Diversification – A Contrarian View


The benefits of a diversified portfolio are well established in the conventional wisdom. “Reduce risk” is at the top of the list of perceived benefits. We will argue that for most investors, the advice to be diversified works against the investor. We will show that the tool used to measure risk is inappropriate for the real risk faced by the investor and that the advice provided based on that tool is the wrong advice. We will suggest a number of paradigm shifts that we think will best serve the IRA Investor.

Defining the “IRA Investor”

Our target investor is a person first realizing the need to make investment decisions about his* retirement with absolutely no idea of what to do. He may be at the point of his first job where his employer is presenting him with a 401(K) opportunity. Our 32 year old male “IRA Investor” has a very long investment horizon; 50 years or more;   thirty-three years of accumulation and then an expected seventeen years of withdrawal.

His investment objective is simple: to have as much money as possible at the time he retires.

Addressing “Risk”

We are going to identify and categorize two types of risk facing the IRA Investor.

Risk Type Description Conventional Solution
I Conventional Panic and Bail when market declines Diversification
II Contrarian Run out of money during retirement Not Considered

Type I Risk

The concern for Risk Type I is evident at the outset of the advisor/IRA Investor relationship. The IRA Investor is assumed to have some measurable aversion to risk. In this case, “Risk” refers to the IRA Investor’s ability to risk his capital, that is, to stay invested,  even though the stock market is declining. The advisor will typically have the IRA Investor answer a set of questions to determine the level of risk the he is willing to assume before he panics and bails out of the market.

Based on the IRA Investor’s willingness to tolerate the risk of losing capital,  the advisor develops a diversified portfolio that is constructed to accommodate the level of Type I Risk the IRA Investor is willing to assume.

Type II Risk

The questions presented by an investment advisor to the IRA investor only address Type I Risk – “How will you react when faced with a prolonged market decline”?

But Type I risk is not the risk the IRA Investor cares about.  The number one concern of the IRA Investor is “running out of money while retired” or, more to the point, “will my money last me until I die”? Here is a clip from a Gallop poll that supports our position about the number one risk facing the IRA Investor:

Personal financial concerns vary significantly across age groups. The top problem for the broadly defined group of middle-aged Americans — those aged 30 to 64 — is not having enough money for retirement, in line with  previous findings, for this group, about seven in 10 worry about not having enough money for retirement
Gallop Poll, April 22, 2014

The Gallop Poll’s finding that “the top problem … is not having enough money for retirement” reflects  the consensus findings of every article and poll that deals with the IRA Investor.

From a slightly different perspective then, it is safe to say that the risk of running out of money during retirement is the risk  the IRA Investor is worried about. We define this as Type II Risk.

Paradigm Shifts

To address this type II risk, we have identified a number of paradigm shifts that need to occur to accommodate and address this Type II Risk.

Paradigm Shift #1:
Rather than quiz the IRA Investor, educate him.

Do not merely  present a questionnaire that determines how the IRA Investor will invest for the rest of his life to someone who knows nothing about investing. The questions asked on the Type I Risk assessment questionnaire are presented to the IRA Investor who is lacking “very crucial information” that would change his answers if he had access to it.  In addition, this questionnaire is rarely administered after the initial assessment, even though the IRA Investor’s risk tolerance level may have changed as he aged and learned more about the market.

The Missing “Very Crucial Information”

  1. History of the Stock Market
  2. Concept of a 50 year investment horizon
  3. Strategy of Dollar Cost Averaging
  4. Strategy  of Buy and Hold
  5. Few, if any, diversified portfolios outperform the CRSP US Total Market Index
  6. Matching the market is good enough. No need to “beat the market”.

We suggest that if the IRA Investor were knowledgeable in the areas presented above, he would have radically different answers to the traditional risk assessment questionnaire.

1. History of the Stock Market

This  graph of the Dow Jones Industrial Average (hereafter, “DJIA”) values from 1900 to 2014 shows that the trend of the market is up; regardless of temporary declines.

DJIA Chart 1900 - 2014

Note the precipitous decline during the “Great Depression” (381 down to 41).  The great depression of 1929 – 1932 was a catastrophic event for those who were counting on their stock portfolios for retirement. The market had huge losses (-17%, -34%, -52%, -23%)  four years in a row. Since then, however, the market has grown by 3570%!

Paradigm Shift #2
Investment Horizon Is 50 years.

Everything presented herein is premised on the assumption that, over the long run, the US economy and the world’s economy will continue to prosper and this will be reflected in the value of the US stock market.

Warren Buffet supports this assumption:

“The nice thing about investing in stocks is that, over time, equities are going to do well,” Buffett tells USA TODAY. “American business is going to do well. America is going to do well. So you have the tide with you Building wealth in stocks is still the way to go, even though the ride can get bumpy from time to time.”

Every pension fund, insurance company, bank, mutual fund, etc. operates under this assumption. If there is a fundamental global shift, then everyone will be plowing new ground. At that time, it will be the job of the advisor to recognize these changed fundamentals and to alter his clients’ investment plans accordingly.

We proceed then, operating under the assumption that in the undefined “long run”, the direction of the market, as represented by the DJIA, is up.

Almost all presentations of how well a particular investment has fared is presented in periods of 1, 3, 5, 10 year periods. Accordingly, Investment Advisors and their IRA Investor clients are conditioned to think in those same comparison periods.

Nonetheless, the investment horizon for a 35 year old male is at least 50 years! This includes the 30 years of accumulation until age 65 and, since the life expectancy for a 65 year old male which is 20 years. We now define the previously ‘undefined long run” to be 50 years.

The IRA Investor must internalize this important fact. The IRA Investor must think REALLY LONG term. He must be conditioned to ignore market short term instability. This means no more discussion of 10 year or even 20 year trends. The IRA Investor needs to be taught to think in terms of 50 years, not what the market may or may not do in the next year, or 5 years or 10 years, etc. The IRA Investor needs to be taught to ignore any short term market instability.

Let the IRA Investor consider what life would be like when he reaches retirement age and has no money. That should help him think in term of a 50 year horizon.

A 50 Year Investment Horizon Changes Everything

A 50 year horizon guarantees that the IRA Investor is not going to lose his money. Index Fund Advisors (IFA.com) introduces a concept they call Rolling Periods. For a selected time period, say 15 years, they look at every instance of 15 years since Jan 1, 1928 through April 30, 2015. There are 869 Rolling 15 year periods in that time frame. The first one starts on Jan 1, 1928 and ends on Dec 31, 1943. The second rolling period starts on Feb 1, 1928 and ends on Jan 1, 1944, etc.

The table below is derived from Index Fund Advisors data. It considers the 449 fifty year rolling periods, the first one starting January 1, 1928.  It shows the results of a portfolio that would have been invested in 100% equity (which will be our 6th paradigm shift) over 449 50 year periods.

Rolling Period Return Data:

87 years, 4 months  (1/1/1928 – 4/30/2015)

Investment Horizon in years 50
Number of 50 Year Rolling Periods 1928 – 2015 449
Median Annualized Return (50th percentile) 11.02
Median Growth of $1 185.99
Lowest Rolling Period Date 9/29-8/79
Lowest Rolling Period Annualized Return 7.43
Growth of $1 in lowest period 36.03
Highest Rolling Period Date 7/49 – 6/99
Highest Rolling Period Annualized Return 13.92
Growth of $1 in highest period 673.03
Source: Index Fund Advisors100 % Equity Portfolio

The bottom line… no rolling 50 year period experienced less than a 7.43% annual return.  The worst period is that of “The Great Crash of 1929 – 1932”. The average for all the 449 fifty-year rolling periods was a 11.02% annual return.

Paradigm Shift #3
Dollar Cost Averaging

Dollar Cost Averaging  (DCA) is the Golden Chalice of investing for the IRA Investor. It is the engine that drives the contrarian view. DCA is the technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.

For example, you decide to purchase $100 worth of XYZ each month for three months. In January, XYZ is worth $33, so you buy three shares. In February, XYZ is worth $25, so you buy four additional shares. Finally, in March, XYZ is worth $20, so you buy five shares. In total, you purchased 12 shares for an average price of approximately $25 each.
When the price of XYZ goes up each one of the 12 shares will participate in the gain. With this technique, so long as the price goes up eventually, the investor will have bought at an average price that is lower than the selling price. DCA happens automatically when the IRA Investor invests periodically, in the same security, come hell or high water.

For the IRA Investor with a long term perspective, DCA is the engine that will ensure the highest possible return. It is the mechanism whereby the investor is guaranteed to buy low and sell high. IIt is the force that keeps the IRA Investor invested during down markets. The IRA Investor must understand and internalize that during down markets, he is getting shares at a discount, at a bargain price and they WILL be more valuable in the future – because the long term trend of the market is up. He must understand that he is to NEVER EVER sell during a down market but instead, if possible, double down on his monthly investment amount.

Paradigm Shift # 4
Buy and Hold Strategy

The investment strategy of “Buy and Hold” becomes the operative strategy for the IRA Investor. This strategy complements the 50 year investment horizon and dollar cost averaging strategies. Buy and Hold” is a proven strategy for accumulating wealth. Other less successful strategies are “market timing”, “stock picking”, “value investing” and “manager picking”.

Buy and Hold means just that. The IRA Investor buys a security and holds it until retirement. Under no condition is the security sold because of market ups and downs. Knowing that no 50 year period has ever lost money, there is no reason for the IRA Investor to ever sell during the asset accumulation phase of his investment horizon.

To reinforce this concept, the IRA Investor can imagine himself at age 65 with NO MONEY.

Paradigm Shift # 5
Diversification is NOT the Solution To Type II Risk

It is our position that the benefit of a diversified portfolio is overrated. It’s only purpose is to prevent the IRA Investor from selling out when ”the market”, typically the DJIA, is tanking.  The idea is that because the IRA Investor’s portfolio is not going down as fast as the DJIA, he will stay in the market.

While the diversified  IRA Investor may sleep better at night in the short run, the relative lack of performance in the long run is going to give him nightmares in his dotage.

The rationale for a diversified portfolio is well known – but wrong!

Callan Periodic Table 1996 - 2015, S&P 500 highlighted

The Callan Periodic Table of Investment Returns (shown above) is often presented as a strong case for diversification. In fact, it touts itself as just that.

The Callan Periodic Table of Investment Returns conveys the strong case for diversification across asset classes (stocks vs. bonds), investment styles (growth vs value) capitalizations (growth vs value), capitalizations (large vs small) and equity markets (U.S. vs international). The Table highlights the uncertainty inherent in all capital markets. Rankings change every year. Also noteworthy is the difference between absolute and relative performance as returns for the top performing asset class span a wide range over the past 20 years.”

This quote from FutureAdvisor‘s (FutureAdvisor.com) website explains how the uneducated  IRA Investor presumably  benefits from diversification:

As the Callan Periodic Table of Investment Returns shows, in some years stocks beat bonds, in other years it’s emerging markets, or real estate, or some other asset class. Broad diversification helps capture these long-term returns of the market and reduces risk.

And finally, this statement pretty well sums up the collective conventional wisdom of diversification:

Diversification is important because we have no way of knowing which investments or asset classes will perform well or poorly or when.

Ultimately, you want to end up with a stocks-bonds mix that’s consistent with your true tolerance for risk, and that you can comfortably stick with even when the market heads south.

So, Diversification Type I is all about preventing the investor from selling out when “the market heads south”

The Contrarian View of Diversification

There are many reasons to discount the emphasis on Diversification.

Equity Asset Classes Are Highly Correlated

The table below shows the high level of correlation between the very asset classes that are identified in the Callan quote above; that is, stocks vs bonds, growth vs value, large vs small, US vs International.

correlation matrix of funds

Because all equity funds are correlated, one-to-another by at least 78%, they will fall or rise in lockstep. The table presents strong evidence that a large movement in one asset sector is unlikely to be tempered by a counter movement in a different asset sector.

In other words, it is very unlikely that the decrease in value of one of the classes will be compensated for by a rise in another asset class. The presumed safety of being diversified will not be realized; thus, there is no protection against Risk Type I with a portfolio consisting of the equity components of the IFA table.

Diversified Portfolios Under Perform Total Market Index

The IRA Investor, seeking to avoid running out of money during retirement (Risk Type II), wants the biggest possible pot of money by the time he retires.

To address Type II Risk, the IRA Investor needs the biggest possible annual return on his portfolio. We will show that a diversified portfolio does not produce the biggest possible annual return viz-a-viz a single broad market index such as the  CRSP US Total Market Index

Let us look again, at what many consider to be the quintessential proof of the need for diversification, the Callan Periodic Table of Investment Returns.

Callan Periodic Table 1995-2014

The table shows annual returns for key indices ranked in order of performance for the years 1995 through 2014. Each index is represented by a different color. As is readily apparent, no index/color consistently dominates the returns. The table looks like a patchwork quilt. This visually and dramatically demonstrates that it is impossible to pick a winner from one year to the next.

A recent unpublished study (Schaber & Schaber, 2014) compared the final value of a portfolio consisting of all the indices contained in the  Callan Periodic Table of Investment Returns to the final value of the S&P 500 over a 20 year period. The S&P 500 outperformed the combined Callan Periodic Table indices  by over 1.5% each year over the 20 year period.

S&P500 VS Callan Periodic Table - 1991 - 2015

The table above summarizes the data in the Callan Periodic Table 1991 – 2015. The average annual return of the S&P 500 exceeded the average annual return of the diversified portfolio by 0.8% each year. There was no performance benefit in being in a diversified portfolio, not even one as highly touted and diversified as the Callan table of investment indices.

Because the IRA Investor is in the market for 50+ years, it is certain that investing in a diversified portfolio such as that represented by the Callan Periodic Table of Investment Returns will  produce less value than merely investing in the S&P500 over a 50 year period.

Note also that the values in the table represent indexes. Unless the average IRA Investor is investing in the indexes, history has shown that he will under perform the indexes.

To put it more directly, a portfolio consisting of only the S&P 500 (or some other broad market index fund) is likely to produce  more money at retirement time, than is a diversified portfolio.

FACT: No portfolio that contains 10% or more of bonds and cash can outperform a 100% percent equity portfolio. Why? Take the best 100% equity portfolio and reduce it by 10%; it will not perform as well since the bonds and cash have a lower annual return than the equity.

This conclusion is substantiated by numerous comparative studies performed by the authors. Results of these studies can be viewed at this web address https://investingforretirement.info/diversified-portfolios-examined/

The conclusion is that being invested in only the S&P 500 (or some other broad market  index ETF) will produce, over the long run, greater returns than would be obtained had one invested in the assets proscribed by the Callan Table.

The corollary  to the conclusion is that there is no risk so long as the overall trend of the 50 year horizon market is up.

Debunking “Expert” Opinion

Next, let us look critically at some of the glittering generalities presented for the case for diversification. First, let’s consider the quote from Future Advisors:

Broad diversification helps capture these long term returns…”?

You only “capture returns”  if you sell.  Since the IRA Investor is in the market for the long haul, he  doesn’t care who’s on first this year or the next. He will only be “capturing returns” after a 30year period of accumulation. There will be no selling or capturing of long term returns during this 30 year accumulation period.

“…reduces risk“.

Once again, “reduce risk” is presented as the rationale for diversification. What risk? Type I Risk? That is not the important Risk Type. If you are in the accumulation phase of the retirement investing cycle, you don’t care about Type I Risk at all.  During the accumulation phase, THERE IS NO RISK OF LOSING MONEY! The more the market declines, the more shares you accumulate with each purchase (see dollar cost averaging) and you will reap your rewards when the market turns around – as it invariably does (see History Is On Your Side).

And finally, returning to this quote that  sums up the collective conventional wisdom of diversification:

“Diversification is important because we have no way of knowing which investments or asset classes will perform well or poorly or when”.

True, we don’t; but when we have a 50 year investment horizon, a Buy and Hold strategy, Dollar Cost Averaging and investment in a single broad market index ETF,  we don’t care about which investments or asset classes will perform well or poorly or when.

Ultimately, you want to end up with a stocks-bonds mix that’s consistent with your true tolerance for risk, and that you can comfortably stick with even when the market heads south.

We have already determined that the “true tolerance for risk” is determined by a flawed instrument and that our newly educated  IRA Investor is in the market for the 50+ years  and feels no need for a “diversified” portfolio with a “stocks-bonds mix”. Any thing other than a 100% equity portfolio will not address the true risk, that of running out of money during retirement (Type II Risk).

Conclusion WRT Diversification

We have presented a strong case against the presumed benefits of diversification:

  1. Equity classes are highly correlated; they all move in the same direction.
  2. Diversified portfolios under-perform a portfolio consisting of a single total market ETF fund.
  3. “Expert” opinion is not applicable to the long run perspective of the IRA Investor.

We can now redraw the Risk table presented earlier and add the Contrarian Solution to it.

Risk Type Description Conventional Solution Contrarian Solution
I Panic and Bail when market declines Diversification Not considered
II Run out of money during retirement. Not considered 50 Year Horizon, Dollar Cost Averaging,  Buy and Hold, “market” performance is good enough, broad market index ETF.

Paradigm Shift #6

The IRA Investor will be best served with a portfolio that consists of a single, broad market ETF.

best served” means that when the investor dies, the value of his portfolio at death and the total income received from his portfolio will be greater than if he had been invested in a  diversified portfolio.

single, broad market ETF”  is now identified to be the Vanguard Total Market ETF (ticker: VTI).

VTI tracks the performance of the CRSP US Total Market Index, which represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and micro-cap stocks regularly traded on the New York Stock Exchange and Nasdaq.

Bloomberg calls VTI “a damn near perfect” ETF.

Paradigm Shift #7

There is no need to “beat the market”; “the market” being the DJIA or VTI. VTI IS the market! You haven’t beat it but you did match it. Just doing as well as the market is good enough. In fact, multiple studies have shown that the typical investor fails to capture the same annual return as that of the DJIA. The average shortfall is over 3% per year.

With VTI as the single security in the portfolio and because the Vanguard Total Market ETF either exactly matches the DJIA or does slightly better,  the investor is guaranteed to do as well as the market.

No IRA Investor or investment advisor is ever going to outperform VTI over a 50 year period!


We have now identified how the IRA Investor can protect himself against running out of money when he is retired (Type II Risk):

  • Invest as much money as possible in VTI every month, regardless of the market’s direction until the day he retires.
  • Sell off shares of VTI as necessary, ONLY  after officially retired.

This behavior coincidentally also overcomes Type I Risk.

The “Sell off shares” phase introduces a new set of contrarian paradigm shifts but that is for another paper.

* “his” implies a male. We will use the male pronoun throughout the paper to avoid the stilted and unnecessary syntax of his or her, him or her,  he or she, etc. Everything presented applies equally to females.