Comments on: Is Simplicity Overrated in Investing?

By: DIY Investor

DIY Investor — Fri, 14 May 2010 11:04:45 +0000

Look for “Blackrock Periodic Table ” under April posts. There are actually 3 posts based on this table.

By: Larry

Larry — Fri, 14 May 2010 02:56:57 +0000

Sorry, DIY, but I couldn’t find that information.

By: Mike

Mike — Thu, 13 May 2010 23:42:28 +0000

I think it’s simply a matter of terminology.

For example, if we were to compare two portfolios:
75% Total Stock Market, 25% S&P 500

75% Total Stock Market, 25% Small-Cap Value

I’d argue that the second is better diversified if you can expect it to lead to less overall portfolio volatility–even though it doesn’t include a greater number of securities.

I’d accept “spreading your investment across more securities” as a reasonable definition of diversification. It just wasn’t the definition I was using in the statement in the above article that appeared to start this conversation.

By: Dylan

Dylan — Thu, 13 May 2010 22:54:00 +0000

To be clear, I’m not saying there is no reason to overweight. I’m just saying that doing so doesn’t improve diversification.

By: Dylan

Dylan — Thu, 13 May 2010 22:51:09 +0000

Mike, I read your other post. I get what you are saying about incorporating investments that are not perfectly correlated, but I don’t think that concept is the same as diversification nor am I making an argument against it. You are talking about investment policy (i.e. asset allocation) and the application of Modern Portfolio Theory and calling it “diversification.” Overweighting and underweighting may provide you with an optimal portfolio (or it may not), but improved optimization does not equate to improved diversification.

Here is an extreme example to illustrate diversification. Which portfolio is more diversified: Portfolio A is 99% ExxonMobil and 1% Total Stock Market Index Fund (which includes ExxonMobil) or Portfolio B is 1% ExxonMobil and 99% in the Total Stock Market Index Fund?

If you conclude that Portfolio B is more diversified, it only stands to reason that being 100% Total Stock Market Index Fund (which includes ExxonMobil) is even more diversified than Portfolio B, even if being overweight ExxonMobil ends up being a more optimal portfolio. Substitute REITs for ExxonMobil.

If you overweight value companies, that means the rest of the market (i.e. every one else but you collectively) is overweight growth (or underweight value). That cannot result in an improved diversification over the rest of the market. Whether or not it results in better returns/lower volatility does not change that; it just means your bet paid off. When you look like everyone else except you, then you are most diversified.

By: Mike

Mike — Thu, 13 May 2010 14:16:10 +0000

My thoughts on the matter of whether overweighting small-cap and/or value improves diversification can be found here.

By: DIY Investor

DIY Investor — Thu, 13 May 2010 14:08:46 +0000

Dylan has a good point…there is no reason to add what is already in the index. The high yield bond sector , however, isn’t in the total bond etf…at least for AGG. AGG is investment grade and higher.
I believe also that most global stock etfs don’t include emerging economy stocks.
If you’re interested in the Blackrock analysis you can see my workup on my site. I like their table because they put in a diversified portfolio so it is a nice visual of diversification compared to market sectors.

By: Dylan

Dylan — Thu, 13 May 2010 13:41:35 +0000

My comment was not about diversification as a criterion considered in making investment selections; I tried to make that clear. I’m specifically challenging the notion that over/underweighting certain securities is somehow improved diversification. Traveling up or down the efficient frontier by over or underweighting certain companies or sectors is not the same as increased or decreased diversification.

By: Larry

Larry — Thu, 13 May 2010 13:17:54 +0000

Dylan, I believe the usual argument is that diversification is not the only criterion when it comes to adding REITs or small cap/value. As DIY says above, sectors like these”act differently than the usual choices and thereby hold down volatility.”

Thanks, DIY, for the tip on Callan and Blackrock .

By: DIY Investor

DIY Investor — Thu, 13 May 2010 11:25:14 +0000

Larry-
Use a periodic table of investments which shows annual returns for various asset classes over 20 years. Callan and Blackrock have produced their versions which you can find online. Then weight the asset classes according to your preferences and calculate 3 year rolling returns. This will give you a range of returns you would have experienced. Could you live with these?
With a little creativity you can get some useful results from this exercise. Note that the last 20 years have been interesting with the dot.com implosion and the 2008 debacle . It’s reasonable I believe that the next 20 years won’t be more volatile.