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. malthus says:

    All this talk of diversification reminds me of the old canard of Dollar Cost Averaging, now shown to be silly.

    Any justification for diversification has to lie in the declining marginal utility of money. If winning $10,000 were felt to give the same benefit as not losing $10,000, in other words, diversification would confer no benefit, and if a person felt that winning $10,000 to be better than not losing $10,000, diversity would have negative utility.

    Diversification is also a questionable game plan in marrying and attending to children. It is certainly not advisable for an entrepeneur to invest only a fraction of his time and his start-up funds in his new venture and the rest in diverse ventures.

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  2. wesley.tate says:

    The world markets move as a single unit. Diversification within the world markets in this scenario simply models a volatility level. As such, the only thing this type of “diversification” provides is a likely unwarranted sense of security, and mindless support for the corporate-government partnerships of global brands.

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  3. J says:

    From the mouth of the chief investment officer that I had the pleasure to work for some years ago: “Anyone that tells you that they have a better way to invest surely can’t have one. If they truly did, they wouldn’t tell a soul”

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  4. -Beezley 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. ”

    adams specifically said his hypothetical portfolio was strictly for a retirement scenario/account. thus, i think he also means this would be sheltered in a 401(k) or IRA of some sort. at least that’s how i read it.

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  5. -Beezley 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. ”

    study after study has shown that it’s nearly impossible to beat the market by stock picking over any significant length of time. (i think the studies are typically ten years and longer)

    it’s also not tax efficient.

    buy index funds. slice and dice if you must (for instance, if you believe fama and french and believe in the small value stock premium over time – then tilt a little and buy more of a small value index fund)

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  6. Mike says:

    First of all, it’s not true that pros don’t beat the market. It’s true that they don’t consistently beat the market.

    I disagree that it’s impossible to beat the market by investing in individual equities. First of all, individual equities are one of the more tax efficient vehicles. You only pay when you’ve made a profit.

    Further, by offsetting with losses, you can minimize your tax issues.

    As for the banks not managing risks – you are correct. When you are levered 30:1, it is difficult to withstand a sustained downturn.

    I have always believed that more equities is better. My grandparents (who lived and worked in the great depression) always owned equities. They made out quite nicely by owning equities and not panicking. Part of the problem is the advent of readily available information which (contrary to academic opinion) makes the markets inefficient. Pricing is distorted due to individuals making emotional decisions.

    Diversification is a basic concept, but it works for people who have long time horizons. Which, given the actuary tables for life expectancy, most people have a good time to live yet.

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  7. frankD says:

    in the casino of life, a/k/a the stock market, the professionals cannot distinguish between investment grade and toxic positions so don’t fret if you don’t “get it” either

    diversification is just another tactic to attempt to legitimize the overall process – truth is, diversifying means spreading around your money among various scams and schemes and rip-offs, so statistically it is improbable that all your various positions get exposed as fradulent at once

    DIVIDENDS ! paying dividends used to distinguish solid financial companies showing results by sharing the annual profits with shareholders by paying dividends year after year

    the market price was set by comparing the entities ability to generate results, real cash results, with a real rate of return, without the mumbo-jumbo that muddies the waters today and this worked for many years

    and diversification meant between industrial sectors – like consumer goods and commodities and manufacturing – which earned real profits realized by reaping more than incurring at measured periods as fiscal year ends

    now, like so many enrons operating today, who the heck knows what the products is or how an entity makes a profit or even if it makes a profit – all that matters is the share price

    anyway that’s my two cents

    frankD
    ft lauderdale

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