Financially reviewed by Patrick Flood, CFA.
Portfolio diversification is considered to be the only free lunch in investing. In this post, I’ll show you why and how to diversify your portfolio.
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What Is Portfolio Diversification?
Portfolio diversification simply means combining different assets in one’s investment portfolio, effectively spreading out your risk. As the related adage says, “Don’t put all your eggs in one basket,” as it could be disastrous. This couldn’t be more true in relation to investing and retirement planning.
By diversifying one’s portfolio, the primary goals are to boost and maintain returns over time and also reduce the risk profile of the portfolio as a whole to avoid the permanent loss of capital and decrease the dispersion of possible outcomes. Specifically, we want to hold assets that don’t move in the same direction at the same time. Portfolio diversification can describe holding:
- Different asset classes – stocks, bonds, etc.
- Different assets within those classes – Google, Amazon, Johnson & Johnson, Tesla, treasury bonds, corporate bonds, municipal bonds, etc.
- Different cap sizes – small stocks, large stocks, etc.
- Different styles – value stocks and growth stocks.
- Different sectors – technology, financials, industrials, etc.
- Different geographies – stocks and bonds from different developed countries and developing countries around the world.
- Different exposure through time, aka temporal diversification.
- Different, independent sources of systematic portfolio risk, known colloquially as factors.
I walk the walk; I check all these boxes in my own portfolio. I’ll show you exactly how to achieve all these later, and it’s easier than you might think. But first let’s talk about why portfolio diversification is important in the first place.
Why Is Portfolio Diversification Important?
To illustrate why portfolio diversification is important, we can use a simple example. As is usually done, we’ll use stocks for the example, as stocks are typically treated as the basis for an investment portfolio due to their greater expected returns compared to other asset classes.
While it may have paid off in cases like Apple and Amazon (survivorship bias!), it should be pretty obvious that it would be extremely risky – and a bad idea – to put your life savings in a single stock for 30+ years. Had you done this with Lehman Brothers or Pier 1 Imports, for example, it would have been a very different story – you’d be left with next to nothing. So we want to hold more stocks.
But we also know stock picking doesn’t work. So extending our example to its logical conclusion, we want to go broader with more types and sizes of stocks, and then going even broader, more asset classes outside of stocks.
Consistency is perhaps the most important thing in investing. Do whatever allows you to stay the course. Portfolio diversification “stabilizes” returns and trims peaks and valleys for a smoother ride. It is the best defense against uncertainty and black swan events. Generally speaking, the shorter your time horizon, the more important diversification becomes. Similarly, once you reach your financial objective (your dollar amount at which you can retire), there’s no real reason to not maximize diversification. That is, after you win the game, stop playing. The exception would be if for some reason you want to continue to attempt to aggressively grow your portfolio after retirement in order to grow the legacy to leave to someone as an inheritance, but this tactic may very well result in you losing the money you need to live in retirement.
At a certain level of diversification on the sliding scale from none to maximum, one’s desire to keep diversifying will depend on their risk tolerance, time horizon, and subsequent asset allocation. That is, how much volatility (fluctuation in value) and drawdown (drop in value) can they stomach psychologically? And how much capital can they realistically afford to lose based on the time until their financial objective? But we can pretty reliably conclude that even the young investor who wants to go 100% stocks for a while should still probably be fully diversified within stocks by using index funds like Vanguard’s total U.S. stock market fund, VTI, or their total world stock market fund, VT.
We must also acknowledge the fact that most investors, especially novices, tend to severely overestimate their tolerance for risk and also succumb to recency bias. If you maximize risk by investing 100% in stocks but then you panic sell during the next market crash when your portfolio’s value drops by 40%, you have overestimated your risk tolerance, and your asset allocation should be adjusted to be more conservative. Recency bias refers to the erroneous belief that the recent past will continue into the future. Investors in the late 1970’s just assumed that high inflation had become a normal part of the economic landscape forever. Investors over the decade 2010-2019 flocked to large cap growth stocks and specifically Big Tech based on their stellar performance during the period, though their valuations now indicate that they have lower future expected returns. The future is unknowable. Trust that you will encounter different economic and market regimes – and likely several crashes – that will test your ability to stay the course. Thus, the sensible investor should prepare accordingly by diversifying.
The annual Callan Periodic Table of Investment Returns is probably the best illustration of why broadly diversifying one’s portfolio is important:
In short, this quilt tells us that different asset classes in different geographies outperform at different times, and this is impossible to predict ahead of time, so it’s likely wise to have some exposure to all of them. Let’s look at how to do that.
How To Diversify Your Portfolio
We can talk about how to diversify your portfolio by going through each asset class. Remember, based on the beautiful quilt above, a low- to medium-risk-tolerance investor should probably want to diversify across different asset classes.
My website analytics tell me the majority of my audience are males in the United States age 18-45. Stocks, also called equities, probably form the basis of the portfolios of this audience (and they probably should). Again, stocks have greater expected returns than any other asset class because they are considered the riskiest, so this makes sense. On average, securities markets tend to reward investors for taking on more risk.
Once again, we know picking individual stocks is not the best idea. I won’t go into all the details here (I did in a separate post here), but here are some quick facts that illustrate this point:
- The evidence has shown that even most professional investors can’t pick winners that beat the market over 10+ years, much less the average retail investor like you and me.
- On the 50th birthday of the S&P 500 index, only 86 of the original 500 companies remained.
- Blindfolded monkeys randomly throwing darts for stock picks have beaten top hedge fund managers not just once, but consistently.
- Most stocks underperform the market; only a select few drive massive returns. Specifically, for U.S. stocks from 1926 through 2017, in terms of lifetime dollar wealth creation, only 4% of stocks accounted for the net gain above T Bills. Looking at global stock returns from 1990 through 2018, only 1.3% of stocks accounted for the positive wealth creation in excess of T Bills.
We can solve these issues in U.S. stocks by using broad index funds like VOO (S&P 500) or VTI (total U.S. stock market). The former tracks the S&P 500, the 500 largest stocks in the U.S., and the latter tracks the entire U.S. stock market which includes smaller companies.
These index funds also provide immediate diversification across all stock sectors – technology, industrials, financials, etc. Just like we can’t predict the performance of individual stocks, we can’t predict the performance of sectors either:
A broad index fund is self-cleansing in this sense; well-performing stocks and sectors rise within the fund and poor-performing stocks and sectors decrease in weight.
But the U.S. is just one single country of many around the world, and like the Callan periodic table tells us, we wouldn’t expect one country to consistently outperform. If one did, that outperformance would also lead to relative overvaluation and a subsequent reversal.
At global market weights, U.S. stocks only comprise about half of the global stock market. International stocks don’t move in perfect lockstep with U.S. stocks, offering a diversification benefit. If U.S. stocks are declining, international stocks may be doing well, and vice versa.
If you’re reading this, chances are you’re in the U.S. You also probably overweight – or only have exposure to – U.S. stocks. This is called home country bias. The U.S. is one single country out of many in the world. By solely investing in one country’s stocks, the portfolio becomes dangerously exposed to the potential detrimental impact of that country’s cultural, political, and economic risks. If you are employed in the U.S., it’s likely that your human capital is highly correlated with the latter. Holding stocks globally diversifies these risks and thus mitigates their potential impact.
Excluding stocks outside the U.S. means you’re missing out on leading companies that happen to be based elsewhere. Similarly, there have been periods where a global portfolio outperformed a U.S. portfolio. During the period 1970 to 2008, an equity portfolio of 80% U.S. stocks and 20% international stocks had higher general and risk-adjusted returns than a 100% U.S. stock portfolio. Specifically, international stocks outperformed the U.S. in the years 1986-1988, 1993, 1999, 2002-2007, 2012, and 2017.
Emerging Markets and international small cap stocks have crushed the U.S. market historically, for example, as they’re considered riskier, and investors are compensated for that greater risk. And this is just talking about performance. The volatility and risk reduction benefits are another conversation entirely, which is of huge significance for a retiree. If I were writing this in 2010 (or 1990, or 1980), we’d be talking about how a global portfolio beat a U.S. portfolio the previous decade. Consider the famous “lost decade” of 2000-2009, for example, during which the S&P 500 was down 10% but Emerging Markets were up 155% and international Developed Markets were up 13%. The important takeaway is that it’s impossible to know when the performance pendulum will swing and for how long, much less how those time periods would match up with your personal time horizon and retirement date.
For U.S. investors, diversifying globally in stocks is also a way to diversify currency risk and to hedge against a weakening U.S. dollar, which has been gradually declining for decades. International stocks tend to outperform U.S. stocks during periods when the value of the U.S. dollar declines sharply, and U.S. stocks tend to outperform international stocks during periods when the value of the U.S. dollar rises. Just like with the stock market, it is impossible to predict which way a particular currency will move next.
Dalio and Bridgewater maintain that global diversification in equities is going to become increasingly important given the geopolitical climate, trade and capital dynamics, and differences in monetary policy. They suggest that it is now even less prudent to assume a preconceived bet that any single country will be the clear winner in terms of stock market returns.
In summary, geographic diversification in equities has huge potential upside and little downside for investors.
I mentioned some international stocks funds in a different post here. You can’t go wrong with Vanguard’s VXUS (total international stock market), VEA (ex-US Developed Markets), and VWO (Emerging Markets). I actually compared those three funds here.
You can also just make it even simpler and go with a single fund solution for the entire global stock market: VT from Vanguard. VT is comprised of roughly 55% VTI and 45% VXUS, for example. VT covers all geographies, cap sizes, sectors, and styles (value vs. growth).
Bonds are also called fixed income. I wrote about what exactly bonds are and how they work in another post here if you’re curious.
Of interest to us here is the fact that stocks and bonds are uncorrelated with each other, meaning when stocks zig, bonds tend to zag. Bonds offer the lowest correlation to stocks of any asset class, and are thus the best diversifier to use alongside stocks. I’ll be referring to this concept of asset correlations a lot from here to the end of this post; it’s the primary concern in considering adding diversifiers to the portfolio.
On average, bonds are less risky than stocks. Because of that, they also have lower expected returns than stocks, especially at low interest rates. But here again, there have been extended periods where bonds outperformed stocks, so it would be foolish to ignore them completely, especially for risk-averse investors and/or retirees. Bonds are particularly useful for retirees who may desire to simply live off the interest payments.
You’ve maybe heard of the classic 60/40 portfolio. It is composed of 60% stocks and 40% bonds, considered a near-perfect balance of risk and expected return. Bonds mitigate the impact of the risks of holding stocks. Stocks mitigate the impact of the risks of holding bonds. Such is the beauty of diversification. Here’s an illustration of this 60/40 portfolio (using intermediate-term treasury bonds, specifically) compared to 100% stocks:
Notice how adding the bonds smooths out the ride (less volatility, measured by st. deviation, and smaller max drawdown) by making stock downturns less impactful, but sacrifices some performance (CAGR) in doing so. Specifically, the 60/40 portfolio’s volatility was about 1/3 lower, and its max drawdown was roughly half that of the 100% stocks portfolio, leading to its higher risk-adjusted return (Sharpe). Looking at the drawdowns (drops) better illustrates precisely why we hold bonds alongside stocks:
Notice how in the Dotcom crash of 2000 and the Global Financial Crisis of 2008, the 60/40 portfolio fell much less than the 100% stocks portfolio. This is particularly significant for a risk-averse investor. Again, I can’t stress enough that most investors severely overestimate their tolerance for risk and do not have the stomach for a 100% stocks position, only realizing it during a market crash and panic selling, which is precisely what you shouldn’t do. “100/0” or “60/40” is called your asset allocation, which is highly personal and is determined by your time horizon and risk tolerance. The asset allocation that’s right for you is the one that allows you to stay the course, invest regularly, ignore the short-term noise, and avoid panic selling during a market crash.
So now we know bonds can be useful. Which type of bonds do we choose?
We can diversify within bonds by holding different types – treasury bonds, corporate bonds, agency bonds, mortgage bonds, etc. You’d get exposure to all those in a total bond market fund like Vanguard’s BND. Just as with stocks, we don’t want to try to pick individual bonds. Bond index funds allow us to avoid having to.
But at this point we need to make an important distinction. In considering adding any additional diversifier, we’re always concerned with optimizing the diversification and risk profile of the portfolio as a whole, not the assets in isolation. Always view your portfolio holistically.
What does this mean in practical terms? Remember our concept of asset correlations. All things being equal, a lower correlation means a superior diversification benefit. Within bonds, corporate bonds (bonds issued by companies) are naturally much more correlated with stocks than treasury bonds (government bonds) are. I explored this concept in detail in a separate post here. In short, treasury bonds reliably act as a better diversifier for stocks than corporate bonds. They’re also conveniently more tax-efficient in taxable environments and avoid the credit risk, liquidity risk, and default risk inherent with corporate bonds. Total bond market funds usually contain about 25-30% corporate bonds.
What about maturity length? A bond’s maturity is the amount of time until its face value is repaid. A closely linked metric is a bond’s duration, a measure of its sensitivity to interest rate changes. Matching one’s time horizon to the bond duration minimizes interest rate risk. As maturity increases, so too do the bond’s volatility and risk. But remember we’re optimizing the portfolio holistically. Longer-term bonds are better able to hedge against stock downturns precisely because of this greater volatility, especially at low allocations. In short, I’d maintain that any long-term investor with 20% or less in bonds should be using long-term treasury bonds, even at low interest rates.
I can see the waves of comments coming in, which I see all the time on forums and Reddit threads:
- “Bonds are useless at low yields!”
- “Bonds are for old people!”
- “Long bonds are too volatile and too susceptible to interest rate risk!”
- “Corporate bonds pay more!”
- “Interest rates can only go up from here! Bonds will be toast!”
- “Bonds return less than stocks!”
So why long term treasuries? Here are my brief rebuttals to the above.
- Bond duration should be roughly matched to time horizon, over which time a bond should roughly return its par value plus interest. I’d guess most people reading this – myself included – have a time horizon of 20+ years. A bond’s duration is the point at which price risk and reinvestment risk – the components of what we refer to as a bond’s interest rate risk – are balanced.
- It is fundamentally incorrect to say that bonds must necessarily lose money in a rising rate environment. Bonds only suffer from rising interest rates when those rates are rising faster than expected. Bonds handle low and slow rate increases just fine; look at the period of rising interest rates between 1940 and about 1975, where bonds kept rolling at their par and paid that sweet, steady coupon.
- New bonds bought by a bond index fund in a rising rate environment will be bought at the higher rate, while old ones at the previous lower rate are sold off. You’re not stuck with the same yield for your entire investing horizon.
- We know that treasury bonds are an objectively superior diversifier alongside stocks compared to corporate bonds. This is also why I don’t use the popular total bond market fund BND.
- At such a low allocation of 10%, we need and want the greater volatility of long-term bonds so that they can more effectively counteract the downward movement of stocks, which are riskier and more volatile than bonds. We’re using them to reduce the portfolio’s volatility and risk. The vast majority of the portfolio’s risk is still being contributed by stocks. Using long bonds also provides some exposure to the term fixed income risk factor.
- We’re not talking about bonds held in isolation, which would probably be a bad investment right now. We’re talking about them in the context of a diversified portfolio alongside stocks, for which they are still the usual flight-to-safety asset during stock downturns. It has been noted that this uncorrelation of treasury bonds and stocks is even amplified during times of market turmoil, which researchers referred to as crisis alpha.
- Similarly, short-term decreases in bond prices do not mean the bonds are not still doing their job of buffering stock downturns.
- Bonds still offer the lowest correlation to stocks of any asset, meaning they’re still the best diversifier to hold alongside stocks. Even if rising rates mean bonds are a comparatively worse diversifier (for stocks) in terms of expected returns during that period does not mean they are not still the best diversifier to use.
- Historically, when treasury bonds moved in the same direction as stocks, it was usually up.
- Long bonds have beaten stocks over the last 20 years. We also know there have been plenty of periods where the market risk factor premium was negative, i.e. 1-month T Bills beat the stock market – the 15 years from 1929 to 1943, the 17 years from 1966-82, and the 13 years from 2000-12. Largely irrelevant, but just some fun stats for people who for some reason think stocks always outperform bonds.
- Interest rates are likely to stay low for a while. Also, there’s no reason to expect interest rates to rise just because they are low. People have been claiming “rates can only go up” for the past 20 years or so and they haven’t. They have gradually declined for the last 700 years without reversion to the mean. Negative rates aren’t out of the question, and we’re seeing them used in some foreign countries.
- Bond convexity means their asymmetric risk/return profile favors the upside.
- I acknowledge that post-Volcker monetary policy, resulting in falling interest rates, has driven the particularly stellar returns of the raging bond bull market since 1982, but I also think the Fed and U.S. monetary policy are fundamentally different since the Volcker era, likely allowing us to altogether avoid hyperinflationary environments like the late 1970’s going forward. That said, I’ve still thrown in some TIPS.
“The purity of noncallable, long-term, default-free treasury bonds provides the most powerful diversification to investor portfolios.”
Ok, bonds rant over.
Vanguard’s VGLT is a very popular fund for long-term treasury bonds. Its average effective maturity is about 24 years.
The research shows that diversifying internationally with bonds doesn’t really provide much benefit, but there are funds for that too. Popular ones include IGOV for international treasuries and BNDX for the total international bond market.
For those concerned about inflation, there’s a relatively new financial product called TIPS (Treasury Inflation Protected Securities) that are a complex type of bonds that keep up with inflation. A small allocation to TIPS may be prudent, especially for retirees. A popular low-cost fund for those is SCHP from Schwab.
Those wanting to be completely hands-off in selecting assets and their allocations can use a target date fund, which changes its asset allocation and risk profile based on your age, or a lazy portfolio.
Commodities (and Gold, Specifically)
Commodities refer to means of production – metals, energy, livestock, and agriculture. Investors typically turn to commodities to hedge against uncertainty and inflation, as their value is simply dependent on supply and demand. Commodities are usually lowly correlated to both stocks and bonds. Great, right? Not so fast.
Another important caveat to note at this point is that in a long-term portfolio, we want our added diversifiers to have positive expected real returns (a positive return after accounting for inflation). If they don’t, we’re reducing risk but we’re not expecting to be compensated for holding the asset, so it’s taking up valuable space in the portfolio and we’re not improving the return or risk-adjusted return (return per unit of risk; measured by Sharpe ratio) over the long term. Put another way, we don’t want to diversify so much to the point that we’re missing out on growth over the long term. Balance is key.
The conversation becomes a bit different for a short time horizon and/or for a very risk-averse investor. The tradeoff of lower returns may be perfectly acceptable for the reduction in portfolio volatility and risk. This is the idea behind the All Weather Portfolio. A retiree, for example, perhaps can’t afford to have their portfolio drop in value significantly, as they’re constantly making withdrawals to cover expenses.
Stock ownership is a claim on a company’s future earnings. A bond is a contractual obligation between a lender and a borrower, with interest payments going from the latter to the former. Unlike these, ownership of a commodity is not value-producing; it involves no earnings or cash flow and is simply a bet on production and/or consumption at that time.
Commodities are obviously useful to your everyday life, but not really as a long-term investment in financial markets. Think of owning a commodities fund as just paying for their storage somewhere. With technological advances, we would expect commodity prices to fall or stay flat over the long term. After fees (commodities funds are expensive; the popular PDBC costs 0.59%), commodities are likely losing to inflation. And indeed they have historically; commodities have had negative real returns over the last 100 years.
But what about gold, the most popular commodity? Don’t a lot of people invest in it?
Like other commodities, gold is not a value-producing asset, meaning it has a long-term real expected return of zero. Gold invariably reduces the portfolio’s volatility and risk due to its low correlation to both stocks and bonds, but it likely simply drags down the portfolio’s long-term total return. I’ll be the first to admit that again, this tradeoff – sacrificing returns to lower the portfolio’s risk – may be perfectly acceptable, suitable, and even desirable for very risk-averse investors or for retirees, but I’d imagine that for most people reading this who have a reasonably long investing horizon, an asset like gold only creates an opportunity cost where you could have held something else in its place – basically, that there are other things, like bonds and TIPS, that can do a better job than gold of achieving the same goal.
The usual pro-gold argument is its ability to hedge against inflation. Unfortunately, the shiny metal has not been a reliable inflation hedge historically. Lastly, gold and metals funds always have higher fees, with broad metals funds being even pricier than gold funds, and also remember that gold in a taxable account is taxed as a collectible at rates up to 28%.
However, once again, an allocation to gold is perfectly sensible for the risk-averse investor with a short time horizon or the retiree who is withdrawing from the portfolio regularly to cover expenses. For these investors, sequence of returns is arguably more important than the size of those returns. They should be aiming to reduce volatility and risk, and gold does do that due to its uncorrelation to both stocks and bonds.
Here’s how adding gold to our previous portfolio examples would have worked out historically, using 50/40/10 stocks/bonds/gold. Just like with the bonds, we sacrificed a bit of return for a smoother ride with less risk:
Those who want some gold can use the fund SGOL. Gold is extremely volatile, meaning its value fluctuates wildly. Consequently, if you hold gold alongside stocks and intermediate treasury bonds, as the retiree probably would, I’d keep it at no more than 10% of the total portfolio.
Cash and cash equivalents are their own asset class, but we’re not talking about a stack of dollar bills under your mattress. We usually mean Treasury Bills aka T Bills, which are just ultra short-term (1-3 month) treasury bonds. They’re considered a “cash equivalent,” and drive the returns of money market accounts and cash equivalent ETFs.
Remember I threw out some stats earlier in the Bonds section about how there have been periods where these T Bills outperformed the stock market. So the return of cash investments is not fixed. Interestingly, cash is also a pretty good inflation hedge, as shorter duration bonds are less sensitive to interest rate changes. Many lazy portfolios have some allocation to some form of cash equivalent.
While T Bills are quite literally the “risk-free asset,” they’re no slouch. We would expect their returns to be slightly higher than inflation, and indeed they have been historically. The annualized historical return of 3-month T Bills from 1928-2020 was 3.32%. The average inflation rate over that period was 3.02%, which means a real return (return adjusted for inflation) of 0.3%.
Larry Swedroe likes to use a “bond barbell” approach where half of the bond allocation is in long treasuries and the other half is in short treasuries (cash). I probably wouldn’t go quite that far. Again, I think time horizon should roughly be matched to average bond duration, and by holding cash we’re dragging down the average duration of the bonds.
In a bond-heavy portfolio, this is a good thing. But here’s an example to illustrate. If half the bond allocation is long bonds with an average effective maturity of 24 years and the other half is in short bonds with an average effective maturity of 2 years, we have an effective maturity of 13 years (the midpoint) for the portfolio. If the investor has a time horizon of 30 years and only 20% or so in bonds, this approach doesn’t make too much sense.
Also recall the point above in relation to Commodities about ideally wanting our diversifiers to have positive expected returns. Cash does meet this criterion, but only barely after we account for inflation.
So all that being said, young investors with a long time horizon and a low (or zero) allocation to bonds very likely shouldn’t be holding any cash (except for your emergency fund), but a small allocation to cash is a perfectly sensible choice for risk-averse investors and retirees with a bond-heavy portfolio.
A popular, low-cost fund for a cash equivalent, in this case 1-3 year treasury bonds, is VGSH from Vanguard. Those wanting true 1-3 month T Bills can use SGOV from iShares.
Alternative Investments (“Alts”)
At the time of writing, stock valuations are extremely high, bond yields are at historic lows, and many investors simply don’t trust securities markets after the circus that was the 2008 financial crisis, so many investors nowadays are increasingly turning to “alternatives” or “alts.” These include more exotic, costlier, highly speculative, typically illiquid assets with idiosyncratic risk like:
- private real estate
- private equity
- venture capital
- private “peer-to-peer” lending
Covering these in detail is beyond the scope of this post, but in the interest of full disclosure, I don’t hold any of them as investments aside from my mortgage on the house I live in. Technically, commodities and gold would be considered “alts” as well, but they’re popular enough to warrant their own discussion, and they have highly liquid funds by which to own them. I don’t own them either.
The world of alts can be turbulent, expensive, and risky. Alts are comparatively lightly regulated, if at all. The pricing of alts is typically not as transparent as with securities markets. Navigate this world of alternative investments carefully and do your due diligence. Advisors typically suggest no more than 10% of your total portfolio be in alternative investments.
A Brief Note on REITs
REITs – real estate investment trusts – are stocks that are often used as a purported diversifier. And indeed, they’re fairly lowly correlated to the broader market with an average correlation about 0.5. But we can say the same thing about the Utilities sector.
Moreover, though they are treated as such, REITs technically aren’t a distinct asset class. In their 2018 paper, Jared Kizer and Sean Grover found that we can achieve the same factor exposure (more on this in the next section) that explains REIT returns – effectively replicating them – with a 66/34 split of small-cap value stocks and lower-credit bonds via long-term corporate bonds, thereby allowing you to avoid altogether the idiosyncratic, uncompensated risk of the real estate market.
If you’re using M1 Finance (I wrote a comprehensive review of the broker here), I created this pie with low-cost Vanguard funds that you can use to replace your REITs holding. This replication has the added benefit of having historically dominated REITs on every metric. Kizer and Grover noted that it conveniently “earns higher compound returns, has lower volatility, achieves a higher Sharpe Ratio, has lower kurtosis, and wins on most historical risk characteristics.”
If you still prefer “real” REITs, SCHH from Schwab is a good ETF for U.S. REITs, and VNQI from Vanguard is one for international REITs. If you want to keep it simple with a single global REIT fund, albeit at a slightly higher cost, REET from iShares fits the bill.
Risk Factor Diversification
At this point you could stop and use the information above and have a well-diversified portfolio. This section and the next are more advanced topics, but I’d be doing you, the reader, a disservice by not at least mentioning them.
Over the past 60 years, advances in the research in financial economics related to asset pricing has given us a much more comprehensive understanding of how markets price risk. Until the early 1990’s, any excess risk-adjusted returns delivered by fund managers not explained by exposure to market risk – known as alpha – was attributed to their skill in choosing good investments. We now know, however, that this “skill” can be explained away by their exposure to independent, systematic sources of portfolio risk, colloquially called factors.
Factors are a huge, somewhat complex topic. I’ll spare you the details here (I delved into them in a separate post here if you’re curious), but here’s the gist:
Factors are being proposed all the time in the literature, but only a handful have withstood the test of time and empirical, out-of-sample observation. Some of these were identified and widely accepted as recently as 2015. In buying a stock market index fund like VTI, we are only exposed to a single type of risk – market risk, known as market beta. In order to diversify that exposure to other sources of risk, we have to overweight (or tilt) these factors relative to their market weight.
Why would we want to do that?
First, these factors exist because they have paid a premium historically. One example is called the Value factor premium. In short, Value stocks are considered riskier than Growth stocks, and have thus outperformed Growth stocks historically. Similarly, small stocks are riskier than large stocks, and have outperformed them historically. This is called the Size factor premium. In short, we expect market outperformance over the long term by taking on excess exposure to these factors that have tended to pay a premium historically. Will these premiums continue into the future? Only time will tell.
But aren’t we trying to lower the risk profile of the portfolio?
Remember that we’re always aiming to optimize the portfolio holistically, not assets in isolation. While it may seem counterintuitive or sound like witchcraft, risk factor diversification actually reduces the portfolio’s risk in terms of both drawdowns and distribution of outcomes, which may be more significant than the expectation of greater future returns.
Researchers even concluded that factor diversification produced superior risk reduction results than asset class diversification, which is pretty staggering. A couple quotes from those papers include:
“The argument that we make for factor diversification partly rests on the expectation that the positive factor premia will continue to persist. But the correlations (or relative lack thereof) of these premia with each other are at least as important. … Factor diversification is highly effective because the average correlation between the five constituents is virtually zero. … It is hard not to conclude that smart investors should include cost-effectively sourced dynamic factor premia into long-term portfolio allocations.”
“Our result which favors a portfolio of factor premia overlay remains unchanged. As previously suggested, the benefit of factor premia is not in their mean returns, but rather in their ability to mitigate adverse conditions…”
These factor premia are larger and more statistically robust as we go smaller in stocks, meaning it’s likely better to overweight factors within the small cap stock universe. A couple new funds from Avantis provide an easy, low-cost way to do this: AVUV and AVDV. I discussed this concept and these funds more in the post on factor investing, a post comparing small cap value funds, and the post where I described my own portfolio.
Temporal Diversification – Diversifying Across Time
First, I’m not talking about dollar cost averaging here.
This one is mostly theoretical but the evidence and its implications are actually pretty intuitive after one’s able to wrap their head around the idea. It just happens to be something that most investors never even stop to think about.
The idea, popularized by economists Ian Ayres and Barry Nalebuff, is known as Lifecycle Investing. Here’s their book. The paper and the underlying math are pretty dense, backward-looking, and based primarily on U.S. stock returns, but the practical implications are significant.
The idea is that because one’s investment capital is largest near the tail end of the investing horizon, most of the exposure to and risk in stocks – and thus, most of the growth – happen at precisely the point at which investors should be heavily adding bonds to decrease portfolio risk. Good stock returns are crucial at this point leading up to and entering retirement. But by no fault of the investor, they may hit a bad decade of performance from sheer bad luck, such as the famous “lost decade” of 2000-2009. This is known as sequence risk.
Getting a “bad sequence” at retirement can drastically diminish one’s savings right before they’re needed most. In this sense, most investors are essentially betting their retirement on a very short time period near the end. The solution, Ayres and Nalebuff maintain, is to utilize leverage – borrowing to enhance exposure – early in the horizon and then deleverage as time passes in order to spread out one’s exposure to risk (specifically, equities risk) more evenly over time. The research suggests this may lead to better outcomes at retirement. At least it has historically, in all periods observed going back to 1871.
This idea from Ayres and Nalebuff has been referred to colloquially as “mortgaging your retirement,” as it’s basically what we do with mortgage loans for houses – putting down a very small amount of money for a lot of exposure. By doing this with investments, we’re aiming to maintain consistent exposure through time, borrowing initially and then paying it down and deleveraging as time passes. While it may seem counterintuitive, the math says this borrowing at a young age actually decreases risk at retirement in terms of returns, withdrawal rate, and distribution of outcomes.
Put another way, the “traditional” method works is like saying you’re going to invest a small amount for most of your time horizon and then invest a lot of money right before retirement. This is just naturally how compound returns work, but it should strike you as possibly being a suboptimal way to go about it. Lifecycle Investing aims to solve this problem. Just as we know it’s smart to diversify across asset classes and geographies, here we’re talking about diversifying across time.
Ayres and Nalebuff proposed a maximum leverage of 2, which is somewhat arbitrary and was simply based on their relative lack of knowledge of available sources of leverage at the time of their paper. There are now 3x leveraged ETFs, options, futures, etc. that can provide leverage greater than 2. Their research suggests that the young investor with a long investing horizon doesn’t need to care too much about being wiped out (a danger of leverage), as they can also accumulate faster again with leverage, though this obviously assumes the investor “stays the course” and doesn’t deviate from the strategy, which would have them worse off than if they hadn’t implemented it in the first place.
Interestingly, the researchers showed that Lifecycle investing would have increased retirement income 100% of the time for anyone retiring in the last 96 years.
The research is very intriguing and it all sounds great on paper, but the main problem I see is that the emotional and psychological aspects of investing are unfortunately very real. We already know most investors overestimate their risk tolerance and can’t stomach a 100% stocks position during a market crush, much less a 200% exposure. This would mean if the market drops 20%, a 2x position would drop 40%. The opposite is also true – gains are enhanced as well – but this assumes the investor can stay invested and keep investing regularly through these major downturns. Easier said than done. Investors are susceptible to the psychological bias known as loss aversion, the idea that humans are more sensitive to losses than to gains.
The details, math, graphs, tables, and specific implementation tactics are beyond the scope of this post, but again, I figured this concept was at least worth mentioning in the context of portfolio diversification. Check out the paper and the book (the book will be much more accessible if you don’t have a background in math/statistics) if you’re interested.
Portfolio diversification seems to be the only free lunch with investing, with the purpose being an attempt to both maintain consistent returns and reduce risk. There are many different types of diversification, and for the most part, it’s likely beneficial to utilize them all. Thankfully, broad, low-cost index funds make this easy.
Diversify, but diversify purposefully. Any additional asset adds complexity and takes up space, so there should be a very specific reason for every asset in the portfolio. We don’t want to be “diversifying for the sake of diversifying,” as was my take on the 7Twelve Portfolio.
Ben Felix also reminds us that there’s a tradeoff between simplicity and optimization. I’m a fan of simplicity, but we still want to make sure we’re sufficiently diversified. Einstein once said “Everything should be made as simple as possible, but no simpler.”
Don’t forget to rebalance regularly! Annually is fine. Rebalancing means bringing the portfolio back to its target allocations after it drifts. For example, in your 50/50 allocation of stocks to bonds, if stocks rise by 10% and bonds fall by 10%, your asset allocation is now 55/45.
It would be impossible for me to construct a diversified portfolio that’s appropriate for investors of all ages and all risk tolerances. Again, asset allocation and risk tolerance are highly personal. Those should be your starting point, as asset allocation is responsible for 90% of a portfolio’s returns.
That being said, if you want to see the above diversification concepts in action in a real-world portfolio, I explain the selection and reasoning for each asset in my own portfolio in this separate post.
To what degree do you diversify in your portfolio? Let me know in the comments.
Disclosure: I am long VOO, AVUV, AVDV, VEA, and VWO in my own portfolio.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.