Index fund fallacy #3 – you need an index fund to provide proper diversification

This is part 3 of a series of articles examining the idea that index funds are superior investments to a portfolio of individual stocks.

Part 1 of this series I examined the idea that index funds necessarily deliver better performance than individual stocks.

Part 2 examined the idea that index funds are a less expensive way to invest than buying individual stocks.

Part 3 will examine the idea that index funds provide the required level of diversification, and that the type of diversification provided by index funds is a good thing.

Before I start the analysis, let me reiterate my stance on index funds – index funds are great. I have a significant portion of my wealth in index funds. I believe index funds are the best investment vehicle for the vast majority of investors.  Index funds are an easy “set and forget” investment. They are awesome for new investors or investors who want to regularly invest smallish sums of money. They are an easy way to capture the average return of the market.

Proponents of index funds aren’t content to stop there though. For some reason they feel the need to make additional claims that just aren’t backed up by basic statistics or common sense. I’m writing these articles to refute some of those claims.

You need to buy an entire index to get sufficient diversification

This is one of the main arguments for index funds – if diversification is good, then more diversification must be better than less diversification. And since index funds provide somewhere between a lot to total diversification, index funds must be superior to owning individual stocks.

Let’s start by challenging the initial assumption. Is diversification good, and if so, why? And what does diversification even mean?

Here’s the definition from Investopedia: “Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.”

This is a pretty terrible definition that’s filled with a number of misconceptions. The biggest is that diversification yields higher returns. Frankly, I’m baffled why anybody would believe that diversification has anything to do with returns.

But before we get to that, let’s talk about what diversification does do.

  • Diversification reduces volatility in a portfolio
  • Diversification reduces risk in a portfolio

Volatility

Ok, let’s get this out of the way first – volatility is not risk. Say it with me:

Volatility is not risk.

The volatility of a portfolio is only a problem if:

  • An investor does something stupid as a result of the volatility, or
  • The investor needs to sell the investment during a time of volatility

That this is at odds with the academic view, which is that volatility is a proxy for risk. Frankly, this is just silly. The path that an investment takes from the time you buy it to the time you sell it doesn’t really matter. Think of it this way – suppose you bought a stock today for $10/share and then fell into a coma for 10 years. When you woke up you checked the price of the stock and found that it was $40/share. That’s a pretty solid 14.9% annualized return. Would it matter if the stock had initially dropped to $1 a share before rising to $40? Would it matter if it had jumped to $100/share before settling at today’s $40/share? No – either way, your investment had gone from $10/share to $40/share.

The path that a stock takes from one point to another doesn’t matter, unless that path causes the investor to do something irrational. This point shouldn’t be discounted – we are all human, and it’s all-too-common for investors to panic when the value of their portfolio drops during a market correction. This results in investors doing something irrational – selling their investments at the worst possible time (when the value is low).

If an investor is prone to make mistakes due to volatility then the investor shouldn’t be investing in volatile investments. If an investor thinks they might need the money from their investments at some point in the near future then the investor shouldn’t be investing in volatile investments.

As long as an investor doesn’t fall into one of the categories above, then volatility is not a risk to a portfolio.

Related: Volatility is not the same as risk

Reducing the risk of a single company blowing up your portfolio

The real risk to a portfolio is not volatility. The real risk to a portfolio is permanent loss caused by one your investments suffering a permanent decrease in value. Reducing this risk is the primary benefit of diversification. The more investments you have (assuming they are not correlated), the lower the risk in your portfolio. If you have a portfolio of 10 stocks and one company goes bankrupt, your portfolio will drop 10%. If you have 100 investments and one company goes bankrupt your portfolio drops by 1%. Diversification reduces risk.

Of course, there’s a flip side – diversification reduces the positive effect any one investment will have. If you put all of your money in Amazon 10 years ago you’d have done a lot better than if Amazon was one of 100 companies that you split your money among.

But, in general, most of us are more interested in not going broke than in hitting a home run, and I think this becomes more and more true as you have more and more money. After all, going from $5M to $10M in net worth is going to affect your life a lot less than going from $5M to $0. As Charlie Munger says, you only need to get rich once.

The value of diversification in a portfolio isn’t reducing volatility, it’s in mitigating the risk that a single company can permanently hurt your portfolio.

THAT is the benefit of diversification.

 

What diversification doesn’t do

Diversification does NOT improve your returns.

I’m always surprised when people talk about diversification being a “free lunch” or improving returns. Why would diversification magically improve your returns?

Let’s say you have $10k to invest and you think about investing it all in stock A. Your portfolio’s return will be whatever stock A returns. If stock A does well then you’ll do well. And if stock B doesn’t poorly, you’ll do poorly. And if, heaven forbid, stock A were to go bankrupt, well, you’ll lose your entire investment.

You wisely decide that’s it’s too risky to put all of your money in a single stock, so you decide to split your investment between stock A and stock B.

Will your returns now be higher? Not necessarily. Your return will be the average of the returns for stock A and stock B.  If stock B had lower returns than stock A then you’ve lowered your returns. If stock B has higher returns than stock A then you’ve increased your returns. Adding more investments doesn’t magically improve returns. Your returns will always be the weighted average of all of your investments.

This concept is the same whether you’re diversifying inside an asset class (buying two different stocks) or diversifying across asset classes (buying a stock and a bond). Either way, diversification doesn’t necessarily improve your returns.

 

How much diversification do you need?

We’ve established that the value in diversification is not in reducing volatility (which doesn’t really matter) but in reducing the risk of a permanent reduction in your portfolio.

When you see academic studies analyzing how many stocks you need for proper diversification what they are usually measuring is a portfolio’s expected standard deviation from the index. For example, a study found that 90% of the value of diversification was achieved with a portfolio of 12-18 equally weighted investments. What this means is that achieving 100% of the value of diversification would imply getting the same return as the market.

These studies aren’t measuring diversification. They are measuring how likely it is that your portfolio’s return will diverge from the return of “the market”. But this doesn’t make sense, since I don’t know of anybody who would consider the possibility of outperforming the market as a “risk”.

The proper definition of risk is a permanent loss.

This risk is easy to calculate.

  • If you have 10 equally weighted investments then a single bankruptcy would wipe out 10% of your total investment.
  • If you have 20 equally weighted investments then a single bankruptcy would wipe out 5% of your total investment.
  • If you have 40 equally weighted investments then a single bankruptcy would wipe out 2.5% of your total investment.

Personally, I don’t see much benefit in going beyond around 20 investments in a portfolio. Bankruptcies are actually relatively rare. How rare?

 

I pulled the numbers from a few different sources so we could calculate the % of publicly traded companies in the US that go bankrupt each year. During the Global Financial Crisis of 2007-2009 the % of publicly trade companies going public peaked at 3.75%. Since then it’s averaged just under 2%/year. That’s pretty darn low.

So if you have a portfolio of 20 randomly selected publicly traded US companies, there’s about a 2% chance for each company that it will go bankrupt in any given year, and for each company that goes bankrupt your portfolio will suffer a 5% hit.

Obviously everybody’s capacity for risk is different, but for me, that’s a pretty low risk portfolio.

And remember, that’s the chance of any random company going bankrupt. By employing some very basic filters (like requiring that an investment be profitable, have investment grade credit, etc.) you can further reduce the chances of one of your investments going bankrupt.

So while it’s true that, by definition, adding more investments to a portfolio improves the diversification (assuming the new investment is anything other than perfectly correlated with the existing investments), at some point the risk reduction will be too small to even measure.

Conclusion

If somebody tells you that you need 500 stocks to be “diversified”, ask that person why 500 stocks is enough. Wouldn’t 1,000 stocks be better? And if more is better, then wouldn’t anything less than owning every public traded stock in the world be non-optimal? AT the very least you should own every public traded stock in the US…right?

And if 500 stocks is enough diversification then why wouldn’t 400 stocks be enough? Or 200? Or 100? Or 20?

You probably need a lot less diversification than you think.