An article that appeared on Yahoo! on January 5, 2007 – here's the link – suggests an investment strategy for 2007 and beyond. There is a lot of common sense that went into the construction of the recommended portfolio.

Author Ben Stein – lawyer, economist, finance commentator, actor – offers good advice about constructing an investment portfolio, and he explains his reasoning clearly and concisely. His key point is that other world currencies – notably the Euro – are likely to strengthen against the U.S. dollar and that a savvy investor in the U.S. will take advantage of this knowledge by investing at least a portion of his hard-earned in foreign-currency-denominated securities. He suggests a diversified portfolio that includes investments in Europe, Australasia and the Far East, emerging markets, a broad class of U.S. equities, real estate, and cash. His specific recommendations were:

• (up to) 25% in iShares MSCI EAFE Index (EFA)
• 10% in either iShares MSCI Emerging Markets Index (EEM) or BLDRS Emerging Markets 50 ADR Index (ADRE)
• 30% in either the Fidelity Spartan Total Market Index Fund (FSTMX) or the Vanguard Total Stock Market ETF (VTI)
• 10% in iShares Cohen & Steers Realty Majors (ICF)
• 10% in iShares Russell 200 Value Index (IWN)
• 15% in cash

Mr. Stein's overall strategy is good and, because he made recommendations of specific securities to implement that strategy, we at Bottom Line Gurus™ decided to analyze his recommended portfolio; it’s in our blood.  Using our Portfolio Optimizer Pro™ software, we created a portfolio and ran a simple analysis using four years, three months of historical data from 11/15/02 to 1/7/07; ADRE opened on 11/15/02, so we couldn't use a longer – say, five-year – history.  This period provides substantial data which could form the basis for an investment decision. The analysis uses ADRE and VTI, but the results would be virtually identical if EEM were substituted for ADRE and FSTMX were substituted for VTI.

First, the summary of the portfolio:

Next, a graph of the monthly returns of each security and of the portfolio, as well as two benchmark indices: the S&P 500 and the 10-Year US Treasury Note:

Note from this graph that several of the securities' returns tend to be up together and down together, exactly the opposite of what you would like for a well-diversified portfolio. This information is captured in the correlation numbers in the summary, above: four of the six securities have average correlations of returns with the rest of the portfolio that exceed +0.5; they appear in red on the summary page. The (pairs of) securities with the highest correlations of returns are:

• VTI & IWN (+92%)
• VTI & EFA (+81%)
• ADRE & EFA (+79%)

Finally, a graph of the efficient frontier for this portfolio:

From the efficient frontier graph, it is immediately clear that the proposed portfolio is fairly close to being efficient; however, at the same level of risk an investor could have obtained an additional 3% per year in return (moving straight up from to the efficient frontier curve), and at the same level of return an investor could have saved about 1.9% in risk (standard deviation of returns).

Note, too, from the efficient frontier graph that most of the individual securities are relatively close to the efficient frontier curve, or, put another way, the curve is relatively close to the individual securities. The reason for this is that the correlations of returns are relatively high; a mixture of securities with lower correlations would give an efficient frontier that is farther to the left: lower risk for a given return, or higher return for a given level of risk.

Finally, going back to the summary, note that VTI appears in red; this means that VTI never appears in an efficient portfolio. Put another way, VTI did not provide any useful diversification to this portfolio over the last 4 years, 3 months.

In summary: the advice given in this article is extremely worthwhile, and the mix of securities in the recommended portfolio is not bad. It could be improved somewhat by searching for securities in similar markets/sectors whose returns are comparable to those of the recommended securities, but which have somewhat lower correlations of returns, and also by eliminating securities that provide no useful diversification. Overall, however, Mr. Stein has suggested a sound strategy and a reasonable means of implementing it.