If data dictate that simple trumps complex, why then do we planners continue to design more complex portfolios?

As an example of simplicity, over a decade ago I taught my son how to invest using just three index funds:

· A total stock index fund such as VTSMX
· A total international stock index fund such as VGTSX
· A total bond fund such as VBTLX

With these funds (or better yet, lower-cost share classes of these funds), my son owned virtually every publicly held company on the planet, as well as an approximation of nearly every fixed-rate investment grade bond in the United States.

What's more, Noble Laureate William Sharpe’s research paper, "Arithmetic and Active Management," proved that owning the entire market at the lowest costs must beat the majority of investors.

Owning even one other stock fund will actually decrease diversification because it will be making specific bets on industries, styles or other factors. In fact, the portfolio can arguably be simpler with a two-fund portfolio, where the U.S. and international stock funds are replaced by a total world stock fund such as VTWSX.

Over the years, I have benchmarked hundreds of portfolios against the equivalent weighted three-fund portfolio and can count on one hand the number of portfolios I have seen that bested this benchmark. Most fall short by far more than expenses can explain.

Yet I can also count on both hands how many times I have personally designed such a portfolio for clients. Admittedly, though these three funds are the core of my personal portfolio, it is still far more complex than I would like.

So why are the portfolios we help design still more complex than they need to be? Here are 10 reasons, some good and some bad.

1) Tax ramifications from legacy holdings
Theoretically, we could sell everything to build the three-fund portfolio. But theory hits reality when the tax bill shows up. It is better to have more money than be theoretically superior.

As an example, I bought my first index fund about 27 years ago. It was an S&P 500 index fund. Clearly, it is inferior in that it misses out on the small- and mid-cap stocks. But rather than pay the Internal Revenue Service sooner, a simple solution is to buy one of many extended market index funds.

This completion fund owns every stock in the United States that is not part of the S&P 500. Thus, a portfolio of about 80% S&P 500 funds and 20% extended market index fund builds a total stock index fund without paying the IRS.

Rarely do I have a client come to me with portfolios that have no tax legacy. Decisions must be made between the costs of building the better, lower-cost and more diversified portfolio vs. the benefits.

2) Bond alternatives
I am not arguing in favor of more expensive active bonds. Although they may outperform bond index funds by taking on more risk, our clients will regret it when markets tank (see 2008).

I have most of my clients buy certain certificates of deposit.

Why? Because bond prices will decline if rates increase.

Many CDs purchased directly from banks and credit unions offer low early withdrawal penalties. This essentially gives clients a put to make the institution buy the CD back at a small discount.

As an example, the Vanguard Total Bond fund would lose an estimated 9% if interest rates rose 2% in one year. By comparison, a five-year CD at Capital One would net a gain of 1.15% after paying the penalty in that same scenario.

Brokered CDs don’t offer the same puts but offer higher rates than the total bond fund. There is less liquidity, however, due to the costs of selling these CDs, because they are essentially bonds.

Low-cost Treasury inflation-protected securities funds also offer some protection against rising rates because their yield is positively correlated to inflation.

3) International bonds
The three-fund portfolio leaves out the largest single investment class on the planet: international bonds. Vanguard makes a very good case that this asset class is a critical part of any diversified portfolio. For decades, I avoided international bonds due to high fees. But a few years ago, Vanguard launched a total international bond fund and includes this fund in its fund of funds such as target date funds.

Although a close call, I have chosen to avoid this asset class because it is still more expensive when you include the hedging costs, and the need for diversification in this asset class is less.

4) Have some fun
It surprises many clients when I tell them that it is OK to gamble a little and have a fun portfolio. I do the same in my own portfolio to accommodate that piece of my mind that wants to have the excitement that index funds don’t provide.

I buy small positions in one or two stocks a year, always being sure to set strict limits. I give clients limits and rules for their fun portfolio as well and caution them that their biggest danger isn’t that they could lose everything. Rather, it is if they do well, they may think of themselves as the next Warren Buffett and bet the farm.

5) Smart beta and other factor investing
Why would you want a capitalization-weighted index when smart beta and other factor investing strategies exist? Small, value, momentum-based strategies that add risk-free return, right? Wrong!!

Even Eugene Fama and Ken French noted that these factors weren’t a free lunch, and Dimensional Fund Advisers (Fama is on DFA’s board) acknowledges the same.

These factors give extra return as compensation for taking on more risk. After the higher fees and tax inefficiencies, you are left with a lower risk-adjusted return. So “dumb beta” may actually be smarter.

6) The belief we know the future
Current opinion seems to be that rates are going to rise and bonds will decline, if not a total burst of the 35-year bond bubble.

Why then should investors own an intermediate-term bond fund? Because economists have a track record of calling the direction of rates correctly far less than a 50/50 coin flip.

And advisors time stocks just as poorly. We think we know what companies, sectors or even countries will outperform. Unfortunately, we time markets badly and build complexity to try to achieve that outperformance.

7) Alternative assets: low and negative correlations
If we can own asset classes that zig when the market zags, we can create a higher risk-adjusted return. This is known as having asset classes with negative, or at least low, correlations to stocks.

We build in alternatives such as managed futures, market neutral funds and even inverse funds. The problem is that these alternatives also have ultra-low or negative expected returns, after fees. As I tell clients, taking half their portfolio to the Las Vegas tables has a zero correlation with stocks but isn’t a very smart move.

8) Income
I have seen more money lost in the name of income than any other reason.

Advisors have told me that master limited partnerships were merely toll roads to pump oil and natural gas and the 5% to 7% yields were risk-free. Rather than own a high-quality bond fund such as a Barclays Aggregate index fund, advisors are again lowering credit quality, forgetting the lessons of 2008.

Total return is far more important. My advice to clients is, take the risk with stocks and have the fixed income act as ballast to their portfolio.

That total bond fund earned more than 5% in 2008 when the average bond fund lost 8%, and many lost half their value or more.

9) Client desires
Many clients come to me saying that they want me to tell them what they want, whether it is income, low taxes or a particular product. I review all their requests, but in the vast majority of cases, I explain why I disagree and refuse to recommend.

Almost all these desires are rooted in the belief that they are smarter than the market. In most cases, the client gets it.

In some cases, the investor doesn’t become a client. I consider both cases successful outcomes.

10) Fee models
In my view, the mother of all bad reasons to avoid simplicity is our fee model. All fee models have conflicts of interests.

If we built a simple three-fund portfolio, how could we justify charging assets under management? All we would be doing is some occasional rebalancing.

Even robo-advisors that charge ultra-low fees use many funds.

Although I am an hourly advisor, that fee model doesn’t eliminate conflicts either. The simple three-fund portfolio with a target and tolerance range for each fund sends the client on their way without them needing me in the future.

Like I said, I rarely design a three-fund portfolio. And the reasons I don’t are almost always due to tax legacy, the use of CDs, TIPS, international bonds and carving out a fun portfolio. But I will keep trying to simplify for my clients, because ultralow fees with the highest diversification is simply brilliant.

This story is part of a 30-30 series on building a better portfolio. This story was originally published on June 16.

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Allan S. Roth

Allan S. Roth

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colorado. He also writes for The Wall Street Journal and AARP The Magazine and has taught investing at three universities. Follow him on Twitter at @Dull_Investing.