traded funds (ETFs). Here’s how it’s done:
- 15% in Vanguard Total Stock Market Index Fund ETF (VTI). First off, you’ll want exposure to a heavily diversified group of domestic stocks. It’s important that these stocks range in sectors and market caps. The VTI fund is one of the best ways to gain this exposure.
- 10% in Vanguard S&P Small Cap 600 Value Index Fund ETF (VIOV). The VIOV fund provides the domestic small-cap value exposure prescribed by the Pinwheel strategy by investing in a long list of small-cap stocks that come with strong value characteristics.
- 15% in Vanguard Total International Stock Index Fund ETF (VXUS). The portfolio also suggests you should have exposure to international markets. The VXUS fund is a great option, investing in a wide range of market caps and sectors across both developed and emerging economies outside the United States.
- 10% in Vanguard FTSE Emerging Markets Index Fund ETF (VWO). Emerging markets have the potential to generate significant growth and represent 10% of the Pinwheel prescription. The VWO fund provides diversified exposure to this class of assets through diversified investments in China, Brazil, Taiwan, and South Africa.
- 15% in Vanguard Intermediate-Term Treasury Index Fund ETF (VGIT). Next up comes the fixed-income allocation by way of intermediate-maturity Treasury debt securities. The VGIT fund is a low-cost way to address this allocation, investing in a diversified group of this exact type of asset.
- 10% in Vanguard Short-Term Treasury Index Fund ETF (VGSH). As an alternative to holding uninvested cash, the VGSH fund provides the cash allocation within the portfolio, with short-term Treasury debt securities being one of the most liquid assets in the world.
- 15% in Vanguard Real Estate Index Fund ETF (VNQ). The VNQ fund provides exposure to the real assets prescribed in the Pinwheel allocation strategy. The fund invests in a long list of REITs, diversifying in property types and regions across the U.S.
- 10% in Aberdeen Standard Physical Gold Shares ETF (SGOL). The SGOL fund provides the prescribed exposure to gold through the purchase of physical precious metals.
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The Barbell Bond-Adjusted Pinwheel Portfolio
There’s an interesting aspect of the traditional Pinwheel Portfolio prescribes cash, which can be interchanged for short-term Treasurys and intermediate-maturity Treasurys, but there’s not a mention of a long-term fixed-income security.
The portfolio may benefit greatly in terms of drawdown risk and overall profitability by taking more of a barbell approach with these types of assets. To do so, you’ll want to keep your cash holdings and replace your intermediate Treasury holdings with long-term Treasury securities, creating a more intermediate-term average. Consider using the Vanguard Long-Term Treasury Index Fund ETF (VGLT), a fund that invests in a diversified group of long-term bonds issued by the U.S. Treasury.
Through this allocation, you’ll benefit from cash when deflation sets in, as the original strategy suggests you should, but long-term debt securities pay higher yields than their short-term counterparts. When it’s time to lean on your bond holdings, long-term options will provide more protection while providing more balance in a portfolio with a significant cash allocation.
The Cashless Pinwheel Portfolio
One of the big gripes many have about the traditional Pinwheel Portfolio is that it prescribes 10% of your holdings to be in cash and cash equivalents like short-term Treasurys. This limits your exposure to assets that could be earning you money, or at least acting as a hedge against inflation.
To address this concern, one small change can be made to turn the Pinwheel cashless.
All you need to do is get rid of your cash holdings and allocate those funds to intermediate-maturity Treasurys. The end result of doing so would be similar to the barbell approach described above, helping to limit your drawdown risk and increase your overall return.
Maintain Balance in Your Portfolio
When investing using the Pinwheel, or any prebuilt portfolio, it’s important to keep your assets in balance. After all, these strategies are thoughtfully designed, using exposure of a specific percentage of your portfolio to each asset to offset downside risk.
As prices fluctuate, some assets will move faster than others, and your portfolio will more than likely fall out of balance over time. When it does, it will either be overexposed to safe-haven assets, limiting your return potential, or overexposed to riskier assets, setting the stage for significant drawdown risk.
You can avoid these risks altogether by taking the time to rebalance your portfolio regularly.
As a buy-and-hold style portfolio, the Pinwheel was designed to be simple to manage, which means you won’t need to rebalance on a weekly or even monthly basis. However, quarterly rebalancing is always wise.
It’s no surprise that so many people are excited about the Pinwheel strategy. After all, it provides a relatively low-risk door into the investing world thanks to heavy levels of diversification.
Not to mention, its returns have been impressive, especially when you consider its heavy allocation to cash and other safe-haven assets. With a leaning toward small-cap and emerging markets risk premium factors, investors who have used the strategy have generated an average annual return of just over 8%.
While that’s slightly lower than the average historical returns of the S&P 500, the portfolio’s drawdowns have been significantly smaller compared to the broader market, making it a wise option for investors looking to take a safe, slow, and steady approach to investing.