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A short version of my question -

What is the "true" definition of a diversified portfolio and why is it better?

A long version of my question -

Regarding portfolio diversification, people generally refer to a portfolio that is all-encompassing: large-cap, mid-cap, small-cap, fixed-income, commodity, international markets (and many other types of investment), as the general arguments have been that different financial assets may perform differently under different economic environments/financial situations.

However, studies found that there is a high correlation among the performance of stocks of different cap sizes and a high correlation of stock and "alternative investments" (e.g. The Only Guide to Alternative Investments You'll Ever Need by L. Swedroe and J Kizer). In addition, considering an average investor in the US (medium US household income: $61,372) for example, who manages to save $10,000 a year for investment, there is not that much money to spread around different assets. If I were to take various index funds (see below) to calculate the return, this is what I get:

(a) the difference in the 1-yr short-term return is ~ $1,622 (equity & bond) or $444 (equity only).

(b) the difference in the 10-yr "long"-term return is $14,652 (equity & bond) or $1,225 (equity only).

Based on the numbers (and based on the feedback from other members)

  1. is investing in one index sufficient to be considered "diversified enough"

  2. does it add MORE VALUE (in return) to spread the "limited" amount of investment fund (i.e $10,000 in this case) into multiple indices? From the perspective of potential gain/loss, it seems no. Is this correct?

large-cap

Vanguard 500 Index Fund Investor Shares (VFINX):
17.74% (1-yr); 17.15% (3-yr); 13.79% (5-yr); 11.83% (10-yr); 11.17% (since inception)

mid-cap

Vanguard Mid-Cap Index Fund Investor Shares (VIMSX):
13.3% (1-yr); 13.66% (3-yr); 11.53% (5-yr); 12.27% (10-yr); 9.97% (since inception)

small-cap

Vanguard Small-Cap Index Fund Investor Shares (NAESX):
16.57% (1-yr); 16.20% (3-yr); 11.34% (5-yr); 12.21% (10-yr); 10.8% (since inception)

fixed-income

Vanguard High-Yield Tax-Exempt Fund Investor Shares (VWAHX):
1.52% (1-yr); 3.57% (3-yr); 4.85% (5-yr); 5.55% (10-yr); 6.45% (since inception)

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    Picking one index does not avoid diversification. The S&P 500 fund has 511 components. VIMSX has 364 components. (In fact, VIMSX is more diversified since VFINX is 21% concentrated in 10 holdings, while has only 7% in its 10 most concentrated holdings). These funds are individually highly diversified. – Ben Voigt Dec 30 '18 at 2:33
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  • @Ben. It is clear that there is an overlap between my question and the cited question, but I would say it's not a bona fide duplicate. It'd be a judgement call whether to close my question or not. Nonetheless, thanks for pointing out the other question, as the provided answers there (esp by littleadv) have valuable information for further exploration. – B Chen Dec 30 '18 at 14:04
  • I also edited my question a bit to add specificity that wasn't emphasized – B Chen Dec 30 '18 at 14:17
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Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Full Definition

You want a portfolio that holds many companies - from different industries, different sizes (small cap, lg cap, etc) and different regions so that you aren't exposed to downside risk if a single industry is out of favor or underperforming.

For example, you have $10k to invest and you buy $10k of Exxon Mobil. Your entire portfolio is Exxon Mobil. In this case your portfolio is exposed to sector/industry risk, country risk, company risk and concentration risk. That is, if the oil industry goes down your portfolio goes down. If the US economy goes down, your portfolio goes down. Or if the oil industry is fine but Exxon is poorly run then your portfolio goes down. Your portfolio is concentrated in a single company so you have zero diversification.

Your examples are all mutual funds, which are diversified by their very nature of owning more than one company. The simplest way to have a fully diversified portfolio is to look at broad based index mutual funds. Vanguard and Fidelity have them, I'll stick with Vanguard for simplicity

Vanguard Total Stock Market Index Fund Investor Shares (VTSMX)

This will give you diversification across US equities - small to large cap, value to growth, all the industries.

Vanguard Total International Stock Index Fund Admiral Shares (VTIAX)

This will give you diversification across non-US equities - small to large cap, value to growth, all the industries.

Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX)

This will give you diversification across US fixed income securities

Vanguard Total International Bond Index Fund Admiral Shares (VTABX)

This will give you diversification across non-US fixed income securities

Now, you need to determine how to allocate your portfolio. A young person with a long time horizon (>30 years) is typically best served in a growth portfolio, commonly around 80% equities and 20% fixed income. There are many sites, including Vanguard and Fidelity, that will help you assess what this allocation is.

As far as why you want diversification - are you going to dedicate all your waking hours to managing your portfolio? If not, then you need to be diversified because you simply won't be able to professionally manage your portfolio and leave yourself open to suffering significant losses due to over-concentration.

As far as bonds go, your perspective is common for young people as well as people with a high tolerance for risk. Bonds typically won't have the same return potential as equities but they are typically less volatile than equities - meaning your equity portfolio may fluctuate by 20% up or down in a year but your bond portfolio may fluctuate by 5% up or down in a year.

Fixed income drastically outperformed equities for a few years post the great recession, so it is possible but not typical.

2

Short answers to your short questions:

What is the "true" definition of a diversified portfolio

Diversification in the inclusion of partially correlated assets in a portfolio in order to reduce risk (volatility).

why is it better?

"better" is relative, but it's "better" than the alternative in investing in a single asset (or two perfectly correlated assets) in that the expected return is the average of the return of the two assets but the risk is less that the risk of a single asset.

Now to some of your other questions:

is investing in one index sufficient to be considered "diversified enough"

How much is "diversified enough"? Diversification is all about reducing risk. As you reduce risk, you reduce expected return, So "diversified enough" is enough to meet your return expectation with the least amount of risk possible. Or alternatively, to give you the highest return possible with the amount of risk you can tolerate.

So a large-cap equity index fund might be "diversified enough" for you, if you are young (meaning you have time to overcome any large market drops) and don't watch the stock market daily and react (meaning you don't panic sell when a drop occurs). If that's too much risk, you might look at a more blended fund that includes some fixed income or other asset classes, or a mix of funds as you have proposed.

does it add MORE VALUE (in return) to spread the "limited" amount of investment fund (i.e $10,000 in this case) into multiple indices? From the perspective of potential gain/loss, it seems no. Is this correct?

With the definition of value as just "return", then no, diversification does not add value. You'd find the single index fund that has the highest historical return and hope that it continues that trend going forward. But when you define value as return relative to risk. Then diversification does add value by lowering risk more than it lowers return.

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A capitalization-weighted index fund would be most-diversified if all the companies that it held were the same capitalization size. Capitalization size, of course, refers to the number of outstanding common shares as multiplied by the stock price. (The point of this paragraph just means that, for example, the S&P 500 would not appear to be capitalization-weighted if all 500 companies in the index were the same capitalization size.)

Fundamentally, a capitalization-weighted index fund holds larger positions in larger companies and holds smaller positions in smaller companies.

So a capitalization-weighted index fund is a type of momentum fund that increases positions in companies that are getting bigger and decreases positions in companies that are getting smaller.

Well, a fund could be capitalization-weighted without being an index fund.

But a capitalization-weighted fund is not the most diversified type of fund.

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    The question was asking for the definition of, and rationale behind, diversification. Your answer only talks about one kind of index fund, so it doesn’t fully address the question. (I haven’t voted this answer down, though.) – Lawrence Dec 30 '18 at 11:52
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    If I read the answer first, and jeopardy style was expected to guess the question, it would not be the one asked. This is a great answer to a different question entirely. – JoeTaxpayer Dec 30 '18 at 14:21
  • The post could have begun by saying that the predominant claim of diversification is actually a capitalization-weighted fund or index. – S Spring Dec 30 '18 at 17:46

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