Although the general consensus among market newcomers is that investing is difficult, time consuming, and confusing, thanks to prebuilt portfolios, that notion couldn’t be farther from the truth. To simplify the process, several investing experts have created their own versions of prebuilt portfolios.
One of the most popular of these experts is Scott Burns.
A personal finance columnist for the Dallas Morning News, creator of the Couch Potato Portfolio and co-founder of assetbuilder.com, Burns has a long list of credentials as a finance and stock market expert.
Another portfolio created by this finance mogul is the Margarita Portfolio. The portfolio follows Burns’ basic idea that investing shouldn’t have to be difficult, time consuming, or confusing. Instead, it should be balanced, effective, and easy.
What Is the Scott Burns Margarita Portfolio?
As a finance expert, Burns has long been a proponent of taking the most simple approach when it comes to managing your money, and living a simple lifestyle for that matter. It’s no surprise that his Margarita Portfolio, like his Couch Potato investing strategy, is one of the laziest of the lazy portfolio category.
The portfolio was based on the balance found in a classic margarita. With one part tequila, one part triple sec, and one part lime juice, the margarita is one of the easiest classic drinks to make, yet it remains effective, both in terms of flavor and the punch it packs.
The Margarita investing strategy is also a three-part recipe that’s designed to be simple and effective. As a three-fund portfolio, with all being equally weighted and thoughtfully chosen low-cost index funds, setup and management are simple. And as you’ll find below, its historic returns have been impressive.
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Portfolio Asset Allocation
The portfolio is made up of three ingredients, each equally weighted, and each representing a different asset class. Here’s the basic recipe of the portfolio:
- One Part U.S. Stocks. One-third of the portfolio is allocated to an exchange-traded fund (ETF) that tracks a broad United States market index. Some of the most diversified funds are based on the S&P 500.
- One Part International Stocks. One-third of the portfolio is invested in international stocks. When choosing an international ETF to meet this prescribed allocation, it’s important to choose one that diversifies in terms of market cap, regions covered, and sectors.
- One Part Inflation-Protected Treasury Bonds. Finally, one-third of the traditional Margarita Portfolio is invested in Treasury inflation-protected securities (TIPS). The fund you invest in should be diversified in terms of maturities.
The Investment Thesis Behind the Portfolio
The Margarita investment strategy is built around simplicity, but there’s quite a bit more to this strategy than initially meets the eye.
First, looks can be deceiving when it comes to the portfolio’s level of diversification. Sure, there are only three funds, but those funds — especially those that focus investments in the equities market — are highly diversified, helping to protect your portfolio from volatility.
Going further, there’s quite a bit to be said about a portfolio that brings international diversification into its equity holdings. After all, the U.S. may be the largest economy in the world, but it only accounts for about 50% of the global market cap. If you leave international equities off the table, your strategy would miss out on half the opportunities the global market has to offer.
Finally, the strategy calls for all of your safe-haven holdings to be nested in inflation-protected Treasury bonds. These are included to limit the blow of significant drawdowns in your portfolio should a correction take place or a bear market set in.
Although it’s always wise to include safe havens in your portfolio, such a heavy allocation to this type of bond may be a mistake because inflation-protected bonds haven’t been as strong a hedge against volatility as intermediate- or long-term government bonds.
Nonetheless, the inclusion of safe havens in the strategy is an important move made to protect your assets.
Margarita Portfolio Pros and Cons
Any time you make a financial decision, whether it’s deciding to follow a specific investment strategy or opening a new checking account, there will be pros and cons that should be considered. When it comes to the Margarita investing strategy, the most exciting perks and painful realities are described below.
Margarita Portfolio Pros
Considering the fact that the portfolio was created by a popular finance columnist, it’s not surprising that so many investors have employed the Margarita strategy. However, there’s more to be excited about than the person behind the curtain. Some of the most exciting benefits of the strategy include:
- Strong Historic Returns. When backtesting the strategy, it has performed slightly above or slightly below the S&P 500 index at any given time. In fact, throughout history, its risk-adjusted returns have been slightly better than the S&P. Considering that one-third of the portfolio is parked in safe havens, that’s a pretty impressive feat.
- Heavy Diversification. Each fund in the portfolio is thoughtfully chosen with diversification in mind. This adds a layer of protection on top of the protection that’s already provided through safe-haven investments because when one stock — or even a group of stocks — falls in value, gains in other stocks or sectors help to reduce the pain.
- International Inclusion. Only 50% of the global market cap can be accessed by investing in the U.S. market. With such a heavy international tilt in this portfolio, you won’t be missing out on the opportunities found in the other 50% of the world.
Margarita Portfolio Cons
Sure, the perks associated with this portfolio are hard to ignore. On the other hand, there are some significant drawbacks you should consider before you decide to deploy the Margarita strategy:
- Inflation-Protected Treasury Bonds. Inflation-protected treasury bonds do offer some protection against volatility, but that protection isn’t strong enough to act as the sole source of safety in a well-balanced portfolio.
- Lack of Small-Cap Value. With two-thirds of the portfolio invested in equities, this portfolio is focused on accepting moderate risk to create meaningful returns. However, those returns could be more meaningful with the inclusion of small-cap value assets. Small-cap stocks have historically outperformed large-caps and value stocks have historically outperformed growth stocks over long time periods. Not including these assets in your portfolio could ultimately limit your gains.
- Increased Risk. Finally, because so much of the portfolio is invested in equities, with the safe-haven allocation being 100% nested in inflation-protected T-bonds, this strategy is far too risky for some investors because significant drawdowns may take place. If you have a short time horizon, are nearing retirement age, or are living off of your investments, these drawdowns could become life-changing.
Who Should Use the Margarita Portfolio?
In the world of finance, there are very few options that are perfect for everyone. After all, you likely have different financial goals than your neighbor. There’s no way to reasonably address every investor’s needs with the same portfolio or financial product.
The Margarita investing strategy is no different. The perfect candidates for the portfolio are:
Investors With a Long-Term Time Horizon
Because of the high level of drawdown risk associated with this portfolio, it’s important that only investors with a long-term time horizon use the strategy. Most investment advisors agree that young investors with a long time to retirement can afford to take more risks in an attempt to tap into larger gains.
On the other hand, if you are over 50 years old or have 10 years or less to invest, this strategy isn’t likely a good fit. If the market were to take a dive, you may never recover your losses.
Investors With a Healthy Appetite for Risk
Risk should always be a consideration when making an investment. After all, even investing in cash comes with the risk of inflation. However, some investments are riskier than others. For example, stocks often see rapid price movements in one direction or the other from day to day. And while bonds change in value too, these changes happen slower.
The Margarita investing strategy is a relatively risky one. Sure, risk-adjusted returns have historically slightly outpaced the performance of the S&P 500, but it takes a brave investor to invest heavily in equities without other investments to balance those risks.
Even with the slightly better risk-adjusted return, significant drawdowns will likely happen from time to time, meaning this isn’t an effective option for risk averse investors.
How to Duplicate the Margarita Portfolio
Duplicating the traditional Margarita Portfolio — or tweaking it to improve volatility protection and returns — is a relatively simple process. After all, this is a “lazy” portfolio.
Duplicating the portfolio involves choosing three investment-grade funds, making sure that they’re diversified and offer low expense ratios. Here’s how it’s done:
The Traditional Margarita Portfolio
The traditional Margarita Portfolio calls for U.S. stocks, international stocks, and TIPS. The easiest way to gain exposure to these assets is spreading your funds equally across the following assets:
- Vanguard Total Stock Market Index Fund ETF (VTI). The VTI fund offers one of the best representations of the entire U.S. stock market available today. The fund invests in a diversified group of domestic stocks ranging in market caps, sectors, and investment styles.
- Vanguard Total International Stock Index Fund ETF (VXUS). When it comes to international diversification, the VXUS fund is the way to go. The fund invests in companies outside of the U.S. that operate in both developed and emerging markets. It’s also highly diversified in terms of market capitalization and sector.
- SPDR Portfolio TIPS ETF (SPIP). Finally, the SPIP fund invests in Treasury inflation-protected securities, or TIPS, including inflation-linked T-bonds, Treasury bills (T-bills), and Treasury notes.
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The Intermediate-Term Bond Adjustment
One of the biggest gripes with the traditional Margarita portfolio strategy is the fact that 100% of its safe-haven allocation is invested in inflation-protected Treasury debt securities. Sure, these are considered safe havens, but they’ve also historically been more volatile than traditional treasury debt securities.
One way to remedy this issue is to invest in a bond fund that focuses on the more traditional treasury bond market. Simply replace the SPIP fund allocation with the Vanguard Intermediate-Term Treasury Index Fund ETF (VGIT). This is a Treasury bond ETF focused on securities with maturities ranging from five to 10 years.
The Small-Cap Value Adjustment
Another issue some have with the portfolio is that it doesn’t include exposure to small-cap value stocks, which happen to be some of the strongest performers on the market throughout history.
Although making a change that brings a small-cap value tilt into the equation will increase the fund count from three to five, the potential returns are well worth the addition of two investment-grade funds. Here’s how it’s done:
- Reduce Allocation to the VTI and VXUS. Instead of giving each of these funds one-third of your portfolio’s value, allocate one-sixth of your portfolio to them, effectively cutting exposure in half.
- Invest In the Vanguard Small-Cap Value Index Fund ETF (VBR). The adjustment above frees up one-third of your portfolio’s value. Allocate half of this (one-sixth) to VBR, a fund that invests in small domestic companies that display value characteristics.
- Invest In the DFA International Small Cap Value Portfolio (DISVX). The remainder of the freed up allocation should be invested in DISVX. This fund offers diversified exposure to small-cap value stocks around the world. It invests most of its assets in small companies from Japan, the United Kingdom, Canada, Australia, and Germany.
The Real Estate Adjustment
Finally, real estate is becoming increasingly popular among investors, and for good reason. Property prices are rising along with the population, demand is high, and inventories are low, making a perfect storm for growth.
If you’d like to bring some real estate exposure into the equation, you can do so by cutting exposure to the VXUS fund to one-sixth of your portfolio and investing the remaining allocation in the Vanguard Real Estate Index Fund ETF (VNQ).
The VNQ fund offers diversified exposure to real estate investment trusts (REITs). These funds purchase real property using money pooled from a group of investors, then rent it out and divide the profits among their investors.
The VNQ offers holdings in various types of real property across the U.S., ranging from apartment buildings to strip malls, cell towers, and more.
Keep Your Portfolio Balanced
When using any prebuilt portfolio, balance is important. After all, each asset in the portfolio was chosen for a specific reason, whether to expose the portfolio to gains or protect it from significant drawdowns.
Each asset in the market will move up and down at its own pace. As time passes, you’ll find some assets grow faster than others, resulting in overexposure to these faster-growing assets and underexposure to the slow, stable growers.
In market downturns, safe assets will fall at slower rates than equities, resulting in overexposure to safe havens and underexposure to the opportunity to benefit from a recovery.
With that in mind, rebalancing from time to time is a must.
When creating both the Couch Potato Portfolio and the Margarita Portfolio, Burns worked to make them as easy to set up and manage as humanly possible. In fact, he suggests that managing your portfolio should only take a few minutes per year.
On the other hand, most experts suggest investors should rebalance their portfolios at least on a quarterly basis. Considering the heavy exposure to equities involved in this strategy, waiting a year before bringing it back into balance may prove to be a huge mistake.
The Margarita investing strategy is popular because it works well for the group of investors it was designed to address. While there are risks, the portfolio offers a better risk-adjusted return than the S&P 500 and does so with only three assets involved.
However, before employing this strategy, consider your goals and how it fits in with them. If you like the simplicity involved, but aren’t a fan of the traditional setup, consider making minor adjustments to make the portfolio fit your needs. If you do so, take the time to research and find the assets that will benefit you most.