Analyzing the case for Diversification
The rationale for a Diversified Portfolio is neatly summed up with this quote from FutureAdvisor‘s website
As the famous 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.
“…reduces risk“. In a word, the point of having a Diversified Portfolio is to reduce risk. What risk? If you are in the accumulation phase of The Plan, you don’t care about risk one whit. During the accumulation phase, THERE IS NO RISK OF LOSING MONEY! The more the market declines, the more shares you accumulate and you will reap your rewards when the market turns around – as it invariably does (see History Is On Your Side).
“Broad diversification helps capture these long term returns...”? You only “capture” returns if you sell at the moment the return is above normal. As the “famous Callan Table” shows, the next year the same asset is likely to be at the bottom of the pile. Since you are in the market for the long haul, you don’t care who”s on first this year or the next. They all average out to the Dow.
If you are in the withdrawal stage of the plan, the value of your at-least-15-year-old, now sizable portfolio may decline, but it will rebound. You’ve got 15, 20 more years to live. The market will recover in that time period (see History Is On Your Side). You do NOT want to be in tortoise mode even when you are retired. That portfolio is still working for you. Don’t cripple it.
“The Plan” is a plan about Investing For Retirement. The length of time The Plan will be in effect for a 35 year old could easily be 47 years (30 years till retirement, 17 years life expectancy at age 65)!
During The Accumulation Phase
A Diversified Portfolio consists of multiple securities representing different asset classes. Ideally, these asset classes will not be correlated with one another. (In practice, they are usually highly correlated.) Ideally, for every asset class that is not “doing well” there may be one that is “doing well”, thereby keeping your portfolio’s performance even with what it “should” be doing. If the portfolio is constructed with non-correlated securities, then, in theory, the total value of your portfolio will not decline as much as it otherwise would when the market is tanking.
If you are in the accumulation phase, that is, you are not withdrawing from your portfolio, it does not matter what each component of a diversified portfolio is doing. You are only concerned with the total value of your portfolio. If the only security in your portfolio is VTI, then the total value of your portfolio is more likely to be higher than the total value of a Diversified Portfolio. See Diversified Portfolio Performance for proof of this statement.
If your portfolio consists only of that one security that defines “the market”, i.e. VTI, then you are accomplishing exactly what a Diversified Portfolio is attempting to achieve with its diversity of securities.
During The Withdrawal Phase
The withdrawal phase introduces a whole new set of problems if you have a diversified portfolio.
- During the withdrawal phase, you will probably have to sell off securities from your portfolio. Few will have portfolios large enough to live off the dividends without drawing down the principle. What securities will you sell?If you are following the plan, the decision is simple. On your first day of retirement, set up Sharebuilder to automatically sell $MIN worth of VTI and deposit the proceeds to your checking account. You are done.If you have a Diversified Portfolio, you now have to decide what securities and how many shares of each you need to sell in order to have $MIN a month. You need to sell some of each in order to maintain the asset class balance that you have decided is best for you. You have to make these decisions each month as the market conditions will always be changing. Do you really want to be doing this in your dotage?
- Diversified Portfolios are supposed to reduce the risk viz-a-viz non diversified portfolios. The “risk” that a Diversified Portfolio reduces is that the market will be down just when you need to start selling from your portfolio. The Diversified Portfolio is supposed to decline less than a non diversified portfolio, thereby reducing your risk.But what is meant by “decline less”? Decline by a smaller percentage or decline by a smaller amount? It is the total value of your portfolio that is important. The value of your portfolio of VTI only will, most likely – again, see Diversified Portfolio Performance, be significantly larger than a Diversified Portfolio. Even IF the Diversified Portfolio falls by a lesser percentage than VTI, the dollar value of the Diversified Portfolio will still be less than that of a portfolio that is invested in VTI only! You would be running a risk with a single stock portfolio if you needed to withdraw everything all at once. But, you are not selling everything, all at once. You will be taking money from your Retirement Portfolio gradually, over a period of years. If you have been building your retirement portfolio over a thirty year period, you will have enough to withstand a temporary downturn.
As will be shown in a future page, few diversified portfolios outperform the VTI over a long period of time. See Diversified Portfolios Examined. In addition, they are difficult to design and maintain. The chance that you will design and maintain a diversified portfolio that outperforms the market and stick with it for 50 years,with or without an investment advisor, is zero.