The goal of diversification is to ensure access to a lot of upside without being exposed to an unacceptable downside. But are you as diversified as you think you are?
Long-time community member, Frank Vasquez says there are three roles bonds have in your portfolio, income, stability, and diversification.
The Holy Grail Principle focuses on what the concept of diversification really means. It doesn’t mean different, it means uncorrelated.
Investors can use online websites to calculate the correlation of two assets that results in a number ranging from 1 to -1.
The closer the number is to 1, the more highly correlated they are. A number close to 0 indicates the assets are uncorrelated and move randomly with respect to each other. A negative result means the assets are negatively correlated and typically go in opposite directions.
Why would an investor want assets that are negatively correlated if that means while one is doing well, the other is not? In the accumulation phase when an investor is trying to build wealth, they probably would want negatively correlated assets. Upon reaching FI, they may be helpful when attempting to ensure the highest safe withdrawal rate.
Safe withdrawal rates for each portfolio will vary slightly and range from 3-5.5%. There are websites online to help calculate the rate for different portfolios.
Frank has three adult children who he advises to max out their retirement accounts in basic index funds. The next bucket to fill is an emergency fund, followed by a taxable brokerage fund to used toward a down payment on a house.
His son’s brokerage account used a risk parity-style portfolio, which is good for intermediate-term savings.
When first starting out, money invested is a big pile of future cash. You invest a little each year and should get it into risky, growth-oriented, and reliable investments, which are stock index funds.
Until you have $100,000 in your account, being invested in one fund is perfectly fine. It’s about earning and saving at that point. After the first $100,000, earnings begin to mean a little more and you can embrace a little more complexity.
In the four phases of investing for retirement, the first two are earning and saving and are the most important to get automated saving going. Phase three is investing and the fourth is managing the investments to ensure they don’t blow up or go away.
Long-term accumulation comes first in a portfolio, and Frank’s son is extremely frugal, making the risk parity portfolio possible. But what considerations are there if you are looking to transition index funds into a risk parity portfolio?
The first step is to figure out where you are going and where the goal is. Next, look at what you have and what needs to be transitioned. Start the process when you hit your FI number or about five years out from when you think you are going to need it. You don’t want to be 100% equities and have the stock market crash two years before you retire.
A risk parity portfolio does not stop earning money. The return is approximately between 6-8% after inflation, but the tradeoff is you are also only getting half the volatility of the stock market.
You can’t optimize the performance of your portfolio in the future, but you can control your expenses, modify them, and take less in one year if you need to.
Treat all of your assets as one big portfolio. You don’t want to incur unnecessary capital gains in your taxable accounts, so moving funds in retirement accounts is appropriate. The least movement possible is best and anything taxed as ordinary income should be put into retirement accounts.
Risky parity is a style of investing that has become more accessible to everyone with no-fee trading. It is finding uncorrelated or negatively correlated assets and combining them to reduce the risk of the overall portfolio.
The main driver of the portfolio is going to be stocks at 4-60%. The most diverse thing from stocks are Treasury bonds, like long-term Treasury bonds, at 20%. Gold may be an alternative.
Bonds are not good income generators anymore. The go-to places for income sources are REITs and Preferred Shares.
If you want to invest in something like Bitcoin, make sure you have a volatility match to it.
Listener Andy asked about what percentage of a stock portfolio should be in international stocks. Frank says the issue with international funds is that they are highly correlated with US funds so they aren’t very useful.
When Frank is deciding on investing in something, he looks at how useful it will be in his portfolio. He looks at its correlation with the rest of his portfolio and its volatility. You don’t want to put very much of something with high volatility in your portfolio.
Listener Luke asked about Frank’s views on factor investing and if has or plans to have small-cap value funds in his portfolio. Franks says he does have small-cap value in his portfolio because they are less correlated with the overall stock market than an international fund.
Franks says you want a basic and diversified two-fund portfolio that covers the whole market would consist of large-cap growth and small-cap value funds.
The correlation between a total stock market fund and an S&P 500 fund is extremely high and a kind of false diversification.
Although index funds are cap-weighted and gaining more and more of the larger companies over time, they are also self-cleansing in that companies doing worse fall down or fall off. Small-cap value funds do the reverse. When a company gets too big, it gets kicked out. Holding both types captures each end of the spectrum.
According to the Macro Allocation Principle, what matters most in investing are the macro allocations between stocks and bonds. According to Jack Bogle, any 60-40 stocks to bonds portfolio is going to perform 94% the same way as any other 60-40 portfolio.
Listener Claudia asks what a bond tent would do to her sequence of return risk. Franks says a bond tent is an old-fashioned way of dealing with sequence of return risk, but he says it’s not functionally different than buying a short-term or intermediate bond fund.
Bonds should move opposite of the market, but lately, they have moved with the market. Franks says different bonds behave differently. Some do not provide much diversification. Focus on Treasury bonds for diversification.
The hallmark of a very diversified portfolio is when you see different things moving in different directions at different times.
Rental real estate and stocks have a low correlation, so it can be a good way to diversify, although sometimes they can move together as in 2008.
In Frank’s mind, diversification should mean uncorrelated, it doesn’t mean having lots of stuff.
Frank’s podcast is focused on risk parity and he has created six sample portfolios at Fidelity that he discusses each week. While Frank likes to nerd out on this stuff, you don’t need to to become a successful investor.

Frank Vasquez

Resources Mentioned In Today’s Conversation

ChooseFI Episode 194 The Role of Bonds in a Portfolio
Portfolio Visualizer
Portfolio Charts
The Four Phases of Saving and Investing For Retirement
ChooseFI Episode 176 Flexible Spending Rules for Early Retirees
Using Gold as a Hedge Against Sequence Risk – SWR Series Part 34
The Little Book of Common Sense Investing by Jack Bogle
Money for the Rest of Us Podcast
Money for the Rest of Us by J. David Stein

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313 | Are You as Diversified as You Think You Are?