Let’s explore the wisdom of the founder of the Vanguard group and the father of index fund investing. As a champion of the index fund investing movement, John Bogle had quite a bit to say on the topic of diversification.
“Don’t look for the needle in the haystack. Just buy the haystack.” - John Bogle
I could not find a better quote to represent all that index investing is. Everyone wants to be the next stock picker. There is a dopamine dump associated with picking and trading stocks. It’s called gambling.
The odds of you being able to consistently pick stocks and outperform the market is highly unlikely and there are countless amounts of data to support that. The majority of mutual fund managers aren’t even able to do that and they commission are tied to their performance.
Similar to mining for gold, you can pay for the permits and try to pinpoint the exact location, or you can purchase the plot of land and excavate all of it.
I highly recommend reading one of the greatest books ever written on investing, “The Bogleheads’ Guide to the Three Fund Portfolio…”
What Is Diversification?
Diversification, when applied to invest, is the spreading out of risk. It’s putting your eggs in many baskets, rather than just one.
When you purchase just one companies stock, or in a single type of asset, you’re exposing yourself to a much larger risk of losing your investment.
If you purchase the stock of 10+ companies, you are lowering the risk that any one of those companies won’t go bust. If one company does realize a reduction in stock value, you may have 15 other companies gaining in stock value.
There are many ways to diversify. My favorite way to reduce market risk is to invest in low fee index funds like VTSAX. As a result, I effectively own a slice of the entire stock market.
“With an index fund you're not paying people on Wall Street to pick stocks for you. Instead, you basically own all of corporate America. At least, a small slice. And over time, low-cost index mutual funds outperform the vast majority of actively managed mutual funds.” - John Bogle
Consider the same approach for real estate investing. Instead of buying one property, locked to specific geography, with several points of risk you can buy VNQ and gain diversification across several real estate types (commercial, residential etc…)
Advantages of Diversification with Index Funds
By diversifying using index funds you’re mitigating your investment risk. The only risk of an index fund like VTSAX or a REIT like VNQ is overall market risk.
By reducing your risk, you’re able to stay heavily invested in stocks longer than you likely would have you bought individual shares of companies.
It’s highly unlikely that you’ll lose your entire investment when you purchase a slice of the entire US economy through an index fund.
Disadvantages of Diversification with Index Funds
It’s not as glamorous as being able to name all the companies in your portfolio as an individual investor. It’s also harder to keep tabs on how each company is performing relative to its peers in your portfolio (though the goal is not to have to).
By diversifying using index funds, you’re reducing your potential return. You’re not going to see the 50% - 500% returns you might see by going “all-in” on the next Facebook, but you won’t experience the loss like you would have if you bought an airline stock in early 2020.
The Case for Investing in Bonds
There is a constant argument over the right mix of bonds in an investment portfolio. There’s no clear answer other than, it depends on your level of risk tolerance.
The best case for including some allocation to bonds is summarized by yet another great Bogle quote on the 2007-2009 financial crisis:
“Your portfolio would have recovered eventually, but what if you needed the money during that time span?” -John Bogle
The Effect of Bonds in a Portfolio
By including an allocation to bonds or bond funds, you are reducing the volatility in your portfolio. Meaning, the ups and downs can be more like hills or speed bumps rather than mountains and cliffs.
Bonds tend to create a “smoothing” effect on your portfolio. You give up potential returns to gain a reduction in risk. Typically, the closer you are to needing or accessing your money, the less risk you should be taking on.
International Index Fund Diversification
Diversification happens on a micro and macro scale. You can diversify in sectors within the United States or between different countries.
Consider the Vanguard Total World Index Fund (VTWAX) and it’s long-term performance as an indicator of the performance of international index fund investing.
Everyone should have some exposure to overseas markets, but again, the question is how much. The answer is always dependent on your investment goals, philosophy, and beliefs about the future.
America first investors may believe the greatest opportunity for growth is in the United States market while others will tell you it’s in India. These are decisions that you as an investor can make.
An easy answer is to allocate some percentage of your portfolio to overseas index funds that will give you a broad range of international diversification.
U.S. Based Companies with International Exposure
Just because VTSAX has foreign holdings of just 0.04% doesn’t mean that its top holdings don’t get a good portion of their earnings from overseas.
Consider Apple, the majority of their factories are in China and a large portion of their business comes from China. They might not be based in China, but they have an awful lot of exposure to Chinese economics.
There are many benefits to diversification with index funds. They have low expense ratios, aren’t actively managed, and have been around long enough to provide us with highly useful data.
While diversification is important, how you diversify is up to you and your investment philosophy. A decent mix of stocks (domestic and international), bonds, and real estate is probably a good strategy to consider.
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Editor’s Note: This post was originally published in July 2019 and has been completely revamped and updated for accuracy and comprehensiveness.