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Is Simplicity Overrated in Investing?

I’m a big advocate for keeping things simple.  In my opinion, it’s essential that your investment strategy be simple enough that you can:

  1. Understand it, and
  2. Implement it properly.

If you don’t have a rock-solid understanding of your investments and investment strategy, your exposure to both scams and costly mistakes goes up dramatically.

That said, simplicity sometimes comes with a cost. In such cases, you have to ask: Can I afford it?

Simplicity and Target Retirement Funds

Target retirement funds are the simplest way to put together a diversified portfolio. But they come at a cost.

At many fund companies, the target date fund includes a level of costs in addition to the costs of the underlying funds that it owns. In other words, you’re explicitly sacrificing returns in order to have the fund manager rebalance between the funds for you.

And even at those companies that don’t charge an additional layer of expenses for their target funds (Vanguard, for instance), you take on an additional level of risk by using a target date fund. Specifically, you take on the risk that the fund manager will change the “glide path” without you realizing it. If you don’t pay attention, your portfolio could end up with a very different asset allocation than you’re expecting.

Is it worth taking on risk (and, depending on the company, additional costs) in order to have a simpler portfolio?

Simplicity and Diversification

Outside of target date funds, the simplest index fund/ETF portfolio I can imagine would be something along these lines:

  • A total U.S. stock market index fund,
  • A broadly diversified international stock index fund, and
  • A total bond market index fund.

In terms of number of securities, it’s hard to be more diversified than that. But many people (myself included) would argue that you could improve your diversification by adding some or all of the following to your portfolio:

Of course, by doing so, you’ve taken the number of funds in your portfolio up from three to six or more. Although, as Larry Swedroe has argued in defense of his 11-fund lazy portfolio, if you’re only rebalancing once per year, adding more funds doesn’t increase the workload by that much.

In this case, I’d vote for better diversification rather than a simpler portfolio.

Simplicity and Annuities

I’ve been writing a lot about single premium immediate annuities lately. In part, it’s because I think they’re an extremely useful tool for retirement planning. But it’s also because I suspect that one of the reasons many people stay away from annuities is that they just don’t understand them.

And that makes sense. Not understanding an investment is a good reason to refrain from buying it. It’s not, however, a good reason to refrain from learning more about it.

What’s the value of simplicity?

All else being equal, I’ll vote for the simpler option every time. But the more I learn about investing, the more I realize that simplicity often (though certainly not always) comes with a cost–whether lower returns or higher risk. And I find that the price I’m willing to pay solely in exchange for simplicity is actually rather low.

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Comments

  1. One danger of having too many funds might be that you might be duplicating asset classes, which makes tracking your allocations more difficult, and may increase your fees.

    One danger of having just a few funds is that you’re not exposed to all possible asset classes. For instance, even your 6-fund model above has no exposure to precious metals or other commodities. One international fund may not have any holdings in Canadian stocks; another may have nothing in international small-cap. And why not international bonds? why not other sectors (energy, health, etc.) besides REITs?

    The question for me is, which asset classes are essential, and which just icing on the cake or otherwise superfluous?

  2. MoneyObedience says:

    I think it is better for most people to keep things simple. Broad based index funds, REITs, and Tips provide market exposure to all important markets. Why complicate matters?

  3. I agree that figuring out the essential asset asset classes is key. I believe 5% should be allocated to emerging economies stocks and 5% to high yield bonds. Both these sectors act differently than the usual choices and thereby hold down volatility.
    Target date funds do come with a cost and should only be used by individuals who throw up their hands and just want to have nothing to do with thinking about their investments. Somewhat surprisingly some advisors use target date funds.

  4. Asset classes should increase, to a point, as the dollar value of your portfolio increases. For very small portfolios, especially those with relatively high near-term deposits, the basic asset classes (combined with dollar cost averaging) are adequate. As a portfolio increases, and relative deposits decrease (along with time), adding asset classes provides a real benefit. At some point, though, it’s questionable whether adding additional asset classes is beneficial. You add complexity, transaction costs, and tax consequences, and when you add, you have to make room by decreasing something else.

  5. What’s your definition of a very small portfolio?

  6. Small is relative and depends mainly on the ratio of “amount currently in the market” to “amount soon to be in the market.” If for example, you are just starting to invest ($0 in the market), and know that you will add 1k per month over the next five years, the dollar-cost averaging effect would likely overcome the benefit of many asset classes. On the other hand, if you have $1 million invested and aren’t adding any more $, carefully chosen additional asset classes and periodic rebalancing would (in many but not all historical markets) help you manage risk. In either case, the bond/non-bond ratio is the most important decision of all. Even with multiple asset classes, if you get the bond/non-bond decision wrong, you can get into big trouble.

  7. I would definitely agree that the bond/non-bond ratio is essential. The problem for me is that this ratio too depends on how much time you have, and people seem to base their idea of the ratio on “risk tolerance” and “whether they can sleep at night” rather than an objective understanding of how money works. And you hear this ratio expressed as anything from “100% in equities when you’re young” to Bogle’s “your age in bonds” to “120-your age in stocks” – which amounts to a pretty large range of possibilities. (I’m close to 62, and when I next rebalance in a couple of weeks I plan for 58% stocks / 42% bonds – moving to about 50/50 by age 65. Too aggressive?)

  8. Risk tolerance and risk capacity are both involved in the asset allocation decision, and the two are often confused. Risk capacity uses objective information (your age, time until retirement, current financial assets, life expectancy, portfolio withdrawal rate, etc) to determine how much risk you should take. Risk tolerance is more individualized and tries to answer “can you sleep at night?” and “at what point would you bail out?” Both are important– there’s no sense taking more risk than you need to, even if you are willing to; on the other hand, if you run the risk of ditching the plan at the worst possible moment, that’s not good either.

  9. A bit off topic, but for a lot of people the simplest (/easiest) decision is to pay someone else to make their investing on their behalf.

    A very costly simple decision!

  10. Well, depends on how much your time is worth!
    However, the problem of simplicity – many small investors exchange ‘simplicity’ and ‘universality’ Simple solutions are great (and since you can’t fool the market they are usually also the most profitable), but those should be your simple solutions. Everybody has different risk awareness, different timing and what is simple for you, can be difficult for me…

  11. I too am a fan of simplicity in investing. But I fail to see how adding REITs, value funds and/or small-cap funds to a total US stock market holding could “improve your diversification.” Those holdings are already part of the total US stock market. Adding those simply overweights you by those duplicated holdings, or in other words, you are now underweight everything else relative to the rest of the market. How is that improved diversification?

    Please note, I am not arguing for or against over or underweighting parts of the market. I’m just pointing out that overweighting does not improve diversification. It’s typically done because of the believe there is a benefit to being less diversified with some of your money, i.e underweight other parts of the market.

  12. Larry-
    Use a periodic table of investments which shows annual returns for various asset classes over 20 years. Callan and Blackrock have produced their versions which you can find online. Then weight the asset classes according to your preferences and calculate 3 year rolling returns. This will give you a range of returns you would have experienced. Could you live with these?
    With a little creativity you can get some useful results from this exercise. Note that the last 20 years have been interesting with the dot.com implosion and the 2008 debacle . It’s reasonable I believe that the next 20 years won’t be more volatile.

  13. Dylan, I believe the usual argument is that diversification is not the only criterion when it comes to adding REITs or small cap/value. As DIY says above, sectors like these”act differently than the usual choices and thereby hold down volatility.”

    Thanks, DIY, for the tip on Callan and Blackrock .

  14. My comment was not about diversification as a criterion considered in making investment selections; I tried to make that clear. I’m specifically challenging the notion that over/underweighting certain securities is somehow improved diversification. Traveling up or down the efficient frontier by over or underweighting certain companies or sectors is not the same as increased or decreased diversification.

  15. Dylan has a good point…there is no reason to add what is already in the index. The high yield bond sector , however, isn’t in the total bond etf…at least for AGG. AGG is investment grade and higher.
    I believe also that most global stock etfs don’t include emerging economy stocks.
    If you’re interested in the Blackrock analysis you can see my workup on my site. I like their table because they put in a diversified portfolio so it is a nice visual of diversification compared to market sectors.

  16. My thoughts on the matter of whether overweighting small-cap and/or value improves diversification can be found here.

  17. Mike, I read your other post. I get what you are saying about incorporating investments that are not perfectly correlated, but I don’t think that concept is the same as diversification nor am I making an argument against it. You are talking about investment policy (i.e. asset allocation) and the application of Modern Portfolio Theory and calling it “diversification.” Overweighting and underweighting may provide you with an optimal portfolio (or it may not), but improved optimization does not equate to improved diversification.

    Here is an extreme example to illustrate diversification. Which portfolio is more diversified: Portfolio A is 99% ExxonMobil and 1% Total Stock Market Index Fund (which includes ExxonMobil) or Portfolio B is 1% ExxonMobil and 99% in the Total Stock Market Index Fund?

    If you conclude that Portfolio B is more diversified, it only stands to reason that being 100% Total Stock Market Index Fund (which includes ExxonMobil) is even more diversified than Portfolio B, even if being overweight ExxonMobil ends up being a more optimal portfolio. Substitute REITs for ExxonMobil.

    If you overweight value companies, that means the rest of the market (i.e. every one else but you collectively) is overweight growth (or underweight value). That cannot result in an improved diversification over the rest of the market. Whether or not it results in better returns/lower volatility does not change that; it just means your bet paid off. When you look like everyone else except you, then you are most diversified.

  18. To be clear, I’m not saying there is no reason to overweight. I’m just saying that doing so doesn’t improve diversification.

  19. I think it’s simply a matter of terminology.

    For example, if we were to compare two portfolios:
    75% Total Stock Market, 25% S&P 500

    or

    75% Total Stock Market, 25% Small-Cap Value

    I’d argue that the second is better diversified if you can expect it to lead to less overall portfolio volatility–even though it doesn’t include a greater number of securities.

    I’d accept “spreading your investment across more securities” as a reasonable definition of diversification. It just wasn’t the definition I was using in the statement in the above article that appeared to start this conversation. 🙂

  20. Sorry, DIY, but I couldn’t find that information.

  21. Look for “Blackrock Periodic Table ” under April posts. There are actually 3 posts based on this table.

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