<<– Continued from Part 1
In addition to showing that large numbers of additional stocks are required to achieve measurable improvements in diversification, the Evans and Archer study clarified other requirements for a well-diversified portfolio. The number of stocks selected for a highly diversified portfolio also depends on what one actually means by “the market.”
To achieve full diversification, as the scope of your definition of the “securities market” increases, you need to hold an increasing number of representative individual securities.
If one means the market for the largest U.S. companies, then the S&P 500 is one of several competing indexes and represents about 70% of total U.S. equity market capitalization. If one means the entire investable U.S. equities market, then the Wilshire 5000 is one of several that could be used. A global index would have many more stocks and would cover an even broader economic base. Therefore, the number of stocks to be well diversified would depend on what one means by the “market.” Within the meaning of finance literature, the full equity securities “market” portfolio is the global equities market and includes all investment styles and all countries.
In addition, to the numbers of different securities and their weighting, Evans and Archer indicated that you need to ensure that your securities selection process is random, if you wish to be fully diversified.
Your diversified investment portfolio construction methods should not biased toward one or another decision factor, such as being skewed toward a single industry or a subset of all industries.
Unless you buy the entire global market through an index fund or exchange-traded fund, your random selection of a subset of the whole market might be a method such as a “toss of the darts” at a capitalization-weighted stock page. This would mean that each security would have an equal chance of being selected for inclusion on a capitalization-weighted portfolio basis. Unless this random selection condition is met, the goal of constructing a highly-diversified portfolio would be disrupted, because you introduced a bias or skew through your selection methods.
Fundamental indexing investment product alternatives have received attention recently. Fundamental indexes select securities based on various company economic metrics rather than on a company’s securities market capitalization.
Concerning the use of capitalization weighting as the index benchmark for the full market and for full diversification, The Skilled Investor is well aware of the controversy percolating in the industry and in financial journals about the possible advantages and disadvantages of market capitalization weighting of mutual funds and ETFs. Supposedly “new” fundamental indexing methods are based upon various measures of a company’s economic impact, such as revenues, dividends, book value, number of employees, etc.
A detailed analysis of this “market capitalization” versus business or fundamental indexing metrics dispute is beyond the scope of this diversification article. In short, however, well-constructed statistical investment analyses of the past several decades have shown that other factors affect securities prices, in addition to the economic risk factors that affect the overall markets. In particular, a “value stock” versus “growth stock” factor seems to exist.
In general, over much longer periods value stocks tend to out-perform growth stocks. However, for shorter periods there is a cyclical and unpredictable ebb and flow, concerning when one or the other strategy produces superior returns.
Whether you should have a “value” versus “growth” emphasis in your investment portfolio selection has been debated for much longer than this more recent debate about “fundamental” indexing. In fact, fundamental indexing might just primarily be a better method to introduce a “value tilt” into an investment program.
However, the higher current fee structure associated with fundamental indexing investment vehicles on the market could nullify its potential risk-adjusted return advantage – partially or fully. There are very broadly diversified capitalization weighted market index funds and ETFs available with annual management fees of only .1% and total costs around .2% annually. [Since decimal points are sometimes hard to read on the web, note that these are "point one" and "point two" percent or one-tenth and two-tenths of one percentage point.]
Fundamentally indexed products have annual management fees that typically are .5% to 1.0% higher – not including other less visible costs, such as incremental trading expenses. You have to be very confident in your convictions about the superiority of fundamentally indexed funds to choose them over much cheaper capitalization weighted index mutual funds and ETFs.
These related articles may also be useful to you:
- What is investment portfolio diversification?
- Investment securities markets do not pay you for the risks of holding individual common stocks and bonds
- Why is diversification valuable to individual investors?
- Is the average individual investor’s portfolio well diversified?
- What is the cost to individual investors of sub-optimal portfolio diversification?
- How do changes in common stock price volatility affect diversification?
- How does the size of the common stock risk premium affect diversification?
- How many mutual funds are needed for a well-diversified portfolio? – evidence
- How many mutual funds are needed for a well-diversified portfolio? – a commentary
Tags: indexed funds
Personal Financial Planning
- American Funds – Capital Income Builder Fund – Class A Shares (CAIBX) attain a +4 Fund Authority Score (Fund Authority Scores rate mutual funds and exchange traded funds (ETFs) on the most important economic factors that influence individual investors' net long term diversified investment fund performance. The Skilled Investor developed the Fund Authority Score system to provide individual investors with concise and objective summaries of mutual funds and ETFs for comparisons within investment [...])
- Part 4 of the Biggest Personal Finance Story of the Past 30 Years ( < <-- Go to Part 3
The Biggest Personal Finance Story of the Past 30 Years - Part 4
What does it mean to individual investors that the financial services industry is now about 21% of S&P 500 market capitalization?
(For a graph of the relative percentage shares of various sectors within the S&P500 index over [...])
- Calculating Your Personal Investment Management Wage and the Opportunity Cost of Your Time (
Your personal investment management contribution is the total value that you add to your investment portfolio less the opportunity cost of your time.
When divided by the hours you spend, you can estimate an hourly wage for your personal investment management contribution. Obviously, the objective is to have a high investment wage. Unfortunately, for most people [...])
- Rational Mutual Fund and ETF Selection (Rational selection of equity and bond mutual funds and ETFs - An Overview
Given the extremely large variety and number of available fixed income and equity investment mutual funds and ETFs, investors need a rational basis to select among them. Without scientific selection criteria and a good understanding of which factors are more or less likely [...])
- California Investment S & P 500 Index Direct (SPFIX) pulls in a +8 Fund Authority Score (
The Standard & Poors 500 stock index is the most common equity index fund benchmark in the U.S. The S and P 500 tracks about 75% of publicly traded U.S. equity market asset value. The dominant issue in choosing among passively managed index mutual funds and ETF funds benchmarked against the S & P 500 [...])
- Always Completely Diversify Your Investment Portfolio (Complete portfolio diversification is always a better idea.
On average, the securities markets will not pay you to hold any skewed subset of the overall market. Doing so is just a gamble that may or may not pay off. You should not expect to be paid any more for the added risk and anxiety.
A previous article, [...])
- Choose Sufficiently Mature Mutual Funds and ETFs (Choose sufficiently mature mutual funds and ETFs
Investing in more mature equity and bond mutual funds and exhanged-traded funds (ETFs) allows you to evaluate the historical consistency of a fund's record.
On average, the future portfolio returns of more mature funds are probably no more predictable than for very young funds with a similar style or strategy. [...])
- Vanguard Institutional Index Fund (VINIX) captures the Best +10 Fund Authority Score (The table below in this article presents The Skilled Investor's Fund Authority Score and other information for the Vanguard Institutional Index Fund.
The diversified investment fund strategy of the Vanguard Institutional Index mutual fund (VINIX)
According to its prospectus filing on the U.S. Securities and Exchange Commission EDGAR system, the investment strategy of the Vanguard Institutional Index [...])
- Vantagepoint 500 Stock Index mutual fund Class II Shares (VPSKX) rate a +9 Fund Authority Score (Here is some really good news for you. The Skilled Investor has published an article about lower cost S&P 500 index mutual funds that you can read, entitled: Low Cost S&P 500 Index Mutual Funds. The Standard & Poors 500 stock index is the most common equity index fund benchmark in the U.S. The S [...])
- DWS S&P 500 Index Fund (SXPAX) receives a +1 Fund Authority Score (The table below presents The Skilled Investor's Fund Authority Score and other information for the DWS S&P 500 Index Fund (SXPAX).
The Scudder Equity 500 Index Fund (BTIEX) and the DWS S&P 500 Index Fund (SXPAX)
The Skilled Investor has published an article about lower cost S&P 500 index mutual funds that you can read, which is [...])
- Market Turbulence and Portfolio Fine Tuning (Markets are in turmoil once again as the “Greek Tragedy” continues to play out on the European stage. German and French banks are girding for a possible default, and the fear of the contagion spreading to the weaker member states of the Eurozone is freezing investors in their tracks. Stock markets are down [...])
- Conclusion of the Biggest Personal Finance Story of the Past 30 Years ( < <-- Go to Part 4
The Biggest Personal Finance Story of the Past 30 Years - Conclusion
This article concludes our series on the greatest personal finance story of the past thirty years. In this article, we discuss whether the dramatic growth in equity value of the financial services sector indicates that securities markets are [...])
- How to Lie with Statistics – Investment Performance Charts (How to lie with statistics: Investment performance charts - A Tip from The Skilled Investor
Darrell Huff wrote a short and very informative book, "How to Lie with Statistics," which was first published in 1954 and was amusingly illustrated by Irving Geis. This book is still in print and remains very popular (Amazon book rank #2,040 [...])
- Diversify fully within asset classes – Step 4 of 10 Financial Planning Steps in the Right Direction (CLICK HERE TO READ THE SKILLED INVESTOR's OTHER ARTICLES ABOUT THESE "10 FINANCIAL PLANNING STEPS IN THE RIGHT DIRECTION."
Diversification is genuinely an investment “free lunch,” and it is a key contributor to improved investment risk management.
Diversification has become an axiom of personal investing, because the specific risks of businesses and other investment entities can be [...])
- Insurable Risks Could Destroy Your Best Laid Financial Plans (
Do not ignore insurable risks that could destroy your best laid financial plans
A previous financial article, “The Solution - ONLY follow financial strategies that are scientific, passive, diversified, savings focused, risk controlled, low cost, and tax efficient,” suggested that investors are much better off with a well-considered financial plan. A stable set of financial beliefs [...])