How many funds are needed to create a diversified portfolio? While there is no absolute answer, let’s explore a range of diversification strategies — from a one-fund to a 12-fund portfolio. An important secondary goal when building portfolios is to keep things relatively simple, so the construction and management of the portfolio is not overwhelming.
Speaking of simplicity — index-based mutual funds and exchange-traded funds allow a client to invest in a potentially wide variety of stocks or bonds or REITs, etc. This type of simplicity is fantastic. But it can also create the illusion of being fully diversified, which is a simplistic oversight.
For example, the most popular index-based mutual fund and ETF mimics the 500 stocks in the S&P 500. This is simplicity done well. But while this type of fund provides diversified exposure to one asset class (large-cap U.S. stocks), it does not provide diversification across multiple asset classes, which is the real point of broad diversification.
QuoteBreadth diversification is achieved when multiple asset classes such as stocks, bonds and diversifiers are combined.
The S&P 500 fund represents diversification depth. Depth diversification is important, but breadth diversification is more important. Breadth diversification is achieved when multiple asset classes such as stocks, bonds and diversifiers are combined, and doing this will require multiple mutual funds or ETFs.
IS MORE DIVERSIFICATION BETTER?
We now examine four progressively more diversified portfolios, all built with index-based mutual funds available at Vanguard (other fund companies could have been used, but for this analysis I chose to use Vanguard). The first portfolio, as shown in “Diversification by Degree,” is composed of one index fund: Vanguard 500 Index (VFINX). It represents a diversified exposure to one asset class, but does not provide breadth (or broad asset class) diversification.
The next step toward breadth asset class diversification is Vanguard Balanced Index (VBINX). This fund has a 60% US stock/40% US bonds allocation. This 60/40 blend is a classic mix that dates back to the 1930s. This particular balanced fund started in 1992.
Next is an equally weighted trio of Vanguard Total funds: Vanguard Total Bond Market Index (VBMFX), which provides broad exposure to U.S. fixed income (approximately 70% government bonds and 30% corporate bonds); Vanguard Total Stock Market Index (VTSMX), which provides broad exposure to U.S. equity (roughly 70% large cap, 20% midcap, 10% small cap); and Vanguard Total International Stock Index (VGTSX), which provides broad exposure to non-U.S. stocks (roughly 80% in developed non-U.S. markets and 20% in emerging non-U.S. markets). This portfolio of three index funds was rebalanced annually in this analysis.
The fourth model is a portfolio that utilizes 12 Vanguard funds (primarily index-based funds), each with an 8.33% allocation. This model, which I developed, is known as the 7Twelve portfolio. It was rebalanced annually to maintain the equal allocation across all 12 Vanguard funds. I’m offering this as one example of a diversified portfolio, though there are many others.
Recall that the goal of this analysis is to determine how many funds are needed to achieve breadth diversification while attempting to maintain a reasonable level of simplicity, both in the design and the execution of the portfolio.
Shown below in the graph called Sweet 16, is the growth of $10,000 if invested in the Vanguard 500 Index from Jan. 1, 2000, to Dec. 31, 2015. The ending balance was $18,587, which represents a 16-year average annualized return (or geometric mean) of 3.95%. This result is well below the 10.02% average annualized return of the S&P 500 over the past 90 years. The performance of the S&P 500 Index (i.e., Vanguard 500 Index) over the past 16 years has been considerably lower than its long-term average return.
QuoteEven though the simplicity and elegance of a broadly diversified breadth portfolio is intuitive to many investors, the required patience after building such a portfolio is not.
Next, we consider the growth of $10,000 if invested in Vanguard Balanced Index, representing a movement from a one-asset-class portfolio to a two-asset-class portfolio. Its ending balance was $22,123, which represents a 16-year average annualized return of 5.09%. Plus, the volatility of the annual returns for VBINX was substantially lower than VFINX (16-year standard deviation of annual returns for VFINX was 18.6% vs. 11.2% for VBINX).
Now we consider the three-fund Vanguard Total Index portfolio that essentially covers the world equity market and the U.S. fixed-income market. The Vanguard Total Portfolio was built with equal allocations to Vanguard Total Bond Market Index, Vanguard Total Stock Market Index and Vanguard Total International Stock Index. As shown, it actually slightly underperformed Vanguard Balanced Index over the past 16 years. Assuming a $10,000 investment on Jan. 1, 2000, its ending balance on Dec. 31, 2015, was $20,801, which results in a 16-year average annualized return of 4.68% and a standard deviation of 13.2%.
Finally, we see the 16-year growth of $10,000 in the Vanguard 7Twelve® portfolio, a broadly diversified model utilizing 12 Vanguard funds (in most cases, index-based Vanguard funds). Its ending balance was $29,223, which equates to a 16-year average annualized return of 6.93%, with a standard deviation of annual returns of 14.1%. The favorable result of investment breadth – that is, broad asset class diversification – is clearly evident over the past 16 years. More diversification produced better performance with lower volatility in comparison to a portfolio that only included large-cap U.S. stocks.
BROAD DIVERSIFICATION REQUIRES PATIENCE
Even though the simplicity and elegance of a broadly diversified breadth portfolio is intuitive to many investors, the required patience after building such a portfolio is not.
Here is where advisers can add significant value by teaching clients three key attributes of diversified investing: (1) your diversified portfolio won’t be the winner every year in comparison to the large-cap U.S. equity market, (2) it will contain mutual funds or ETFs that perform very differently (if built correctly), so it’s important to not bail out of the funds that are temporarily down and (3) the value of broad diversification is manifested over time frames of 15 to 20 years.
But even for less-patient clients, the virtue of broad diversification will often manifest itself over shorter time frames. As shown in “Rolling Along,” the rolling three-year returns for the 12-fund Vanguard portfolio have generally surpassed the other three less-diversified portfolios. However, in recent years, the single-fund portfolio that includes only VFINX has clearly been the victor. The price of short-run outperformance is the pain of repeated underperformance. If performance consistency matters, more diversification is better. It’s just that simple.