By Dr. Jim Dahle, WCI FounderI had an interesting question via Twitter:
It got me thinking about diversification. There are actually multiple levels or stages of diversification, with a diminishing amount of importance as you move down the list. So while Dr. Hersch might feel he is diversified, and likely is at one level, I feel he isn't because he hasn't diversified enough of these stages to actually be diversified. Let's go through the six levels and discuss them. Also, at the end, I'll throw in a few comments about the idea of overdiversification.
Diversification Level 1: Multiple Asset Classes
The most important ratio in your portfolio is your stock to bond ratio. This will dictate at least 70% of the performance of your portfolio. In the case of the tweeter above, there is one asset class. A stock to bond ratio of 100:0. Since this is the most important type of diversification, I would dispute the “I am diversified” statement on this alone. Other major asset classes include real estate, precious metals, commodities, etc.
Diversification Level 2: Multiple Securities
The next most important level is simply owning a lot of different securities. If Enron goes out of business or Argentina defaults on its bonds, you don't want to be the one left holding the bag. Actually, it's fine to be holding the bag, as long as it is one of 5,000 bags you're holding. Then it won't have any significant effect on your portfolio and especially your financial goals.
Diversification Level 3: Multiple Types of Securities
What am I talking about here? I'm talking about sub-asset classes. US stocks, developed market stocks, and emerging market stocks for instance. Financials, utilities, staples, and energy stocks. Or corporate, treasury, and inflation-protected bonds. Or single-family, multi-family, retail, and industrial real estate. Gold, silver, and platinum. Oil, corn, and pork bellies. Yen, dollars, Euros, Pounds, Renminbi and Bitcoin. You get the point. Even if you own 50 different stocks, if they're all financial stocks, you're not that diversified.
Diversification Level 4: Multiple Factors
We're getting into less important levels now, but even within the passive investment community, there is a great divide between the slicers and dicers and the total market folks. The total market folks believe that the most diversification you can get is to own all the securities in an asset class in a market capitalized manner. So if Apple is bigger than Caterpillar, more of your money is in Apple. Slicer Dicers believe in “factors”, the idea that true diversification comes from “tilting” the portfolio toward small, value, momentum and/or dozens of other factors that academics have “discovered” (usually by massaging retrospective data).
If you believe the past is indicative of the future and that these factors are real, being diversified means tilting the portfolio toward them. If you don't, skip this level of diversification. Personally, I think they're probably real so I tilt my portfolio a bit, but not more than I'm comfortable with if it all turns out to be data-mining on a very limited set of data.
Diversification Level 5: Multiple Managers
If significant active management is being used in your portfolio, you may wish to have multiple managers doing it. It may turn out one of your managers is really untalented or even a thief. If you're using passive (usually index) funds run mostly by a competitor, this is less of an issue. In most areas of my portfolio, this isn't an issue for me. I'm perfectly comfortable having a single Vanguard computer system run all of my index funds. But when I branch out into other things (like the 5% of my portfolio I invest in hard money loans) I prefer using 3 different managers to do so.
Diversification Level 6: Multiple Companies
I often get asked whether it's safe to have all of your money at Vanguard or whether some should be put at Fidelity or Schwab or eTrade. Frankly, I think it's fine to have all your money at Vanguard (or even all at one of the other major mutual fund or brokerage firms) but if that makes you worry, all it will cost you (and your heirs) is a little extra hassle to spread it around a bit. One situation where it can really make sense to go with multiple companies/banks is if you are investing in CDs. If you go to a new bank, you get a new FDIC limit, which has a certain amount of value.
Overdiversification
Is there such a thing as overdiversification? Of course. The more managers, companies, factors, and investments you own, the more hassle you're going to have to deal with in your life. But what people are really talking about when they use the term overdiversification is false diversification. That's when you own 16 different actively managed large cap stock mutual funds. Yes, there are 16 different managers, but they're all buying the same stocks. You'd probably get more REAL diversification just buying the Vanguard Total Stock Market Index Fund.
Investment collectors and those dealing with poorly trained “financial advisors” get into this trouble too. They end up with a portfolio of 31 mutual funds, 16 individual stocks, 5 muni bonds, three annuities, bitcoin, your brother's failing business, and a whole life policy. That isn't a portfolio, that's a mess.
The Solution?
The solution to this dilemma is to own a low-cost, broadly diversified mix of stock, bond, and real estate index funds. That gives you the first three levels of diversification. If you want to go for level four, add a fund or two to tilt the portfolio. If you get into private real estate funds or syndications, be sure to use multiple managers (level 5). If you're a little paranoid about Vanguard, move a little money somewhere else.
There you go. Diversification complete. Can you still lose money in a bear market? Absolutely. But those losses are going to be both limited, temporary, and easily endured because you know you are following a reasonable investment plan. All you have to do is rebalance, continue to contribute, and enjoy the ride back up the other side of the valley. And it turns out that Dr. Hersch is more diversified than the original tweet would lead you to believe:
What do you think? What does diversified mean to you? How do you know when you're diversified?
I had just recently started diversifying in terms of syndication companies for real estate just to spread the risk a bit (although even with my original company, each real estate holding was its own separate LLC and would not be impacted if the syndicated company that provided the offering failed at any point).
I also do a very small tilt towards small cap stocks. When Personal Capital did a free analysis a long time ago about my portfolio they talked a bit about sector investing and sometimes I do a little DIY tilt in particular sectors.
But the main diversification, as you said, is in my market portfolio and what % I choose to allocate to stocks, bonds, and alternatives.
Great back to basics post! Keep them coming!
Have seen those messy portfolios created by “advisors”; use that word loosely
That is done to make you, the investor, think its too complex to do on your own
The age of AUM advisors is dead(Ric Ferri)
Keeping all assets with Vanguard or an other is wise for the simple reason is if someone else has to take over the controls
5-10 index funds is more than enough
Keep up the GREAT WORK-American investors in a recent study are highly financially illiterate
I like the tweet at the end. Clever writing style. I was not expecting that, and it drives home the point. I would add level 7: The purchase of your medical education and the dividends it will produce. I know a handful of physicians in their 70’s not working really because they have to, they are working to keep their mind and body active, enjoyment of the field, and a diversifier in case there is a great depression. It works well in the internal medicine world. A few shifts at urgent care or perhaps 6 to 7 hospitalist shifts per month can do wonders for an individual.
Over-diversification is accurately thought of as di-WORSE-ification. After a point, there are diminishing diversification benefits from getting into more and more stocks, ETFs and other instruments. Thanks for the article.
Nice article.
Simple strategy that works for both Bull and Bear markets will keep you from stressing too much about this.
Appreciate all that you do
I don’t know that guy or his situation but it sounds like he already has an appropriate portfolio for that stage of life.
As long as he has enough knowledge and confidence to not panic and sell everything at the bottom of a crash he should be good.
3-5 noncorrelated asset classes should be good for most folks. Adding a dozen more classes ads expense and complexity that often isn’t worth it.
I would add diversification of income streams to the mix- side hassle, a pension , rental income , royalties, blog revenues :)))
Those would make inevitable losses in a bear market… bearable until the next upswing
I love the Freudian slip- side hassle.
Also consider a paid off mortgage for those who choose to go that route – a noncorrelated asset that also helps decrease mandatory spending in a bear market.
Since this week’s blog, focusing on diversification, was organized into levels 1 through 6, I initially assumed that a level 6 would be the most mature and diversified portfolio, and a level 1 was a rudimentary non-diversified portfolio (eg. putting 100% of your retirement into your employer stock plan). I was wrong. These levels refer to various aspects of diversification, rather than rungs of a ladder to climb.
My 403b,457, and 401a portfolios all mirror each other and all contain the approximate allocations recommended by William Bernstein (shown below), except I cut my bond and TIPS allocation from 45% to 30%. My Fidelity retirement accounts allow vanguard purchases. This is in addition to my pension, which will start at age 65.
10% Vanguard Large-Cap Index
12% Vanguard Value Index
3% Vanguard Small-Cap Index
8% Vanguard Small-Cap Value Index
4% Vanguard REIT Index
2% Vanguard European Stock Index
2% Vanguard Pacific Stock Index
3% Vanguard Emerging Markets Index
3% iShares MCSI Value Index
25% Vanguard Short-Term Investment Grade Bond
20% Vanguard Inflation-Protected Securities
5% Money Market (taxable)
The levels are listed in order from matters most to matters least.
anyone use the THREE FUND PORTFOLIO
I use a straight 3 fund portfolio 40% US / 30% International / 30% bonds right now. As my expense ratios are similar across accounts, I even keep that ratio within each account.
The challenge is to not listen to the others and add complexity for a possible small benefit. If I were to die, my wife could handle this investment strategy without too much problem. We have even talked about going to a target date fund for more simplicity.
I am aspiring towards a simple 3 fund portfolio of Vanguard total stock market, total bond index, and international index, and will rebalance my retirement funds to this as soon as I can get around to it.
However, it’s the taxable accounts where I feel stuck. The Dr-ess and I previously followed the advice of a planner that spread our taxable accounts into about a dozen index funds. Vanguard total stock market, small cap, mid cap, large cap, S&P 500, international value fund, global equity, etc, etc. The philosophy seemed to be more for the sake of more.
Not only is it complicated, but it is preventing me from tax loss harvesting due to wash sales. But if I sell and consolidated everything, I’ll be hit with a lot of capital gains tax since these have all been held for a while now.
First world problem, but annoying nonetheless. Any suggestions?
— TDD
Kind of depends on how much your taxable income is now, and which way you are headed. And which way tax rates are headed. If you will be in a lower cap gains tax bracket in the future, then hold off. If you are already able to get in a low bracket, then just sell and make it easier for your future self.
(Sadly my crystal ball is broken re: future taxes, but with my military pension it is unlikely I will ever be in a much lower cap gains bracket, so I don’t hesitate to simplify my taxable accounts now and just pay the tax. Joy of being a “lower earning military doc” – $63000 of my income is non-taxed plus I can pay state taxes in my home state – FL, rather than in HI where I currently am stationed.)
No magic wand. Annoyance aside, nothing really wrong with holding. That said, you could wait for market drops and tax loss harvest the funds you want to get out of.
Stop reinvesting dividends first.
Check the basis next. Some might not have much in gains or even a loss. You can sell those.
If you give to charity, use the most appreciated shares.
If you give to adult kids in low tax brackets, consider giving the most appreciated shares and have them sell them.
The rest you hold and build your portfolio around and leave them to heirs (or sell later in life when you’re in a lower tax bracket) if you want to own them.
If you don’t want to own them, you bite the bullet, sell, and eat the capital gains. You might wait for the next bear to do so (when the gains aren’t so high or you have losses from TLHing to offset them), but there’s an element of market timing there.
Thanks a lot for the suggestions! I’ll have to check the basis on the accounts, and yes will likely wait until the next bear market to get rid of some of the unnecessary funds.
— TDD
Of course, the next bear may not have lower lows than today’s price…
I think Levels 2 and 3 are more important than Level 1. What good is a portfolio that’s 50% Enron stock and 50% Argentinian bonds? You’d be much more diversified with basically any conventional index fund, even 100% S&P 500.
Pretty extreme example required to make your argument work.
100% S&P 500 is the first of 150 portfolios that are better than mine, even though it misses the first level of diversification.
Yup.
Just a thought on level 6.
There have been more than one trading day where the websites at some of the major fund companies have been slowed to the point of being unusable toward the last part of the trading day. One I clearly remember occurred in mid-August of 2015; I was unable to rebalance my portfolio as the Vanguard and T Rowe Price websites had slowed to a crawl and (concomitantly) their phone lines were pretty much jammed. I do not remember the date when this happened again, but it may have been in early 2016 – long enough after the first incident that I expected at least one of these companies would have implemented a fix. (There was quite a bit of internet chatter about the 2015 incident, and I believe other companies may have also had issues on that day).
While this example is not a dire issue (intraday market values had triggered a rebalance point, so I simply did the transfer the next day, since I had been locked out on the trigger day), it illustrates that having all your eggs in one (or two) basket(s) can become an issue if you CANNOT reach the basket! Having options gives you a better chance of being able to access at least part of your portfolio for whatever reason when issues arise.
Why trade on those days? Just wait a day or two. No biggie. I try not to enter the “casino” at all on volatile days if I can avoid it. Money you need to access within days shouldn’t be in there at all.
Love the article; cringeworthy title. For the brilliance of WCI and his editors, ending a sentence with “at” is like nails on a chalkboard. ‘Where are you at’ simply becomes ‘Where are you’. Beautiful!
Now, someone tell me, “There, their, they’re.” Haha
Thanks for the valuable feedback.
WCI is making an incorrect statement – Bitcoin is often not touted by financial advisors because whole life commission situation is totally different – there’s actually money involved for the FA with pushing whole life. There is simply no reason to push Bitcoin because there exists widespread extremely low fee or zero fee options.
Doesn’t mean you should put a ton in Bitcoin but if you believe in the long term rational value then it can make sense to have a small amount. The CFTC regulates Bitcoin futures so they are classified as commodity and commodity money – closest to digital gold which does add alternative asset diversification.
Why else is Yale investing in crypto (includes Bitcoin): https://www.bloomberg.com/news/videos/2018-10-05/why-yale-investing-in-cryptocurrencies-could-be-a-big-deal-video
Long term rational value thesis by ex-KKR ex-McKinsey institutional investor: https://s3.eu-west-2.amazonaws.com/john-pfeffer/An+Investor%27s+Take+on+Cryptoassets+v6.pdf
I will also ask – how do you measure diversification? Does anyone realize that this is such a fundamental question but was never mentioned in a “diversification” article? Anything from interest rate risk, event risk, black swans etc. Assets have moved together since 2009 so not sure how the author can claim diversification without these sort of discussions.
No mention of bond classification? Portfolio correlation of certain bonds with stocks can be high and does truly provide diversification.
No discussion of alternatives? These do provide much more diversification out of stock market correlation – not sure how there is much diverse discussion in this.
Not enough discussion to size position. Position sizing is a huge important topic.
The author should consider putting a warning on the bottom to denote this only touches the surface. Otherwise the reader may be misled.
I’ll give an example if one has 50% VTSAX, 50% junk bonds (often disguised as they are usually called high yield fixed income). Is this that much different than 100% VTSAX? Look at your bond fund to see how much junk bonds are in them. Often these BBBs (“investment grade”) can easily turn junk as well.
This sort of comment is best answered by pointing out that nobody reads 10,000 word blog posts. You simply cannot mention EVERYTHING about diversification in a single blog post. Consider it part of the entire website. Pretty much everything you mention has been discussed elsewhere on the site.
Not sure what statement you’re referring to. I agree with you that few financial advisors push Bitcoin. But few real financial advisors push whole life to be fair. The ones pushing it are insurance agents masquerading as advisors.
As far as Yale:https://www.cnbc.com/2018/10/05/yale-investment-chief-david-swensen-jumps-into-crypto-with-bets-on-two-silicon-valley-funds.html
If you want to put a tiny portion of your portfolio into cryptocurrency, I think that’s fine.