Diversification

[Jerry1]

Was listening to a podcast today and the host made an interesting observation about diversification and index funds. He used the S&P as an example. Since you cannot but the index (it's a statistical model), we but an index that closely matches the index. In the S&P the stocks are weighted. Without getting into details, he stated the following:

The first 5 stocks make up about 12% of the S&P.
With the next 5 (top 10), you're up to about 20%
Another 10 (to 20) and you're at about 30%.

So while we think we have broad exposure to the market by following an index fund, the weighting distorts that. If you look at the top 5, Apple, Microsoft, Amazon, Facebook, Johnson and Johnson you're highly weighted on technology.

Another point he made is that as a ton of people have moved into index funds, this weighting causes the index fund managers to buy in a weighted manner which is somewhat of a momentum push for those stocks.

I thought it was interesting and his only conclusion was to look into the index you're buying and understand what stocks and what proportion you're actually buying.

I was wondering what the group thought of this and this also lead me to my next thought - should I concentrate my investments in an index fund which has a goal of tracking an index or, should I concentrate on good funds with a track record and goal of maximizing return based on an objective (thinking of Wellington and Wellesley).

 

[Onward]

Value of track record = 0

Value of goal of maximizing blah blah = 0

Index.

 

[bw5972]

I would never invest in a fund without taking a good look at its Morningstar page.
If you have not used it, here is an example link to Vangards S&P 500 index fund.
Note the sections on "Top Holdings", "Top Sectors" for starters. Lots of other good info as well.

VFIAX Vanguard 500 Index Admiral Fund VFIAX Quote Price News

 

[FlaGator]

What has worked for me:

-Broad market indices - Total US market, Total International
-Some concentration in small caps, both US and Intl
-Diversifying away from the sector I was employed in. My continued employment and compensation was heavily leveraged to the residential RE market. I worked in a real estate related business, and the last thing I wanted was to own when I was employed was a REIT, or any rental properties.

I think it is easy to get wrapped around the axle with index composition. They are all imperfect, but if you're in a broad index, you'll capture your share of the upside.

Did the active fund thing for a many years and my results were consistent with what I have seen reported here - some really good years, some poor, and would have been better with a broad index.

It's the big things that matter. If you work for an airplane manufacturer, don't hold a bunch of their stock in your 401K. IMO, holding ANY employer stock longer than one has to is stacking on risk while you are in the accumulation phase. Ask the former employees of Enron and WAMU how that worked out for them. And don't kid yourself it can't happen. Total failures of large public companies are infrequent, but spectacular disasters when they do. Aerospace in Seattle nearly collapsed in the early 70's. May never happen again, but it would be imprudent to think it couldn't.

ETA: not saying the OP holds a bunch of company stock or works for an airplane manufacturer. Saw a post earlier today from someone who apparently does, so that situation was in my mind.

 

[donheff]

If you want to analyse and pick stocks you don't belong in an index in the first place. It seems to me that a market weighted index is reflective of the market. Equal shares of all participants or some other scheme is not. Buying up shares out of proportion to their market cap would distort markets more than simply buying them in proportion.

 

[pb4uski]

+1 The objective of an index fund is to hold the entire market in roughly the weightings of the entire market so you receive the performance of the market.

Did the genius on the podcast explain the implications of this fatal flaw in index investing and how to avoid it?

I guess part of the solution is to not focus on the S&P 500 as it is a bit narrow (but much broader than the Dow which is ony 30 stocks). For the Total Stock Market Index Fund the top holdings are 16.4% of the total (vs ~20% for the S&P 500):

Month-end ten largest holdings as of 06/30/2017
Rank Holdings
1 Apple Inc.
2 Alphabet Inc.
3 Microsoft Corp.
4 Amazon.com Inc.
5 Facebook Inc.
6 Johnson & Johnson
7 Exxon Mobil Corp.
8 Berkshire Hathaway Inc.
9 JPMorgan Chase & Co.
10 Wells Fargo & Co.
Ten largest holdings = 16.4% of total net assets

There are index fund that invest in the S&P 500 in equal weightings rather than market cap, but it essentially just skews to mid-cap stocks which sometimes do better than large caps and sometimes do worse. See this article:

https://www.forbes.com/sites/rickfe...-lunch-from-equal-weight-sp-500/#4dacb6183356

 

[easysurfer]

If you want to analyse and pick stocks you don't belong in an index in the first place. It seems to me that a market weighted index is reflective of the market. Equal shares of all participants or some other scheme is not. Buying up shares out of proportion to their market cap would distort markets more than simply buying them in proportion.

+1

My goal is to follow the index come hell or high water without trying to overthink things .

 

[OldShooter]

@Jerry1, it's no surprise you are a little confused. The word "diversified" really has to be supplemented with some other words.

Start with a basket of stocks. Various things I have read say that it is necessary to have 30-60 stocks in the basket to "diversify away" "individual issue risk." (This is the essence of Modern Portfolio Theory). What that successful diversification leaves you with is the risk of the whole basket. So for example, if your basket contains 50 stocks, all emerging market stocks, then you have 100% of the market risk of the emerging market sector but little or no individual issue risk.

First point: It's the same thing with the S&P 500. Assuming that with 500 stocks you have diversified away the individual issue risk, you are left with the risk of the US Large Cap sector.

Second Point: Your podcast guy (and others) argue that given the S&P's cap weighted structure, it may not have completely diversified away individual issue risk. Personally, I am agnostic on that.

Third Point: If you really want to reap the benefits of passive investing, Eugene Fama says "you have to hold the market portfolio." IOW, everything. Now you have diversified away sector risk and are left with the only unavoidable risk: total market risk. At this point, people can mitigate total market risk by allocating some of their assets to fixed-income securities. The jargon is sloppy here, too, because it equates risk with volatility. To me, risk is when my assets go down. I'm not unhappy when volatility makes me richer. If you really want to dig, look up "Sharpe Ratio" and "Sortino Ratio."

I have drunk the academic kool-aid, as have @pb4uski and @FLGator. I would question @easysurfer's statement because I don't know what he means by "the index." If by "the index" he means the S&P 500 index, then he has the sector risk of US Large Caps and zero exposure to other sectors. If by "the index" he means the All Country World Index (ACWI), All Caps, then he is truly a passive investor and following the religion of Markowitz, Fama, and French.

HTH

 

[W2R]

should I concentrate my investments in an index fund which has a goal of tracking an index or, should I concentrate on good funds with a track record and goal of maximizing return based on an objective (thinking of Wellington and Wellesley).

Good question. When I was planning my retirement portfolio and asset allocation, I couldn't decide which I liked better. So, I did a little of each.

I have mostly index funds. But I also have 30% Wellesley, and a substantial amount of the TSP's "G Fund" (government bond fund, guaranteed to never drop in share price).

 

[mickeyd]

Was listening to a podcast today and the host made an interesting observation

It would be good to know who the "host" of the podcast was. Seems more like a sales pitch.

 

[easysurfer]

...

I have drunk the academic kool-aid, as have @pb4uski and @FLGator. I would question @easysurfer's statement because I don't know what he means by "the index." ....

HTH

By "the index" I actually meant the indexes as in a total US Market index, total international index, and a total bond index. Each allocated and reallocated to targeted allocations. The goal is to just deal with % allocations and take other factors out of the picture.

 

[OldShooter]

By "the index" I actually meant the indexes as in a total US Market index, total international index, and a total bond index. Each allocated and reallocated to targeted allocations. The goal is to just deal with % allocations and take other factors out of the picture.

Sweet. Just out of curiosity, how much home country equity bias do you have? That is the one thing where the academics don't seem to be a lot of help. No bias would be 50/50 US and International. We are running 65/35 right now but I don't have a strong defense for picking that bias.

 

[easysurfer]

Sweet. Just out of curiosity, how much home country equity bias do you have? That is the one thing where the academics don't seem to be a lot of help. No bias would be 50/50 US and International. We are running 65/35 right now but I don't have a strong defense for picking that bias.

At this moment, my target allocation is:

34% US
17 % International
36.25 % US Bond Index
12.25% Cash

Summarized, 52% equity, 49% Bonds + Cash. The target allocation changes slightly each year as I get older.

Of equity amount, I like to keep about 2/3 US equity, 1/3 international.

I've always found too that the suggested allocations, can be very subjective based on risk tolerance.

 

[Lawrencewendall]

Cash 1.48%
Intl Bonds 1.81%
U.S. Bonds 8.09%
Intl Stocks 8.7%
U.S. Stocks 60.33%
REIT 19.59%

YTD returns 10.24%

Works for me.