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. Ignatius Goronzola says:

    Everyone has their magic formulae, I suppose. Irrespective of this, one should look at fundamentals. Is the market cheap by historical standards? What is the P/E? Splitting your portfolio to five decimals won’t help if you are getting in when it is too pricey. Diversification won’t help, because stocks are correlated – if AT&T goes down, then so does GE. On the other hand, it’s harder to go wrong if the market has taken a beating and is down below its long term averages. This can be true for short term dips, not just crashes. Then there is the question of dividends. Too often, people (including fund managers) chase the mirage of growth, and ignore stocks that pay a nice reliable 5% a year, plus inflation. So here’s my advice: get a good feel what reasonable dividends and PEs are, over a 50 year time span. Pick a nice portfolio of boring dividend paying stocks with a P/E below 15. Put them in a spreadsheet. And then wait for a dip in the market, and buy them. Buy when other people are scared, not when they’re exuberant.

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  2. assumo says:

    What percentage should I keep hidden under my matress?

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  3. Robert says:

    Before you read another book on investing read “Extraordinary Popular Delusions and The Madness of Crowds.” Published almost 170 years ago it covers the Tulips, the South Seas, the Mississippi etc. etc. It is better than the current crop of bubble books as by its very age it makes clear that human financial foibles have been apparent for a long time, its just that no one ever listens.

    What I don’t like about things like baroque formulas, portfolio theory, financial engineering, or simple minded rules of thumb is that they seem to me like just so much window dressing. In my mind the naked truth is that the financial markets are full of humbug and are made up of ruthless people who want to get rich without really working.

    Most of us poor schmoes are out in the retail world trying to allocate our IRAs or pick between the crap mutual funds our 401Ks provide. If we are smart we have read the tomes on the random walk and feel smug as we index and search for the efficient frontier. But really, aren’t we probably kidding ourselves? This could be 1907 for all we know, in 20 years we could be even more smug, in 23 suicidal, in 30 just poorer.

    I’m not saying that disaster is around the corner, I’m just saying that there is a strong element of deck chair rearranging that makes us look stupid. Beyond that I think there is a rich vein of credulity that the financial press/media have been mining for years and I think we should stop being such suckers for a clever well spoken line gibberish.

    Peace Out.

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  4. Roy Hall says:

    Buy the S&P 500 (ETF IVV)
    you get the top 500 us companies, who are diversified worldwide, represent
    all industries , and are a mix of smaller and larger companies. The ETF allows stop losses, option strategies etc. AND
    seldom does a so called “Pro” beat the index. There is alot of BS published by
    the investment industry.

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  5. Rudiger in Jersey says:

    Dilbert on Diversification:

    Don’t just put your cash under the mattress.
    …..Put some in the fake flower pot. Some in the dog’s favorite plush toy. Some in the frozen foods. And some in the in the hole in the wall.

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  6. Art says:

    The advise to diversify via Vanguard Emmerging Market fund is bad for a practical reason. Not because its a bad fund, but because its hella annoying at tax time to deal with the foreign tax issues if your a turbo tax kind of guy like me.

    It was very bad two years ago when Vanguard stopped providing a form that I had relied on in past years, instead posting foreign tax percentages on their web site, that, with 2-3 hours of calculations, you could perhaps transform into the method of reporting foreign tax that Turbo Tax said was likely best.

    This year, I was finally able to port the Vanguard data into Turbo Tax automatically. Truthfully though, I have no idea which of the two methods of reporting foreign tax I went with, or if I used the best method or not. Might have payed extra, and that annoys me greatly.

    Dont go there, it aint worth it. Stick with the US stocks unless your rich enough to not worry about what you pay your accountant.

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  7. Jerryz says:

    Given the advent of program trading and dark pools replacing market makers I’ve begun to doubt the viability of the market for the retail investor. Traditional tools have no way to adequately protect you and will often leave you at the mercy of the volatility created by the same said programs. ETF run the same risks. That leaves traditional funds. But they now run higher Capitol gains than at any time in history. Again due to program trading. Without a way to shelter those gains. IRA or 401K? How do you stay in the game ?

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  8. Garry Kanter says:

    Here’s the greatest advice of all. In 3 panels, Mr. Adams explains the financial crisis on December 13, 2008:

    http://www.dilbert.com/strips/comic/2008-12-13/

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