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The Power of Effective Diversification: Part II

Last week, I posted an article discussing how diversification is one of the most misunderstood concepts in investing. In today’s post I continue with the second half of this two-part series titled, “The Power of Effective Diversification.”

In Part I of this article, I discussed the difference between naive diversification (holding lots of stuff in a portfolio) and real diversification (combining assets in a portfolio to create risk offsets).  I also showed how a well-diversified portfolio can maintain the ability to participate in market rallies while still mitigating risk.  In Part II, we will explore what an effectively diversified portfolio looks like today.

Target Date Folios: Designed for Diversification

In Part I, I used Folio Investing’s 2020 Moderate Target Date Folio for a case study.  This portfolio combines a range of asset classes, with the goal of maintaining a risk level appropriate for an investor retiring around the year 2020, while also keeping allocations to asset classes with return potential that investors are likely to need in funding an extended retirement.  This Folio has largely kept up with the S&P500’s impressive roughly 40% cumulative gain in the last three years, while reducing exposure to the S&P500’s volatility.

So how has this Folio so substantially reduced risk while keeping up with the S&P 500’s rally?  To answer this question, it is useful to look at the actual portfolio holdings:

Company Symbol
Vanguard Short-Term Bond BSV
PowerShares DB Commodity Index Tracking DBC
Vanguard World Fd Extended Dur EDV
iShares Tr High Yld Corp. HYG
iShares Trust S&P National AMT-Free Muni Bond MUB
PowerShares Insured National Muni Bond PZA
iShares Barclays TIPS Bond TIP
Vanguard Index Small Cap ETF VB
Vanguard Energy ETF VDE
Vanguard Information Technology ETF VTG
Vanguard Utilities ETF VPU
Vanguard MSCI Emerging Markets ETF VWO

The portfolio (Folio) consists of twelve index Exchange Traded Fund (ETFs).  The aggregate expense ratio (the expense ratios for all of the ETFs, weighted for the allocations) for this portfolio of ETFs is 0.29%.  This is well below the average expense ratio for Target Date Mutual Funds.

This asset allocation will probably look fairly unconventional to many readers.  Indeed, this is one of the most common comments that Folio gets about the Target Date Folios.  This portfolio has no allocation to benchmark asset classes such as the S&P500 or the EAFE index.  There are substantial allocations to energy stocks (15% in VDE) and information technology stocks (15% in VGT).  There are also substantial allocations to municipal bonds (15% in PZA and 3% in MUB).  Commodities represent 15% of this Folio as well (DBC).

The Target Date Folios are re-analyzed each year and 2012 is the first year for which municipal bonds have been included in the Folios.  In 2007, when the Target Date Folios were launched, TIPS were a major holding whereas today they have almost no allocation.  The allocations change somewhat from year to year as risk for different asset allocations change and as correlations between asset classes evolve.

Quantitative Diversification: Measure Risk and Correlation

The idea of diversification is not new.  The apparent lack of effectiveness that many investors perceive in a range of conventional asset allocations is largely due to poor execution rather than a flaw in the theory.  Simply owning large numbers of securities does not necessarily result in a diversified portfolio.  Effective diversification requires a robust quantitative approach to measuring risk and correlation among asset classes and for accounting for total portfolio risk.

The Target Date Folios show what is possible when diversification is tackled rigorously.  As theory suggests, you can maintain the upside potential from market rallies while reducing volatility and the sensitivity of a portfolio to a decline in any single asset class.  Even in light of market performance in recent years, when many felt that diversification had lost its effectiveness, our research and real-world experience demonstrates that diversification is highly effective at mitigating risk while allowing a portfolio to participate in the upside potential provided by exposure to risky asset classes.

Note: for reference, the performance of the 2030 Moderate Folio and the 2040 Moderate Folio are shown below for the same time period as used in the chart of the 2020 Moderate Folio above.

Funded Performance of the Target 2030 Moderate Folio vs. S&P 500:


Funded Performance of the Target 2040 Moderate Folio vs. S&P 500:


Learn More about Folio Investing’s Target Date Folios

To learn more about the not only the Target Date Folio methodology, but all of our more than 33 Target Date Folios, visit Folio Investing today.


The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services.

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