Investing doesn’t have to be complicated. All it takes is an investment in three index funds to build a diversified portfolio at very low cost.
However, many investors become very interested in making their simple portfolios more complicated. It’s completely natural. You are passionate about your finances and your money, and you want to do everything you can to maximize your returns. You know that small changes in your investment returns over time can make a big difference. For example, reducing the expense ratios of your mutual funds from 1% to 0.1% can be worth millions of dollars over the course of your career because of compound interest.
Here are some things that investors try to do (often in vain) to improve their investment returns:
Tweak their asset allocation to the latest trend
I don’t need to look at Yahoo! Finance to know how international stocks have been doing relative to U.S. stocks.
All I would need to do is start a thread on Bogleheads and ask for people’s international stock allocations. There is fierce debate about the role of international stocks in a diversified portfolio, so when international stocks are outperforming domestic stocks, you see more Bogleheads readers saying that they are 40% or 50% international stocks. When international stocks are doing poorly, or Europe’s economy is slumping compared to the United States, people run to the Warren Buffett or John Bogle camp that you don’t need international stocks.
Unfortunately, some investors will fall into the trap of jumping around from allocation to allocation — holding international stocks after a period of outperformance and U.S. stocks after a period of international underperformance.
Add additional asset classes
The big three asset classes are U.S. stocks, international stocks, and U.S. bonds. There are other minor asset classes such as emerging markets stocks, gold, oil, currencies, cryptocurrencies, and real estate. It’s tempting for a sophisticated investor to do something “different” from the crowd and try to start dabbling in these other asset classes.
However, adding 5% of your portfolio to a new asset class probably won’t make an appreciable difference in your portfolio returns. And if you’re saving a significant amount of money in your income, you will have a comfortable retirement without these extra asset classes. Could you have a little bit more money by adding more asset classes? Potentially. Could you achieve a slightly less risky portfolio by adding diversification through these alternative asset classes? Maybe. But that small difference in returns or risk probably won’t make the difference between a good retirement and a great retirement. As you get wealthier, additional money doesn’t make you significantly happier, and I doubt you’ll notice the difference between the risk or returns of a simple portfolio and a complicated portfolio.
Chase returns by purchasing individual stocks
Inevitably, almost every investor will have to try their hand at picking individual stocks. I certainly have. The problem with picking individual stocks is that it is impossible to know if your performance is due to luck or skill.
By picking individual stocks, you introduce much more volatility in your portfolio, without necessarily improving your expected return. By adding individual stocks, you begin to take away the benefits of diversification. Your stock portfolio becomes very sensitive to the moves of the individual companies in your portfolio. This can be a good thing if one of the companies you own gets bought out. But it can be disastrous if things go south for one of your stocks.
Use portfolio tilts
A portfolio tilt is when you overweight a certain segment of the total stock market because you believe it will provide excess returns compared to the rest of the market. For example, Eugene Fama won the Nobel Prize in part for his research that showed that small-cap stocks and value stocks have historically overperformed large-cap and growth stocks, respectively. Many investors try to increase their returns by tilting their portfolio towards small-cap or value stocks.
However, we just don’t know whether this outperformance will persist in the future. Past performance is not a guarantee of future returns. Of course, value stocks and small-cap stocks are more volatile than the general market, and investors should be compensated for that risk, but why use small cap and value stocks instead of just holding more stocks? And by tilting your portfolio towards small-cap value stocks, there’s always a chance you may have too much risk in your portfolio.
Conclusion
I understand that investing gets kind of boring if you just invest in a few index funds. Talking about investments with your friends at the dinner party or the doctor’s lounge is much more fun when someone is bragging about their investment in Nvidia stock or Bitcoin.
And I know that there’s a tendency for eager investors to try to maximize every cent out of their portfolio. But I believe that in investing, as in other areas of life, the perfect is the enemy of the good. By seeking to maximize your portfolio returns, you are expending energy that could be used elsewhere. If reading about investing and investment strategies is your hobby (like it is for me), you shouldn’t stop doing what you enjoy. But there’s always a chance that all that reading may make you want to tweak your portfolio just for the sake of tweaking your portfolio. Potentially, all that reading could be hurting your portfolio instead of helping it.
What do you think? Have you deviated from a simple portfolio of index funds? Do you think it will make an appreciable difference in your investment returns?
[Charts courtesy of StockCharts.com]
It does not get boring seeing my net worth increase each month…I do agree though, investing individually needs time and effort so if you enjoy it and can afford to do it, then do so…otherwise stay simple and do a 3 fund portfolio.
We tilt to some degree using index funds. We are currently slightly tilted international. It’s never more then ten percent beyond our normal levels and largely done with new money.
You’re exactly right! People love talking about their “winners” no matter how late they got in on the action.
Generally, the simpler and more boring the portfolio, the better the results. The possibilities of sexier returns and better stories are too alluring.
I have deviated and I think it makes a difference. If you look at Nobel winner Harry Markowitz’s papers on modern portfolio theory, he discusses a concept called the efficient frontier. The efficient frontier is achieved by designing a portfolio that is more efficient than the sum of its parts. It is a portfolio consisting of non correlated assets. The reason you choose bonds in a 3 fund portfolio is because bonds are NON CORRELATED. To be non correlated means the asset’s change in value is independent of the change in value of other assets in the portfolio. The argument over small caps v foreign v large cap v growth is pretty much nonsense in terms of a diversity argument because these issues are NOT “non correlated”. They are weakly uncorrelated. You may get a little better or a little worse returns by choosing one over the other but in a down market like 2008 THEY ALL POINT INTO THE GROUND. This is not diversity. It’s playing with yourself. If your reading Bogleheads selling this soap they don’t have a clue.
Non correlated assets are things like Bonds, money. Gold or other commodities, REIT (to some extent) and alternatives like the ARQ long short fund, a job, perhaps the most productive non correlated asset. The point of non correlated assets is to reduce volatility in the face of normalized gains. There is a portfolio called the Harry Browne Permanent Portfolio which has performed with near market returns but has a volatility of 1/3 of the market vol. Its mix is 25% SPY, 25% TFT, 25% BIL, 25% GLD. This is a very diversified portfolio. In the 2009 crash period which lasted to about 2013 it lost money only 1 year and its draw down was only about 5%. I’m not advocating this portfolio I’m just pointing out there are alternatives to the Boglehead religion, and there are real economics that underlay their moorings.
The problem is if you loose 50% in a crash you need 100% to be made whole, whereas if you loose 30% (lower volatility) you only need 60% to be in the black. In the 2008 crash The S&P took till 2013 to retrace the value it held in 2007. My more diversified less volatile portfolio was even in 2011, and 18% ahead in 2013.
If choosing a 0.1% drag ETF is a boon over a 1% fund, certainly making an additional 1% per year return due to real diversity (Markowitcz’s free lunch) is worth a look.
I’m not a zealot on this, I have a different and well reasoned Nobel laureate approach. In addition I invest in DFA funds (which is Eugene Fama’s mutual fund company), precisely because they further optimize value over long periods, and eek every point they can in terms of efficiency. If you a have Van Guard 3 fund portfolio you have a pretty viable vehicle. The real money maker is to get as much as possible as often as possible into that vehicle. The $1 you put in at the beginning of your career become $8 by the time you FIRE. The 1$ you put in 7 years before you fire barely becomes $2. The other thing you absolutely NEED to do is aggregate your portfolio. Make sure every dollar is considered as part of the whole. No separate accounts. It’s the only way you can do real risk management. If you have 5 accounts that are not aggregated you don’t have a clue what your doing. 2 words on this PC Capital.
Best
I’ve evolved to have a highly torqued, more complicated portfolio. I’m 42% equities / 38% muni bonds / 20% alternatives. The equities are equally split US/Int and heavily tilted to small value on both sides. The bonds are high quality and relatively short duration. I take risk elsewhere in the portfolio. The alternatives include AQR Style Premia and Managed Futures, and Stone Ridge Alternative Lending, Reinsurance, Variance Risk Premium. As mentioned above, I’m a huge believer in MPT and minimizing volatility drag. I believe that by diversifying across sources of return I have created a more efficient portfolio with smaller SD and maximal drawdown for same expected return. I have a bigger dose of safe bonds than other portfolios with same expected return. Of course, as mentioned in the essay, this all comes at increased cost. Cost is certain. Benefits of more efficient portfolio only potential.
Dave
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