By: Larry MacDonald

Lazy investors may be less enchanted these days with the Lazy Portfolio approach (investors hold a diversified collection of exchange-traded funds and are spared the task of researching individual stocks). Paul Farrell’s scorecard shows that eight high-profile Lazy Portfolios in the U.S. are down more than 25%, on average, over the year. Over the past five years, annual returns are barely above breakeven.

Drilling down on asset allocations, we see they all had high exposures for stocks. The designers, as has been popular this decade, appear to have been influenced by the empirical studies showing stocks historically have averaged about 9% annually over the long run, better than bonds (5%) and cash (3%).

However, during the recent bull market, dividend yields got down to the 1.5% to 2% range. That was not a good omen because about half of the long-run return on stocks derives from dividend yields of 4.5% earned during the historical periods.

Lazy Portfolios constructed during the bull market were thus destined to earn about 6% annually on their stock exposure (ceteris paribus). The recent crash digs a deep hole for them but the impact may be just to lower long-run equity returns by a third or so (assuming dividends hold up reasonably well during the recession).

In retrospect, by taking valuation levels into account, the boom-era Lazy Portfolios may have captured a better risk-reward ratio by allocating less to stocks and more to investment-grade bonds.

Sensitivity to market valuations is what William Bernstein urged in Chapter Two of The Four Pillars of Investing when he recommended the dividend discount model (DDM) as an alternative to extrapolating expected returns from the past (more on this in next post). Another approach, which also takes valuations into account, adjusts allocations to stocks according to departures from their historical average return (see the One-Minute Portfolio).