Diversify, Diversify, Diversify

Long-Term Chart for the S&P 500 Index

It is without doubt that the U.S. stock market has been one of the greatest wealth generators over the past fifty-three years, but it has been a rocky ride for some. Market movements, whether up or down, never occur in  a straight line, and, as can be seen in the above graphic, the S&P 500 has seen its share of choppiness over the last five plus decades. However, there is no arguing that, if the parents of those children born in 1960 had purchased shares of the S&P 500 index in their children’s names, those children (Uhh, Hmm, I mean gracefully aged fifty-somethings) would be sitting on rather sizeable profits.

Chart Pattern for the S&P 500 Index for the Period Ranging from 1996 to 2013

If, however, you are one of those poor souls who began investing at the height of the Dot.com bubble, in late August of 2000, then you have just cleared the “I promise, God, if you just let me break even I will sell all of my stocks and swear to never foolishly invest ever again.” hurdle. Certainly, investing over the last seventeen year period has not been for the faint of heart; and, if you are one of those investors who, in your late forties, said to yourself “I had better start investing now for the future because I don’t have enough saved.” people, then you may very well now be one of those people who required the implantation of a pacemaker in order to keep you heart rhythm in-check.

Indices Growth Rates for Various Periods

In the above table, the annualized growth rates for the periods between 1960-2012, 1970-2012, 1980-2012, 1990-2012, 2000-2012 and 2007-2012 are shown. (Note: The date range begins at the end of the previous year for the ranges measured.) As can be seen, the growth rates for the years between 2000-2012 and 2007-2012 (the period which saw the birth of the Great Recession) have been rather dismal. If the average lifespan of a human being is ~70 years of age, then the twelve plus years from 2000 to 2013 (i.e. as of today, May 30, 2013) would represent slightly over seventeen percent of the person’s total lifespan. Now, that can be rather discouraging to an investor! Imagine living with stock losses for approximately one quarter of your time investing. I can see why so many people living today would be hesitant to invest in the stock market.

One point, however, needs to be made clear here, and that is that the information in the table above does not take into consideration any dividend reinvestments or any other material events (e.g. stock splits, mergers (with regard to individual equities) etc.) that would have had an impact on one’s investment portfolio. It also does not take into consideration any other asset classes (e.g. bonds, real estate, precious metals etc.) outside of equities; it simply looks at equity indices; which brings me to the oh so crucial point — diversification.


When I think of the idea of diversification, I recall reading an article, written some years ago, by a very well renown investment guru in which he stated that he only believes in investing in the best of the best — after all, why waste time investing in securities which will only serve to drag down your other investments. The problem is, however, that investors are a very fickle bunch. They are constantly seeking-out new opportunities to make money, and, as such, they will move along the different levels of the investment spectrum in much the same way that water will flow from one side of a tank to the other when the tank is rocked back and forth. Now, if the investor/s is/are small, then investor fickleness will not affect the rest of us. If, however, large institutional investors or hedge fund managers decide to move monies under their management from one asset class to another (i.e. rebalance), then the rest of us are going to feel a tectonic shift in our own, little investment world. And, given that no one can truly know when such changes will occur, the only way to be prepared for such changes is to be “diversified.”

In a recent article entitled “Should You Maintain an Allocation to Bonds When Current Rates Are Low?” contributing AAII author Craig Israelsen showed the historical returns of six different portfolios, as measured over a period of fourteen years. The information is designed to represent the results for different portfolio mixes for an investor in her/his retirement years.

7Twelve Portfolio Results

Though the article is geared toward retirees, it shows the importance and value of diversification. As can be seen in the above table, the most diversified portfolio, which Israelsen refers to as his “7Twelve Model” portfolio, faired better than all of the others. In the article Israelsen never reveals the composition of his 7Twelve portfolio, however, he does describe the portfolio in the following manner:

The 7Twelve portfolio includes 12 asset classes that are equally weighted at 8.33% of the portfolio. The asset classes are large U.S. stocks, mid-cap U.S. stocks, small-cap value U.S. stocks, non-U.S. developed stocks, emerging non-U.S. stocks, real estate, natural resources, commodities, U.S. bonds, TIPS (Treasury Inflation-Protected Securities), non-U.S. bonds and cash. Each asset class is rebalanced annually.

Though portfolio specifics are never revealed, a collection of ETFs and mutual funds can be used to easily create a portfolio with the mix described in the article.

  • Vanguard Total Stock Market ETF (VTI)— Expense Ratio: 0.05%
  • Vanguard FTSE All-World ex-US ETF (VEU) — Expense Ratio: 0.15%
  • Vanguard Total Bond Market (BND) — Expense Ratio: 0.10%
  • Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares (VWITX) — Expense Ratio: 0.20%
  • Vanguard Long-Term Tax-Exempt Fund Investor Shares (VWLTX) — Expense Ratio: 0.20%
  • Vanguard REIT Index Fund Investor Shares (VGSIX) — Expense Ratio: 0.24%%
  • Vanguard Short-Term Inflation-Protected Securities ETF(VTIP) — Expense Ratio: 0.10%
  • PowerShares Global Agriculture Portfolio (PAGG) —Expense Ratio: 0.75%
  • Vanguard Materials Index Fund (VAW) — Expense Ratio: 0.14%
  • Vanguard Energy Index Fund (VDE) — Expense Ratio: 0.14%
  • PowerShares DB Base Metals Fund (DBB) — Expense Ratio: 0.75%
  • iShares COMEX Gold Trust (IAU) — Expense Ratio: 0.25%
  • Gold Trust ETF (GLD) — Expense Ratio: 0.40%

Now, as one can see, the portfolio I have created is heavily weighted toward Vanguard’s products, which I tend to favor because of the low expense ratios and because of the company’s conservative management style. I have also included securities that cover areas of investments not mentioned in the AAII article (e.g. agriculture and municipal bonds). I have also included two Vanguard muni funds to cover the municipal bond market and two gold trusts that can be substituted for one another (GLD being the larger of the two and IAU having the lower expense ratio). With regard to the muni funds, an investor can choose whether or not she/he is more comfortable with long or intermediate term municipal bonds. If, however, one were to look at the composition of both funds, one would find that they are very similar, with ~50% of the investments in both funds situated in the 5 — 10 Year category.

VWITX Portfolio Characteristics
as of 4/30/2013

VWITX Portfolio Characteristics
as of 4/30/2013

VWITX Portfolio Characteristics as of 5/30/2013 VWLTX Portfolio Characteristics as of 5/30/2013

Both funds pay dividends on a monthly basis, and the current Distribution Yields are: 2.97% for VWITX and 3.77% for VWLTX.

Investing is much more an art form than it is a sport, and, as such, a large part of constructing an “artful” portfolio involves diversification. Fortunately, for all of us, creating such artwork does not need to be difficult or expensive, it simply needs a clear vision of the picture we wish to paint for ourselves.

Note: Information for this article was collected from AAII.com, MeasuringWorth.com, StockCharts.com and Vanguard.com. Chart data courtesy of optionsXpress.com.

Disclosure: No positions at this time, and no intentions of purchasing any of the securities mentioned in this article within the next three trading session (i.e. as of 6/3/2013)

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