Building the Perfect Portfolio

We're always told to build a diversified stock-fund portfolio, but we're rarely shown how. We tried our hand at it earlier this year, so let's see how we've done.

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How to Build a Diversified Portfolio

As you may recall, we cobbled together a couple of model stock-fund portfolios a few months ago. One was a collection of nine funds with above-average returns over time, below-average expenses and tenured management. The other was a stripped-down, low-maintenance portfolio with two funds for nonfund junkies. Both portfolios are mostly made up of no-load funds because I'm using my own counsel in putting them together.

In the wake of the Nasdaq Composite's collapse over the past year, the tide of email from folks asking for help building a less aggressive and tech-heavy portfolio has steadily risen. As a scribbler for TheStreet.com I'm not allowed to offer specific financial advice, but maybe a fresh look at these portfolios will give you some good ideas of where to go from here.

The first portfolio, with the not so humble sobriquet "The Perfect Portfolio," blends a core indexing strategy ((VTSMX Quote)Vanguard U.S. Total Stock Market fund) with a roster of growth, value and sector funds. The idea here is to get cheap, broad access to the market without making an outsize bet on any single sector or investment style relative to the S&P 500 .

The Perfect Portfolio
35%	Core U.S. Stock	(VTSMX Quote)Vanguard Total U.S. Stock Market
15	Core Foreign Stock	(VWIGX Quote)Vanguard International Growth
10	Growth	(GABGX Quote)Gabelli Growth
5	Growth	(FIDYX Quote)Invesco Dynamics
10	Value	(LMVTX Quote)Legg Mason Value Trust
5	Value	(OAKMX Quote)Oakmark
10	Small-Cap	(MGSEX Quote)Managers Special Equity
10	Sector	(DRGTX Quote)Dresdner RCM Global Technology (FSPHX Quote)Fidelity Select Health Care (FSFSX Quote)Invesco Financial Services
Source: Morningstar. Data through May 31.

It's often assumed that spreading your money broadly across sectors and styles leads to ho-hum returns, but over the past one-, three- and five-year periods this portfolio beats the S&P 500 without more volatility. Over the past five years through May 31, the most recent data available on Morningstar's Principia software, the portfolio has rung up an average 15.9% annualized gain compared with 15.1% for the S&P 500.

In real-world terms, a $10,000 investment in this portfolio five years ago would be worth $20,881.94, compared with $20,710.99 for the same investment in the (VFINX Quote)Vanguard 500 Index fund, according to Morningstar.

Above-Market Gains ...
... Without Excess Volatility
	Perfect Portfolio	S&P 500
Worst Year	-21.8%	-21.6%
Best Year	47.0	52.0
Five-Year Beta	0.97	1.0
Source: Morningstar. Data through May 31.

One reason for this portfolio's solid returns is simply savvy stock picking. Only two of these funds trail their average peer over the past three years, according to Morningstar, and each is explainable. The (OAKMX Quote)Oakmark fund's below-average 4.4% three-year annualized gain is the remnant of a blue period during former manager Robert Sanborn's watch. Current manager Bill Nygren has trounced his peers since taking the reins about 15 months ago.

And the (FSPHX Quote)Fidelity Select Health Care fund's 7.6% annualized gain over the past three years lags its peers mainly because it didn't bet as heavily on the mercurial biotech slice of the health sector. While this may hold the fund back now, it will also keep it from taking steep tumbles as biotech stocks go through their inevitable feast-or-famine cycles.

Another driver of this portfolio's success is diversification. Its overall sector weightings are within shouting distance of the market averages, using the S&P 500 as a yardstick. The dearth of outsize sector bets should keep the portfolio's lows from being too low.

Under the Hood
	Perfect Portfolio	S&P 500
Technology	20.1%	20.0%
Financials	22.2	17.8
Services	16.7	11.7
Health	14.6	13.0
Industrial Cyclicals	8.9	12.1
Consumer Staples	3.4	6.4
Energy	3.4	7.5
Retail	6.1	6.5
Utilities	2.2	3.4
Consumer Durables	2.5	1.8
Source: Morningstar. Data through May 31.

"I think it's a pretty good portfolio," says Morningstar senior analyst Scott Cooley. "One thing is that you probably could've found lower-cost funds. It's possible that over a long period of time that an ultralow-cost portfolio might do better. But these funds aren't ridiculously expensive compared to their categories."

These nine funds' average annual expenses are 0.81%, compared with 1.38% for the average U.S. stock fund, according to Morningstar. That said, the (VFINX Quote)Vanguard 500 Index levies just a 0.18% annual toll and S&P 500-tracking exchange-traded funds, or ETFs, charge even less, though they typically entail a brokerage commission whenever you buy or sell shares.

While everyone likes low expenses, not everyone loves obsessing about their investments. For those of us who aren't fund junkies, there is an easier route, and it probably looks something like our low-maintenance portfolio.

If you're looking for exposure to domestic and foreign stocks, you could get that by putting about 80% of your money in the Vanguard Total U.S. Stock Market fund and 20% in the (TBGVX Quote)Tweedy Browne Global Value fund. This gives you broad diversification with low expenses. And unlike the Perfect Portfolio, this lineup will be a lot easier to rebalance at the end of each year.

The Low-Maintenance Portfolio
80%	Core U.S. Stock	(VTSMX Quote)Vanguard Total U.S. Stock Market
20	Core Foreign Stock	(TBGVX Quote)Tweedy Browne Global Value
Source: Morningstar. Data through May 31.

You might be wondering why this portfolio uses the Tweedy Browne fund for foreign exposure, while the Perfect Portfolio used the (VWIGX Quote)Vanguard International Growth fund. Very simply, growth-niks should choose the Vanguard fund and bargain-hunters should check out the Tweedy Browne fund. Both have solid track records, but in such a stripped-down portfolio it's usually best to emphasize the value investment style, which is less volatile than the growth style.

Despite this portfolio's vanilla pair of holdings, its returns are nothing to sneeze at. Through the end of May, it's beating the S&P 500, and it only trails the benchmark by 1.1 percentage points over the past five years. Given its 0.90 beta over the past five years, it's also been about 10% less volatile than the index over that period.

A Less-Bumpy Ride
Volatility
	Low-Maintenance Portfolio	S&P 500
Worst Year	-19.1%	-21.6%
Best Year	44.7	52.0
Five-Year Beta	0.90	1.0
Source: Morningstar. Data through May 31.

And from the expenses and diversification angles, this portfolio looks solid as well. On average, expenses are just 0.44%, less than a third of the average U.S. stock fund's fees. Its sector weightings don't stray too far from the S&P 500's either.

Under the Hood
	Low-Maintenance Portfolio	S&P 500
Financials	20.2%	17.8%
Technology	16.2	20.0
Services	14.2	11.7
Health	13.6	13.0
Industrial Cyclicals	11.5	12.1
Consumer Staples	8.4	6.4
Retail	5.4	6.5
Energy	5.1	7.5
Utilities	3.0	3.4
Consumer Durables	2.4	1.8
Source: Morningstar. Data through May 31.

"They're both good funds, and it will be a pretty tax-efficient portfolio," says Cooley. "To be honest, we just added that Tweedy Browne fund to our 401(k), so there's not much I can say bad about it."

While I'm not allowed to tell anyone what funds to buy, this exercise shows how you might fish a few decent candidates from the ocean of funds out there. For more ideas, you might check out this archive of our fund screens, which sift out 10 or so solid performers in each fund category.

And one last idea to keep in mind is that none of these portfolios is complete without at least a modest bond-fund allocation. We've looked at why just about every type of investor out there should at least consider owning a bond fund, with the cheapest and most-vanilla option being the (VBMFX Quote)Vanguard Total Bond Market Index fund. For more bond-fund ideas, check out this recent bond-fund screen.