Hi, I’m Rick Van Ness and this is Rule #4: Diversify.
Click to start this interactive lesson.
By now, you might be wondering: what stocks should you buy? And how much of each?
If your goal was to beat the Market Return – then you would want to choose the very best stock and put all your eggs in that basket. That is what Warren Buffett does, but he cautions that this strategy is only for professionals who make this their business.
If your goal is for any company failure to have as little effect on your wealth as possible, you would spread your money evenly over as many stocks as you can so your exposure to any individual company failing is diluted.
But, if your goal is to get the maximum return from a portfolio of stocks for the least amount of risk possible, that would lead you to a different answer. Would you like to learn how to do that?
In his colorful way, John Bogle told us the answer, “Don’t look for the needle in the haystack. Buy the whole haystack.”
But I don’t want you to just smile and admire his clever wit which helps make this memorable. I want you to understand why this is brilliant, and genius, and may be different from what you imagined.
We are going to see that it is not enough to simply own hundreds of companies. There’s an especially interesting portfolio. You will learn what the portfolio is, why YOU would want to own it, why everyone in the world would want to own it, and where you should put your money for the highest return for the least amount of risk.
First, you’ll learn the great advantage of owning poorly correlated assets. This part is truly cool! Magical.
To help me show you, let’s imagine two companies: Bathing Suits Inc. and National Umbrella Company. A rainy year means sales at the Bathing Suit company fall but the umbrella company does well. In a sunny year, the bathing suit company does well and the sales of umbrellas fall.
The price of these company stocks move in opposite directions so they are negatively correlated. The Bathing Suit company is more volatile because the total annual return has an average value of 7% but a variable component of plus or minus 1%. This is both higher return and higher risk than the umbrella company which has an average return of 3.5% plus or minus 1/2%.
Diversification is important in investing because of the benefits from low correlation. “No correlation” is when the value of two assets (say, stocks) don’t move together. To illustrate this I’ve selected the rare situation where they two stocks move in exactly opposite directions at the same time (perfect negative correlation).
This is the magical part. Look what happens if you invest 2/3 of your money in the umbrella company and 1/3 in the bathing suit company. WOW! Adding some of the more volatile company not only increases the average return, but it lowers the variability (or risk). Pretty much a free lunch!
Here what it looks like on a risk-return chart. The Bathing Suit Company is up here with twice the expected risk and return as the umbrella company. If you owned 100% of the umbrella company you’d be here. Now if you gradually invest part of your portfolio in the more risky Bathing Suit Company, your returns increase as you expected, but your risk, as measured by the variability of that return, actually decreases. Owning both is superior to only owning either of the companies.
Let’s return to the real world, with real companies, and real choices. We can represent a stock’s expected return as its average value, and its risk as the volatility or its standard deviation around that average return value.
We can compare them on this Risk/Return map. Now we are going to make two assumptions: that investors are rational and will prefer higher returns to lower returns, and less risk to more risk, as measured by volatility.
Now consider this: you want to do some long-term investing in the stock market, and you can invest in any of these four stocks, or any combination of these that you wish. Pick one of these four choices and then we’ll discuss.
Would you choose Motorola, because it has enjoyed this high average return?
Would you choose Merck Pharmaceutical, because it has a similar high return with a lot less volatility?
Would you choose General Motors, because it is the least volatile?
Or, would you choose some combination of these? If so, which ones and how much of each?
The answer is absolutely fantastic, and two people won Nobel Prizes for work related to this. But the answer is also very simple. Make your decision, and then I’ll explain.
Yes, the superior portfolio would own all the stocks, even McDonalds! It turns out that when you have three or more stocks and information about how their stock prices are correlated to each other, there are possible combinations of those stocks up-and-to-the-left of each of the individual stocks. We still need to work out how much to own of each.
And if you keep adding stocks, you end up with something extraordinary. The best portfolio has the highest return per unit of risk.
This is the Market Portfolio. It is the portfolio of every stock in the world, held in its local currency, with the proportion of every individual stock determined by its market capitalization.
Well, those are some big words! It simply means that instead of buying equal amounts of each stock, you hold them in proportion to how big they are. So, if the price of Apple Stock is $200 per share and there are ten billion shares owned, then the market capitalization is two trillion dollars. So, in this way, the big companies like Apple and Exxon are a proportionally bigger part of this preferred portfolio, than, say, Merck Pharmaceutical or McDonalds.
These portfolios are more efficient than any of the combinations that are below and to the right because they promise the same expected return for less risk.
Remember, for any typical company like Motorola, this standard deviation around its expected return represents the volatility risk.
For this Market portfolio, all company-specific risks get diversified away—organizational risks like their products, company leadership, and their labor force.
For those of you that were tempted to pick any of the individual stocks, I told you that owning individual stocks was owning uncompensated risk. Does this make sense to you now? For instance, owning Motorola is taking this much risk that you are not being compensated for. The Market won’t compensate you for taking that extra risk, because everyone else can earn that same return for only taking this much risk.
Now, some of you will point out that any data set is always historical and cannot predict future performance. That’s right! You can’t know the future. This is just a model, but it is useful and valuable.
It’s an answer to the questions: What stocks should you own, and how much of each? This is called Modern Portfolio Theory and is over 70 years old, and it says that it is not enough to look at the expected risk and return of individual stocks. By investing in many stocks, you both improve the return and reduce the riskiness of the portfolio.
YOU can easily create attractive portfolios without Warren Buffett’s skills. There’s no forecasting here. We’re not trying to pick stocks. We’re not trying to predict how the market’s going to do next month.
All we’re assuming is that means and variances are stable over time, and the correlation is stable over time. Those are nontrivial assumptions, I grant you. But if you believe in those assumptions more than you believe in your ability to forecast what’s going to happen to individual stocks six months from now, then this might be a good way to construct a portfolio.
Let me offer an analogy. Let’s say that I’ve been writing down how long it takes me to drive home from a big city for twenty years now. Can I predict how long it will take me to drive home on some future date? It would be a wild guess since I can’t predict the weather, traffic accidents, or road construction. On the other hand, I have some information that is stable:
The average commute time gives me an expected commute, the standard deviation tells me how volatile that estimate is, and I additionally know that my drive time is highly correlated with workday rush hour.
You’ve just learned something extraordinary: the Market Portfolio promises the maximum return per unit of volatility risk and collectively this is what we all want to own. It’s what we do own. It’s not a new idea, and the whole mutual fund industry has exploded to provide you with what we all want: this pre-packaged diversification—easy and convenient for a very low cost.
In Rule #3 I said that choosing between risky and safe investments is a goal-by-goal decision. This is probably your most important decision, so let’s get our arms around this. It’s very interesting!
But first, where is this safe investment? Where would you put a risk-free asset on the chart? Let’s say there is a bond that anyone can buy, that is backed by the U.S. government, yields a small amount of interest, and grows with inflation so there is no inflation risk. Make your decision and then we’ll discuss how to do this.
A risk-free asset would be here. It might be something like an I-bond.
- It is backed by the U.S. government so it has the highest possible credit rating in the world.
- It might have zero- or a low-interest rate, so essentially the value does not change with interest rates. And
- It tracks the consumer price index, so there is no inflation risk.
Or, it could be an FDIC-insured bank saving account that pays enough interest to keep up with inflation.
Or, similarly, a good money-market fund that does the same.
Push “Continue” and learn how this all comes together for you now.
Continue
Correct. So now you have two things you can allocate your money between. (1) somewhere to put money that is risk-free—the safe part of your portfolio, and (2) the risky part of your portfolio which is the Market Portfolio of all the publicly traded stocks. This is the portfolio that everybody in the world would prefer if there was no cost to own it.
Why do I say that? Because when you are mixing a risky stock portfolio with risk-free assets, you cannot get a steeper line. That’s the highest return you can get per unit of risk.
If you need money on a certain date and you don’t want to risk it being in the volatile stock market, then you would gradually move money out of the stock market and down this line. The efficient frontier becomes this straight line between 100% risk-free assets and 100% the Market Portfolio.
If there’s an acceptable level of risk you can live with, you can stay with a fixed allocation between the Market Portfolio and your risk-free choices. There are lots of choices for this safe part of your portfolio—but that’s for another lesson.
If bigger risks and returns are for you, you can mortgage your house and buy more of the Market Portfolio and beat your friends that are gambling with uncompensated risk.
Isn’t this great? There are thousands and thousands of individual stocks, and combinations of the stocks in baskets called mutual funds and electronically traded funds, but all you need to care about is owning the Market Portfolio and some version of a risk-free portfolio!
We covered a lot of ground in this lesson, but it’s worth it. For you to make good decisions about how to own stock, and to stick with those decisions, you need to understand that it really can be this simple. Can I summarize the four important points in this lesson and give you some final thoughts?
YES, Summarize Key Points!
(1) When 3 or more stocks aren’t perfectly correlated with each other, there will always be combinations with better risk/return than they have individually.
(2) Company-specific risks can be diversified away and all that remains is the Market Risk—things like interest rates, currency risk, and recessions. You can mitigate this risk by allocating between the Market Portfolio and your version of a risk-free asset.
(3) Owning individual stocks is to own uncompensated risk because other investors don’t need to take that risk to get that return.
(4) There is a portfolio that everyone collectively prefers and should, theoretically, individually prefer. It is called the Market Portfolio and yields the greatest return for risk. It owns every publicly traded stock in the world in proportion to its size or market capitalization. Today, you can closely approximate this with a low-cost index fund.
(5) To own a slice of the world you start with a Total U.S. Stock Market Index fund. People typically choose enough of an International (non-U.S.) stock index fund to become 20% to 50% of the total, because the exchange rates make these funds slightly more expensive.
Additional Tips
Dollar Cost Averaging is a good form of additional diversification. It diversifies the purchase dates. This works well with automatically investing newly earned money. For example, if you automatically invest $500 every month to buy your fund, then on days that the fund price is lower than average, you’ll buy more shares, and on days that the fund price is higher than average, you’ll buy fewer shares.
Avoid having too many funds. Instead of adding additional diversification, this generally adds complexity and confusion.
Avoid too many brokers (investment companies). This is another version of the same problem. Your intention might be to protect yourself from a bank failure. But these companies are not like banks that take your money and then loan it to borrowers. Instead, these are custodians that are holding assets that are registered to you. Working with multiple investment companies increases the complexity of your portfolio and adds confusion about what you actually own. This tip does not preclude you from buying Vanguard ETF funds for your retirement account at Fidelity, it just encourages you to do this with a purpose and a plan.
Let the receiving brokerage consolidate for you. Your goal is nearly always to simplify without triggering any taxable transactions. As custodians, these investment companies can use “in kind” transfers to accomplish this for you.
Useful resources
This video is Rick’s summary of Professor Andrew Lo’s course on Portfolio Theory which is available free online at this link:
https://ocw.mit.edu/courses/15-401-finance-theory-i-fall-2008/pages/video-lectures-and-slides/
This interactive video may be shared with the Creative Commons Attribution ShareAlike license
