Diversified? Yes or No?

In the April edition of a newsletter written by Mathew Young, the author brings up an interesting point about achieving diversification through the use of low cost index funds, as championed by proponents of Modern Portfolio Theory (MPT) such as John Bogle, founder of Vanguard funds. While this method is undoubtedly the best way for the average investor to put their retirement savings on automatic pilot, it contains hidden dangers.

In previous articles, I have discussed the criticisms of Benoit Mandelbrot and Nassim Taleb, who have pointed out that MPT makes the assumption that market performance can be described as a normal distribution when, in fact, the actual data produces thicker tails than are found in a Gaussian distribution. This means the market is a more dangerous place than explained by MPT.

From my understanding, the problem comes down to what data to include and what data to exclude. This question can cause violent disagreements between rational engineers. If all the other 200 data points on a graph lie along a nice straight line, what caused the one point that is way off by itself? If a sleepy junior engineer working the night shift forgot to take his zeroes before making a run, the point should be discarded, but if the cause is unknown, it might be an actual system instability that appears under rare conditions that we don’t understand. In this case, not only should the point be included, but additional testing will be recommended to the sponsoring organization.

When this question occurred in financial decision making, hedge fund programmers using accepted statistical methodology made assumptions that, while mathematically correct, made no sense outside of academia. While an occurrence can be calculated as a once in 2,000 year event based on 50 years of data, trusting this result with real money in the real world is just the kind of madness that led to the crash of 2008. This story is examined in exhaustive and exhausting detail in The Plight of the Fortune Tellers by Riccardo Rebonato, an outstanding though difficult read.

Young notes that many investors choose to buy shares in an S&P 500 index fund that mimics the value of the 500 largest corporations on the New York Stock Exchange or NASDAQ. Sounds good? Well, Young points out that market value weighting factors used in the S&P 500 put 22% of your money in technology stocks, one of the most unstable sectors in the economy. Also technology stocks are notorious for paying small dividends. Over the course of many years, you can expect about ½ of the growth of your investments to come from the compounding power of dividends. Do you really want 22% of your money in one sector that doesn’t pay a good dividend? Young points out that Apple accounts for 3.65% of the S&P 500, an amount equal to the 100 smallest constituents in the index.

Remember what happened in the Dotcom bust in 2000. Companies such as the FANG stocks (Facebook, Apple, Netflix, and Google) that went up very fast in 2015, can also come down just as fast. The average price earnings ratio for the S&P 500 over the last 130 odd years is 16. Currently the FANG stocks have a price earnings ratio of 61.

Even if you are buying mutual funds rather than shares in individual stocks, it is still worth your effort to know what you are buying. Normally a quick Internet search will list at least the top 10 positions in a mutual fund. For example Vanguard Wellington, (VWELX) a managed fund that I have purchased for my own portfolio, lists the top ten positions as Microsoft, JP Morgan Chase, Chevron, Intel Corp, Wells Fargo, Alphabet Inc, Bank of America, Comcast, Chubb, and Merck. If this was my only holding, I would be worried about an overexposure to money center banks.

Wellington, my TSP-C Fund, as well as my personal holdings, all feature Chevron.

So, “Am I diversified?” is not always an easy question to answer.

An example of the holdings of a Vanguard Target Fund appropriate for someone around the age of 40:

Vanguard Total Stock Market Index Fund Investor Shares51.9%
Vanguard Total International Stock Index Fund Investor Shares35.0%
Vanguard Total Bond Market II Index Fund Investor Shares9.2%
Vanguard Total International Bond Index Fund Investor Shares3.9%