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What’s the Purpose of Diversification?

“Owning one total U.S. stock index fund is the most diversified U.S. stock portfolio one can have.” –Allan Roth in How a Second Grade Beats Wall Street

“A total market fund is not inherently bad. It is not, however, a well diversified portfolio in terms of asset class diversification.” –Larry Swedroe in What Wall Street Doesn’t Want You to Know

So who’s right? Is a total stock market fund the most diversified U.S. stock portfolio you can have? Or is it possible to achieve better diversification by adding other types U.S. stock funds?

That depends on why you’re diversifying.

Spread Out Your Investment

Many would argue that the purpose of diversification is to spread your investment over as many companies as possible. If that’s the case, then the U.S. portion of your stock portfolio can’t be more diversified than a Wilshire 5000 fund.

  • Adding a REIT fund would not improve your diversification. A Wilshire 5000 index fund already includes REITs.
  • Adding a value fund would not improve your diversification. A Wilshire 5000 index fund already includes value stocks.
  • Adding a small-cap fund would not improve your diversification. A Wilshire 5000 index fund already includes small-cap stocks.

Minimize Volatility

Others would argue, however, that the purpose of diversification is to reduce the overall volatility of your portfolio. If that’s the case, you can improve your diversification by investing in asset classes that have less than perfect correlation to the rest of your portfolio.

In other words, if you can find funds that:

  • Have a similar long-term expected return to the rest of your portfolio,
  • Have similar volatility to the rest of your portfolio, and
  • Behave differently from the rest of your portfolio…

…then you should do it. It will improve your diversification.

Example: A large-cap value fund has similar expected return and similar volatility to a total stock market fund. Yet it performs differently on a month-to-month and year-to-year basis. So adding it to your portfolio–while it won’t increase the number of companies you’re invested in–should reduce overall volatility.

Why Do You Diversify?

I’m reluctant to say that either definition of diversification is better than the other (though personally, I lean toward the second). I would, however, argue that it’s essential for you to understand what you’re trying to achieve when you construct your portfolio.

If you don’t know why you’re diversifying, you won’t know how best to do it.

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Comments

  1. What do you think about diversifying not just in a variety of sectors of stocks but also types of investments such as peer-to-peer lending and the like?

  2. Hi Ben.

    My answer depends upon what you mean by “and the like.”

    In this particular article, I was speaking only to diversification within your stock portfolio, but I absolutely see the benefit of diversifying into other types of assets–US Treasury debt most especially.

    Thus far, I’m not sold on the concept of peer-to-peer lending. I’m not saying that it’s a bad idea, just that I’m not putting any of my own money toward it until there’s more of a track record. My assessment so far (which could turn out to be wrong) is “limited upside with high risk and poor liquidity.”

  3. I look at it a bit like this: I could go to a supermarket and find just about any foods I wanted. Or, with only a little more effort, I could buy most of my groceries at the supermarket but go to the fish store and the Italian bakery in town because I know they offer fresher fish and more scrumptious baked goods. Or I’ll go to the Latino market two miles away when I want Mexican chiles and the best chorizos.

    I know some argue for the virtues of single-fund simplicity, the ultimate example being the target retirement funds. One stop and you’re done, and since there’s plenty of selection, you can get everything you need.

    Personally I’ve been educated to believe that you get more control especially for rebalancing if you branch into multiple funds. When I started with Vanguard, the person who helped my design my portfolio felt that I could take advantage of different styles of performance if I not only bought Total Stock, Total International, and Total Bond, but if I had small-to-moderate holdings in REITs, value, small-cap, TIPS, and GNMAs, because in various ways all these could compensate for fluctuations in each other. Boglehead Investing says for example that REITS are a special type of stock whose behavior does not correlate with other stocks. And I think this allocation must be working for me, because in the crash of 2008 when some people were losing 50%, the maximum I lost was about 25%.

    I know some have criticized my portfolio for not being simple enough and too difficult to track. But with VG’s Portfolio Watch tool I can effortlessly find out what percentage of my money is in what asset classes at any time. And even the experts may say one thing one day and another the next. I’ve read Rick Ferri recommend portfolios of only 2 funds and then design a portfolio with as many as 14. So I’m not convinced one approach is necessarily right and the other wrong; it may be a matter of personal temperament.

  4. Mike, I wonder if the question is not so much “Why diversify?” as “Why diversify into multiple funds?”

    Unless you just buy 100% company stock, you probably already believe in diversifying. But you do get a lot of diversification with target funds and funds like VG’s Total Stock. What you don’t get with such indexes is the ability to fine-tune and rebalance sectors to your liking.

    Probably fine-tuning / slicing-and-dicing can be overdone too, so that you could buy Total Uruguay and Arkansas Health Care Mid-cap Growth. And you have to watch the fees for these sub-allocations too. But when my portfolio was designed for me by a friend, he advised taking Total Stock and Bond as the cores, keeping a 60/40 overall ratio, but also adding some other options for fine-tuning:

    – REITs because they are uncorrelated to the US market and can be an effective hedge along with bonds.
    – Value because it’s less volatile than growth, may have better long-term returns and higher dividends, and is not emphasized in the TSM.
    – Small Cap because TSM is mainly in large caps, but small caps invest in less established companies and may have greater volatility/reward.
    – TIPS because inflation protection is guaranteed due to their low correlation with regular bonds, although they are best bought when interest rates are low and return best when inflation is high.
    – Short-term bonds because they may have lower yields but reduce interest risk and are advisable 2-4 years before retirement.
    – GNMAs because they are backed by the Feds and on average are of shorter duration than intermediate bonds, with the downside that they could lose value if interest rates rise and their duration lengthens.
    – European, Pacific, and Emerging Markets separately if you want to weight each market differently from the Total Intl. 2:1:1 proportions.
    – Precious metals because they are highly volatile but correlate with nothing else and could hedge against inflation.

    I went with REITS, value, small-cap, TIPS, GNMAs, and a small % of metals when the VG fund reopened. I bought Total Intl. rather than the three markets. But I wonder if GNMAs are worth keeping in themselves, as they are 1/3 of TBM.

    Your thoughts would be appreciated.

  5. Larry: That’s almost identical to my thoughts on splitting things up into specific asset classes.

    TIPS make a lot of sense to me for somebody with significant bond holdings. Allocating 50% or more of one’s bond holdings to TIPS wouldn’t seem unreasonable to me.

    REITs and small-cap/value: My thoughts mirror your friend’s.

    I’m not entirely convinced about GNMAs. I’m not sure the tiny additional yield they earn over similar-duration Treasuries is worth it. That said, the additional risk they carry is also quite small.

    Precious metals: I don’t own any myself, but my thoughts mirror Bernstein’s: For the high volatility and nonexistent correlation, it can make sense for a very small portion of one’s holdings.

    Slicing and dicing by country: Not worth the hassle in my opinion. I have no reason to think I’d gain anything from it.

  6. S+D international: The only reason I can think is if you would want more risk/reward in Emerging Markets. BTW, do you prefer FTSE World ex-US to Total International? Is it just because of Canada?

    My biggest stumbling block with my portfolio, however, is not these sub-allocations. It’s knowing the best way to deal with multiple portfolios from different providers – Fidelity for the 401k, Vanguard for the tIRA and Roth. Could you do a column on that?

  7. “BTW, do you prefer FTSE World ex-US to Total International? Is it just because of Canada?”

    That’s the idea. I sometimes ponder though whether it’s worth the extra 0.06% expense ratio. I imagine the real answer is “doesn’t matter much either way.”

    “My biggest stumbling block with my portfolio, however, is not these sub-allocations. It’s knowing the best way to deal with multiple portfolios from different providers – Fidelity for the 401k, Vanguard for the tIRA and Roth. Could you do a column on that?”

    Sure. Certainly seems worth discussing.

  8. While it’s going too deep for true oblivious investors, your exposure is also weighted towards sectors / industries / companies, as well as asset classes.

    In a market-weighted index, you may have some allocation to small company stocks or agricultural stocks, say, but they may be dwarfed by the money in Exxon and other energy companies (for instance – I haven’t checked the US indices).

    Tracking an equal-weighted index would give you more diversification, I think, in the terms you’re discussing, at the cost of the risk of diverging from the commonplace market-weighted approach.

  9. Why I diversify:
    1) reduce risk – if one company plummets, I have other safe money
    2) try for increased earnings – the whole market usually performs better than stock picking
    3) increase value – rebalancing lets me buy low and sell high
    4) reduce costs – index funds have lower costs than buying and selling the stocks myself, even at discount broker prices
    5) reduce research time – I don’t have to understand a company or an industry if I’m buying some of everything

  10. This is a great discussion of lowering portfolio volatility. I think Swedroe and Roth, however, would argue that their quotes are about completely different things.

    Roth seems to be talking about diversifying within a stock portfolio. Swedroe says a Total Market Stock Fund isn’t great in terms of “asset class diversification”. I think most investors would understand asset classes to be stocks, bonds, real estate, commodities, etc. Obviously, a total stock market index fund wouldn’t include anything but stocks.

    Of course, I don’t have the book in front of me. Maybe in context, Swedroe meant only different kinds of stocks.

  11. Hi, Pop. Thanks for adding your thoughts to the discussion. 🙂

    I’d agree that Swedroe is talking about “asset class diversification.” Provided with the quote’s context, it’s explicitly clear that’s what he’s discussing.

    I’d argue, however, that asset class diversification is what Roth is discussing as well. The quote comes immediately after a discussion of Morningstar style boxes and is followed with the statement that “it’s impossible to add a second U.S. stock fund that would improve diversification as it would only begin to overweight one of the style boxes or industry sectors.”

  12. Maybe we’re saying the same thing and just have different ideas of what an asset class is. In my mind, “stocks” or “bonds” would be an asset class. “Large value” or “small growth” aren’t asset classes. They’re just categories within the “stock” asset class (which is what the Morningstar style boxes would be showing you).

    So let’s say my investment portfolio had a total stock market fund, a large growth fund, a midcap value fund, and a smallcap biotech fund. My entire investment portfolio is made up of just one asset class: stocks.

    And of course, a quick Google search has Morningstar addressing this very discussion: http://news.morningstar.com/articlenet/article.aspx?id=104364&_QSBPA=Y&wmcsection=assetmix1

    I should have just Googled to begin with!

  13. Hi Pop.

    It sounds like you’re exactly right with the hang-up being a difference in terminology. (Very similar to what’s going on with the disagreement when some people call a Total Stock Market + Total Bond Market portfolio “diversified,” while others would say it isn’t.)

  14. Mike-

    Let me first say that I really, really, respect your work and for those of you that don’t know Mike and I agree on a lot of things and have a relationship that allows for open conversation on those things we disagree on.

    With that said:

    Really how much did any of this help in 2008?

    If the primary focus of diversification among equity asset classes is to lower volatility it failed right at the time we needed it most.

    The only way to really lower volatility (if you even consider this an appropriate way to measure risk for a real person) is to have more of your money in cash or very short term CD’s. I know they pay next to nothing, BUT they are actually going to provide a cushion when you need it rather than a theory of a cushion that doesn’t actually work when you need it.

  15. Hi Carl.

    Thanks for contributing your thoughts. I don’t think we disagree here actually. Or at least, not very much.

    There’s no debating that equities took a beating in 2008–small caps, large caps, value, growth…everything. In absolute crisis situations like we experienced at the end of ’08, no amount of diversifying among stocks will save you (regardless of how you define “diversification” among those stocks).

    And, while I’d add U.S. Treasury debt to your mention of cash and short-term CDs, I agree with your general idea: Don’t look to stocks for any degree of safety in a crisis.

    That said, just because something doesn’t protect you in a crisis doesn’t mean it has no value whatsoever, does it? It seems to me that there’s a value in smoothing out the ride in other years (if, in fact, overweighting small-cap or value stocks can help to achieve that goal).

  16. sure there is value…at far as it goes. But I think the issues is there is far too much talk of splitting things up, optimizing (whatever the hell that is) down to the nth degree, in a misguided hope that it will catch you when you fall. The reality is that equity investing is risky. Risk by its very nature is something that can’t be controlled. I think that the industry has given the false sense that we can control risk by just turning a dial until it is just the right about for you. You can’t! So focus on the things that matter: the mix of stocks to bonds and behavior.

  17. “Focus on the things that matter: the mix of stocks to bonds and behavior.”

    I’m in complete agreement that those (and costs, actually) are far and away the most important things to discuss. But I don’t think I’d agree that they’re the only things worth discussing.

    And by blog post #337…. 😉

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