In the last two posts we’ve looked at how holding multiple actively managed mutual funds and/or holding a number of individual stocks is not diversification. Instead, holding multiple funds, which is essentially holding multiple investment strategies, multiplies the odds of under-performance, and holding individual stocks expands exposure to specific business risk without spreading it out far enough to meaningfully reduce it.
Two Free Lunches—Diversification and Compound Growth
Why is proper diversification so important? Let’s start at the beginning. We don’t invest for thrills or easy money or the dream of beating the market. We invest because we want our money to work as hard as we do. Essentially, we are looking for the compound annual growth of invested capital. As invested capital grows over time, it grows faster and faster since any added growth also grows along with the contributed capital—it compounds. Compounding growth allows us to meet our financial goals. It’s why we invest instead of stuffing money in a mattress.
Compound growth is a “free” lunch because the original investment provides the basis for the compounded growth.
Diversification removes the specific business risk of owning individual companies or following active strategies from this process. It allows us to reliably take what the market offers—market returns—year in and year out, while keeping our eye on our goals and not on the stock market.
True diversification is a free lunch because a broad selection of uncorrelated assets may have a higher average returns over time than any single asset class by itself.
We save and invest so that our capital grows over time sufficiently to pay for future goals like college tuition, a new house, and the largest lifetime goal we face, providing income throughout a potential 30-year retirement. Proper planning and a robust savings habit allow us to meet these goals with the least risk to capital possible.
Start with the Household Balance Sheet
To meet our goals, we don’t just invest all of our capital or whatever amount we feel comfortable investing in the stock market. The later is what Wall Street calls “risk tolerance,” which is just another guess about risk and the stock market. We can do better than guess about how much capital we should expose to market risk.
If we step back and focus on the whole household balance sheet, and not just the investment portfolio, the picture changes. The balance sheet puts financial capital in the same column as the present value of human capital (income from work) and social capital (Social Security benefits and pensions). In the other column the balance sheet puts the present value of all future expenses. The PV of expenses net the PV of human and social capital is the Income Floor that must be covered by financial capital to maintain the household lifestyle over the lifetime of the plan (Floor = PV of Expenses – (PV of Human + Social Capital)). It’s the amount of financial capital we need to pay the bills for the rest of our lives. That is why the Floor is the centerpiece of a successful financial plan, not the investment account.
Understanding the Floor on the balance sheet provides the most powerful “investment” insight available to anyone—the amount of Upside on the household balance sheet. Upside is the amount of financial capital above the Floor not needed to cover future expenses (Upside = Financial Capital – (Floor + Reserves)). Upside is the amount that can be exposed to market risk for growth without jeopardizing household lifestyle.
Investing the Upside Portfolio
Once the Floor is identified and protected, the question becomes, what is the best way to invest Upside for growth? To support our financial goals, we need to continue saving and investing Upside for compound growth based on reliable returns with the least risk.
We’ve seen that mutual fund investment strategies and stock picking do not provide reliable returns year in and year out. How to get reliable returns?
Own the whole market! And then market returns will follow, year after year. This is where diversification comes in. A global market portfolio diversifies away specific business risk while delivering the whole stock market’s equity risk premium—the annual return that stocks provide above the risk-free rate (Treasury bond interest), comprised of dividends + market risk.
Market risk (beta) is the risk of investing in the global market rather in individual businesses. Market risk cannot be diversified away—we hedge market risk by investing only Upside in the market and investing the Floor in risk-free assets to protect the household standard of living.
Bearing market risk delivers the equity risk premium as the reward for investing in an Upside global equity portfolio. The long-term historical average for the equity risk premium is about 6-8% compounded annually (depending on how you slice it). That’s the expected growth for Upside investing over a long horizon. The market may go down and not recover for many years, which is why only Upside is exposed to market risk, particularly for those in or nearing retirement, who cannot afford to wait while accessing their portfolio for income. The Floor provides risk-free income, not Upside.
What is a global market portfolio? The easiest way to build a global market Upside portfolio is with broad, passively managed low-cost index ETFs (exchange traded funds). An Upside portfolio can be as simple as owning a single index ETF, the Vanguard Total World Stock Fund (VT), for example, which follows the FTSE Global All Cap Index.
Or we can use a number of ETFs and build an Upside global market portfolio from individual index components, such as VTI (US Total Stock Market), VB (US Small Cap), VGK (Europe), VPL (Pacific), VSS (International Small Cap), and VWO (Emerging Markets). There are many similar ETFs available. In edition, we might carve out 10-15% of the total to add in global real estate with VNQ and VNQI and commodities with DBC.*
Whether one, a couple, or many ETFs, the costs are a fraction of the fees that Wall Street firms charge for strategies that do not consistently deliver market returns.
What to do: Determine Floor and Upside from the household balance sheet. Build a global market portfolio based on Upside. Contribute savings monthly. Reinvest dividends. Check the household balance sheet once a year or so to adjust the Upside and Floor allocation. Plan for the future.
And stop worrying about the stock market. Next we’ll start a series on three kinds of Floor—At-Risk, Rolling, and Dedicated.
*Disclosure: The author and clients of LFA LLC invest in these and similar funds in their Upside portfolios as part of their lifetime or retirement policy allocation.