Dilbert on Diversification

Scott Adams, the author/creator of the Dilbert comic strip, has some very sensible things to say about asset diversification in this great blog post, World’s Simplest Portfolio:

First, let’s assume the hypothetical money is invested entirely for retirement, so we don’t need to worry about keeping any of it liquid for college or buying a house. That assumption is just to keep things simple.

Second, we’re only talking about investments up to 10 years prior to your planned retirement…

I suggest, as a starting point for our discussion, that a perfectly adequate simple portfolio for young(ish) people might involve putting 50% of your money in an ETF from Vanguard (VTI), which captures the entire Wilshire 5000 … The fees for the ETF are a low .015% per year, and because ETF managers don’t do much buying and selling within the portfolio, it doesn’t generate much taxable income to pass along to investors…

For the remaining 50% your investments, let’s say you buy the Vanguard Emerging Market ETF (VWO) with a .27% expense ratio. That gives you a play on the best companies in emerging markets around the world, at low cost, with excellent diversity, and low taxes.

Asset diversification really can be just this easy.? Adams’s advice underscores how bizarre the diversification message is in E*Trade’s? “Wolf Call” commercial:

What does it mean to diversify like a wolf?? In a world with low-cost stock indexes, asset diversification is downright boring.? Hardly something to brag about to your girlfriend.

Adams’s post, however, makes a claim with which I take issue.? He says:

I picked 50% to allocate to this investment because I contend that no expert has a good reason for picking a different figure. Some experts might tell you 25% is the right allocation for U.S. stocks, and some might say 75%. I contend that most allocation recommendations of that sort are no more defensible than horoscopes.

Adams is right when it comes to traditional allocation advice.? In?Lifecycle Investing, we similarly criticize the “birthday rule,” which arbitrarily advises investors to allocate “110 minus your age” in stock.? The birthday rule counsels 20-year-olds to invest 90 percent of their portfolio in stock, and 60-year-olds to allocate 50 percent to stock.? Adams is right that such advice has become the industry consensus without the benefit of good theory or empiricism.

But Barry Nalebuff and I derive an optimal allocation rule that maximizes expected utility for an investor with constant relative risk aversion:

Samuelson share = Return/(Risk2 * Risk Aversion).

In?a recent post, I showed how this allocation equation can be updated to take into account changed expectations about risk and return.?Lifecycle Investing shows that this allocation equation (when properly applied to the present value of current and future savings contributions) will often lead young people to invest 200 percent of their current portfolio in stocks.

Adams’s approach still wins hands down in a simplicity contest (and in fact, before I wrote this book my portfolio emulated his advice).? But we show that there are substantial gains from doing some extra work to better spread market risk across time.? Historically, the Leverage Lifecycle approach can reduce risk by more than 20 percent.? Or, the benefits of this new diversification technology can be channeled to safely increase your expected return by 60 percent.? Until a mutual fund has the good sense to automate our system (we’re working on it), time diversification will require some additional work.? But doing a better job diversifying risk across time can be worth the effort.

(Hat Tip:?Joshua Gans)

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  1. Eric M. Jones says:

    “Why can’t we concentrate our resources across the board?” (Dilbert 1996)

    Still, the investor (this writer included), believes he can glean some information that gives an edge in the market. In general, it hasn’t worked for me. I have to wonder if this is really anything more than gambling….and the house has it fixed to keep the rubes coming back.

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  2. Dave says:

    What about non-stock assets? Or is he just assuming stocks always go up. We don’t all live 100 years, someone ought to introduce him to the multi decade bear markets that have existed over the past few centuries.

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  3. Dan says:

    Scott Adams is recommending a 50-50 split on the allocation between US stocks and foreign stocks (until you’re within 10 years of retirement). Ian, you’re talking about the allocation between stocks and other investments.

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  4. AaronS says:

    May I make a simple observation? I find that I if I devote myself to a single decent stock, I can get so “in tune” with it, learn so much about it, develop a feel for it, etc., that I can do pretty good with the stock.

    And with a trailing stop-loss, I typically get out with minimal risk even if there is some bombshell moment that takes it or the whole stock market down temporarily (I say temporarily, because if the fundamentals are strong, the stock market WILL recover–just as it did shortly after even JFK’s assassination).

    Yes, I can be “safer” by broad diversification. But there is also vast opportunity cost, I believe. While I maintain greater safety, I “pay” for it by not being in Qualcomm the day it went up over $150 (I was in!). I pay for it by having great advances balanced out by losing stocks.

    There is never full safety in the stock market. You’re going to have to take a risk. I suppose I am just willing to take a bigger risk in order to have the opportunity for greater gains.

    I know that Sirius XM Satellite Radio (one of the few penny stocks I’ve played) has made me thousands over the past year–keeping my head above water even thought unemployed.

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  5. Bob Brown says:

    Let’s hope the new health insurance law has an assisted suicide proviso for those of us whose retirement funds are underwater.

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  6. BenK says:

    In the end, this presumes you have some sensible way of assessing the risk of various investments. In fact, we don’t. The big banks didn’t, the little people don’t, the government doesn’t – and the only people who have some claim on risk assessment (Taleb, for example) has a completely different strategy for investing.

    Mostly, it seems, the informed people spend all their time sucking up insider trading dollars or muttering about the sky falling. So, the wise investor just avoids being taken to the cleaner, does his daily job well, and hopes to maintain his home, family and employment.

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  7. Kevin H says:

    Doesn’t both the ‘risk’ term and the ‘return’ terms in your equation blow up when your time horizon gets large?

    That would make the equation very unstable to minor mis-calculations of risk and anual-return. A classic example of spurious specificity, which is basically what Scott Adams is saying.

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  8. hello says:

    For anyone who cares………..

    the constitutents of any market-cap-weight emerging market index fund basically mimics the SP500 (eg big cap energy, tech and financials).

    Yes, you are getting some intl exposure but you’re not elimating much risk. And your “portfolio” is heavily dependent on energy and discretionary consumer spending.

    for the past decade all the world’s stock markets have extremely high correlations bu splitting your portfolio up solely among stocks is up to you.

    My anonymouse suggestion:

    50% US small caps (IWM). 50% carry trade (DBV) (or 50% small cap emerging market).

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