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I understand this might be a subjective matter. The context from which I'm asking is this: a friend and I were talking about my "portfolio" (I use the term loosely), which is currently just two very simple investments: one in a domestic total stock market index fund (VTI, if it matters), and another in a similar fund for the international stock market (kind of embarrassing, but I don't remember which one at the moment—anyway, I'm hoping it's not really critical to the question).

I am of the opinion that for me, this is a great approach as I'm not passionate about researching different stocks but also don't want to put all of my eggs in one basket. My rationale is that by spreading my investment roughly evenly across the entire stock market through VTI, I'm basically just investing in the continued growth of the U.S. economy (and the same goes for the international fund). Which feels to me pretty low-risk over a long enough period of time.

My friend, however, felt that by investing in only these funds I am doing the very thing I want to avoid—i.e., putting all my eggs in one basket. He encouraged me to invest in other funds as well, to better diversify and not be quite so vulnerable in the event that VTI performs poorly in the coming years.

To my mind, this is a backwards recommendation since investing in other funds that are not so broadly distributed across the entire market will effectively just make my overall portfolio more lopsided in favor of the more specialized funds. But maybe I'm missing something? Do I need to rethink my strategy? Is there something I'm overlooking?

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2 Answers 2

up vote 5 down vote accepted

You are diversified within a particular type of security. Notably the stock market.

A truly diversified portfolio not only has multiple types of holdings within a single type of security (what your broad market fund does) but between different types. You have partially succeeded in doing this with the international fund - that way your risk is spread between domestic and international stocks.

But there are other holdings. Cash, bonds, commodities, real estate, etc. There are broad index funds/ETFs for those as well, which may reduce your risk when the stock market as a whole tanks - which it does on occasion.

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Also, with regards to the vehicles of investment: holding multiple mutual funds / ETFs is not as effective at diversification as having diverse holdings within the mutual funds you do have. You can get a pretty diverse portfolio with a single fund (e.g. a target-date fund). You shouldn't add mutual funds just for the sake of having a variety of mutual funds, add them for the sake of having different underlying holdings, like adding bonds to your stock-only holdings. –  fennec Jul 18 '12 at 20:45

Typically investing in only two securities is not a good idea when trying to spread risk. Even though you are in the VTI which is spread out over a large amount of securites it should in theory reduce portfolio beta to zero, or in this case as close to it as possible. The VTI however has a beta of 1.03 as of close today in New York. This means that the VTI moves roughly in exact tandem as "the market" usually benched against the S&P 500, so this means that the VTI is slightly more volatile than that index.

In theory beta can be 0, this would be akin to investing in T-bills which are 'assumed' to be the risk free rate.

So in theory it is possible to reduce the risk in your portfolio and apply a more capital protective model. I hope this helps you a bit.

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Two securities is not what this investor is in. He's well diversified within the stock market. –  JoeTaxpayer Jul 17 '12 at 4:27
    
while your right he is not in two securities per se as in GOOG or CSCO, he is in funds, those funds themselves do provide risk protection, but they inherently are as volatile as the actual market and thus he can reduce his risk. Having a portfolio beta of 1 is considered well diversified, I was just trying to point out that he is as well diversified as the market and will loose or gain approximately as the market does. Thank you for making that more clear then I did @JoeTaxpayer –  MCP_infiltrator Jul 17 '12 at 13:47

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