What is Portfolio Diversification?

I was in a Facebook group when I saw this post:

First, kudos to the original poster for realizing that the money you invest today should not be needed for 5+ years.

Next, while they were not explicitly asking about diversification, it felt like this person wanted to “add to the mix” because doing so would be beneficial. Perhaps they felt having variety meant being diversified.

It’s a common misconception.

And while it’s not going to ruin your investments, it could create unnecessary complexity.

What is Diversification?

Diversification is the adage – “don’t put all your eggs in one basket.”

We intuitively understand this. If you buy one stock, your fortunes are tied to a single company. If you buy an S&P 500 index fund, your investments are tied to the 500 companies in the S&P 500. Having your money in 500 baskets is better than having them in one.

You can get a better investment return while reducing your risk through diversification. However, risk in the investment world isn’t the same as in the real world.

In the investment world, when we say risk, we mean volatility.

Volatility is the speed at which stock prices move. In the short term, a stock’s price can sometimes be volatile.

Your risk increases if a stock (or the overall market) is volatile at the wrong time. If it falls in value, and you need the money, you may need to sell it when it’s down.

In the real world, risk is the likelihood that a business will lose money or go out of business. If you invest in your cousin’s restaurant, the risk is that he will fail, and you will lose all of your money.

By owning a basket of stocks, you lower your risk considerably because it is rare for 500 companies to move in the same direction at the same time to the same degree (but it still happens!). This is especially true since they will be in different industries experiencing their business cycles.

Diversification isn’t about owning more funds

Returning to the Facebook post, the commenter said they had VOO and VTI; were there other funds they should invest in?

• VOO is the Vanguard S&P 500 ETF
• VTI is the Vanguard Total Stock Market Index Fund ETF

Both are great investments but have 87% overlap (almost all of VOO is in VTI). You’re owning a lot of VOO with a bit of dilution into the rest of the market with the differences in VTI. Also, VTI has different weightings for the holdings since it has a different benchmark.

In other words, you own two very similar funds.

It’s unnecessary to own both, but there’s nothing wrong with this (i.e., if you already have this set up, I don’t see a compelling reason to change it and face the tax consequences for selling).

However, picking different funds to add a variety of tickers to your portfolio has no benefit.

You have to pick the right funds.

Consider a Three or Four-Fund Portfolio

If you want to diversify, the simplest way to do it is with a three- or four-fund portfolio. Vanguard does this with its Target Retirement Funds, which have trillions of dollars under management.

If it works well for trillions of dollars, it’s probably good enough for you (and me!).

The three-fund portfolio comes from Taylor Larimore, and it’s as simple as it gets:

• Domestic stock “total market” index fund
• International stock “total market” index fund
• Bond “total market” index fund

Everyone has these types of funds, so check your broker, but the three Vanguard funds are:

• Vanguard Total Stock Market Index Fund (VTSAX)
• Vanguard Total International Stock Index Fund (VTIAX)
• Vanguard Total Bond Market Fund (VBTLX)

If you want to diversify a bit more, you can add a fourth fund—a Vanguard Total International Bond Index (BNDX)—thus making it a four-fund portfolio.

In the example above, the investor had shares of VOO and VTI, both of which fall within the Domestic stock “total market” index fund bucket. To round out their portfolio, they need some international exposure and some bond exposure. Their exact allocations will depend on their age, needs, and horizon.

To keep it simple, we can lean on the “120-Age Rule” (of thumb) for allocation. 120 minus your age is your percentage in stocks. So if you’re 40, that’s 80% in the Stock “total market” index funds and 20% in the Bond “total market” index fund. Most experts suggest 15-20% of your portfolio should be in international stocks (Vanguard recommends 20%).

So, that would be:

• 64% – Domestic stock “total market” index fund
• 16% – International stock “total market” index fund
• 20% – Bond “total market” index fund

Then, remember to update your percentages annually by rebalancing. The asset classes will grow (and fall) throughout the year, so you want to ensure your percentages are relatively close to your targets. You can accomplish this by adjusting your contributions to avoid tax implications.

Remember to Keep it Simple

Keep your financial systems as simple as possible.

Owning a variety of funds can feel like doing the right thing, but you may be introducing complexity when it’s not required or beneficial.

Vanguard Target Retirement Funds have trillions of dollars under management, and they use just a few funds. The same goes for Fidelity and Charles Schwab. If simple works for them, it’ll work for you.

If you have a complex basket of stocks and funds, it’ll be OK. Adjust as needed, but don’t feel like you have to sell everything and put it into a few funds.

You can use various portfolio analysis tools to review your allocation and adjust it according to your needs.

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