Why Not A Diversified Portfolio?

Every investment advisor will recommend that you diversify your portfolio in order to “reduce risk”.

What Is A Diversified Portfolio?

Diversification is a technique that (allegedly) reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event.

Why A Diversified Portfolio?

 It aims to maximize return by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while  (allegedly)  minimizing risk.

Why Not A Diversified Portfolio? Here’s Why…

  1. Diversified portfolios DO NOT reduce or minimize “risk”. EXPLAIN
  2. Diversified Portfolios do not perform any better over the long run than a single fund that tracks the S&P 500 . EXPLAIN!
  3. A truly “diversified portfolio” will include an International component. However, adding International Equity to the IFR recommended portfolio will reduce its performance. EXPLAIN!
  4. Higher costs of a diversified portfolio reduce performance potential. EXPLAIN!
  5. Diversified Portfolios are difficult to construct. EXPLAIN!
  6. Diversified portfolios are difficult to maintain. EXPLAIN!
  7. There are no benefits to a Diversified Portfolio when the investment horizon is 50+ years as it is with The Plan. EXPLAIN
  8. You will need an investment advisor if you insist on a diversified portfolio. This will cost you even more money. EXPLAIN
  9. A 100% Single Equity  Portfolio  (S&P500)  Outperforms A Diversified Portfolio Every Time EXPLAIN!

  10. On-line broker, Fidelity, inadvertently demonstrates that diversification does not match S&P500 performance. EXPLAIN.
  11. Owning only a fund that tracks the S&P500 is guaranteed to capture all “the market” has to give. EXPLAIN!
  12. A Theoretical Proof that debunks the “diversify” advice:
    On The Principle of Diversification and Risk; A Contrarian View

Conclusion

The objective  of the Investing For Retirement investor is to have as much money during retirement as possible. Having a Diversified Portfolio does not improve the chances that there will be more money at beginning of the retirement period.

As shown above, it is most likely that there will be less money from a diversified portfolio than from a portfolio consisting of only VTI.

Diversified Portfolio Definition

Diversifed Portfolio.

Beware the “You Must Diversify” Mumbo Jumbo

Wealthfront is an online investment management company that says this about itself:

Wealthfront is re-imagining how people invest their money

By building an automated investment service from the ground up to put the client first, Wealthfront is paving the way for a new generation of investors to achieve their financial goals. We believe this is a once-in-a-generation opportunity to change an industry and build something new, something different, something better.

Wealthfront makes it easy for anyone to get access to world-class, long-term investment management without the high fees or steep account minimums

They invoke all the important sounding concepts in their marketing

  • We use Modern Portfolio Theory (MPT) to identify the ideal portfolio for each client. The economists who developed MPT, Harry Markowitz and William Sharpe, received the Nobel Prize in Economics in 1990 for their groundbreaking research.
  • We also evaluate each asset class on its potential for capital growth and income generation, volatility, correlation with the other asset classes (diversification), inflation protection, cost to implement via ETF and tax efficiency.
  • Wealthfront determines the optimal mix of our chosen asset classes by solving the “Efficient Frontier” using Mean-Variance Optimization (MVO).
  • MVO requires, as inputs, estimates for each asset class’s standard deviation, correlation and expected return.
  • To estimate each asset class’s expected returns, we start with the Capital Asset Pricing Model (CAPM) (Sharpe, 1964) as the baseline estimate.
  • “tax-loss harvesting”
  • “Automatic rebalancing”
  • Efficient Frontier

The whole white paper, “Wealthfront Investment methodology White Paper”  can be read HERE.

So, How Does The Portfolio Recommended by Wealthfront Do?

But it turns out, that with all their attention to modern portfolio theory, et. al. the Wealthfront’s portfolio failed to beat the simple S&P 500 over the ten year period, 1/31/2007 – 11/16/2017.

Proof of this outcome is presented in THIS spreadsheet.

The chart below says it all.

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

 Explanation

  • Each of the 10 colors in the above chart represents one type of asset in a “diversified” portfolio.
  • The type of security and the annual gain/loss is shown in each colored block and reproduced in the table that can be accessed by clicking HERE
  • Each column represents one year; twenty years of data are represented in the chart.
  • The yellow line tracks the annual percent gain/loss of the S&P 500.

After 20 years (1996-2015) the average annual gain of the S&P 500 is 10.39% versus 9.46 for the diversified portfolio of 10 “diversified” assets.

Conclusion

To summarize, in any given year, some of the diverse funds will do better than S&P500, some will do worse. Over the years, these random variations around the S&P 500  trend line will sum to zero meaning that a diversified portfolio will not outperform the S&P 500, nor will it reduce your overall risk over a horizon of 20 years or more.

If, after 20 years, the average return of a diversified portfolio is less than the average return of the S&P 500, there is no reason to invest in anything other than a fund that merely tracks the S&P 500. This superior performance holds for all time periods greater than 15 years.

The data that supports the conclusion can be seen by clicking on this link: S&P vs Callan Diversified Portfolio.

In 2008, the year when the market lost OVER half its value at one point, the diversified portfolio of 10 securities lost 32.5%, the S&P lost 37% of its value. Missing out on the superior overall performance of the S&P 500 is a high price to pay just to lose a little less in the worst market in 80 years.

The “Investing For Retirement” Position

We do not believe that any one who is Investing For Retirement needs to have a diversified portfolio during the active “accumulation” stage of the accumulate/withdraw stages. In fact, having a diversified portfolio is actually contrary to the Investing For Retirement investor’s best interest.

Other Risks, Not Addressed By Diversification

Failure to Participate Until Retirement

This is the real risk. That you will quit contributing to your Sharebuilder account every month.  You might get discouraged during times of a declining market. It’s tough to see the value of your most important asset, losing value. But this is when you should be rejoicing. Every one of your dollars that you invest during this declining market will buy more shares than they would have when the market was up. These additional shares will ALL increase in value when the market turns around as it invariably does (see History Is On Your Side, Dollar Cost Averaging).

You have to have confidence that the market will recover, as it always has. If you don’t have that core, fundamental belief, then you shouldn’t be invested in the markets at all. Keep investing, no matter what; it’s that simple.

Risk of  Losing Purchasing Power

Purchasing power is the real coin of the realm. You can lose purchasing power because you have less money or you can lose purchasing power because your money won’t buy much. Inflation is a constant, persistent and insidious truth. If  you limit the performance potential of your portfolio by loading up your portfolio with “safe” (e.g. CDs or bonds or money market funds) but poor performing assets, because of fear of losing money, you will lose  purchasing power.

Risk of Losing Potential of Alternative Investments

There may be some other investment alternatives that MIGHT get you more money. You might also lose a lot of money chasing them down. I did. Purchase only VTI and forget about finding a silver bullet.

Risk of Losing the Plot

This is about the risk of not investing continuously until retirement. Following the plan is a commitment to a long term investment policy. There will be all kinds of reasons for not making the monthly investment. The desire to skip “just this month’s investment” will be hard to ignore. The Plan is a “set and forget” plan. Easy to follow, simple to execute, no more having to use energy worrying about what to do.

Risk of Losing Faith

If the market is down for 2,3 years in a row, it is easy to become discouraged as you see the value of your holdings decrease. You give up. As has been demonstrated earlier,  (see dollar cost averaging) these down markets are pure gold for someone who is in the “accumulation” period of the plan. You get more shares for the same amount of money. Later when the market recovers, ALLl those “cheap” shares increase in value and the total value of your portfolio increases exponentially.

Risk of Panicking

This is the “traditional risk” that Investment Advisors” caution against and it is the reason they recommend a diversified portfolio.

If the market is down, worse than losing faith and giving up, you may be tempted to sell all now and then get back in when the market starts back up. This “market timing” is  the worst strategy possible. You are guaranteed to “Buy High, and Sell Low”. You will lose lots of money with this strategy. It has been proven over and over.

Knowing when to get back into the market is the problem. Now? No Wait; Now? No; Now? OK- how much? All of it? Wait, the market just went down again. This behavior will whipsaw you in and out of the market until you have nothing left. Been there, done that. I have a horrible war story to relate about this strategy.

Risk of Listening to Advice, Chasing Performance

Taking your eye off the prize because, for a while, some other security is doing a lot better than VTI. But it never lasts. By the time you recognize a high performing security, it is at the end of its run and you will again , “Buy High and Sell Low”.

  • Trying to “beat the market”

    Regular investments in a single security is not cool. Not much to talk about (except the performance of your portfolio – which, more than likely is better than your peers). You may be tempted to change things up. Try something new. DON”T. There are no strategies that will accumulate more money in the long run than this simple plan that I have given you.
    .

  • Listening to “advice” from “professionals”

    Investors are the recipients of constant advice. Tips abound. Can’t miss strategies are all around you.

Losing Potential of Diversified Portfolio

You may not believe that VTI can outperform most diversified portfolios. You may not trust the examples I have presented. As I indicated, I’m sure there are diversified portfolios that outperform VTI but they are nearly impossible to construct. Many have tried, few have succeeded.

If you feel you must build a diversified portfolio digest the contents of this website, Index Fund Advisors.  It does an excellent job of presenting the case for a diversified portfolio . Index Fund Advisors is the only investment advisor I would listen to. Their advice is backed by solid research.  Remember, diversified portfolios have their own problems.

The key take-away

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