What do you think you are doing when you diversify investments?

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Over the last year or so, I've read 20-30 books on investing, including short handbooks like The Index Card and somewhat more technical volumes like Jack Bogle's Common Sense on Mutual Funds.The thing virtually every book I've read on investing has in common is a recommendation that part of a portfolio be invested in bonds, and it took me a long time to understand why.I finally did come to a few conclusions on this score, which I shared in this modestly interesting thread on the Saverocity Forum.I'd like to take a slightly different approach to the same question, through the prism of some financial independence bloggers who are kind enough to share their actual investment portfolios online (or at least what they claim to be their actual investment portfolios). These aren't bloggers I necessarily follow myself, but are rather bloggers who seem to have a general attitude towards investing that reflects mine: invest as much as possible in funds that cost as little as possible.

The White Coat Investor

Here's the latest investment portfolio shared by the White Coat Investor blog:

  • 75% Stock
  •    50% US Stock
  •       Total US Stock Market 17.5%
  •       Extended Market 10%
  •       Microcaps 5%
  •       Large Value 5%
  •       Small Value 5%
  •       REITs 7.5%
  •    25% International Stock
  •       Developed Markets 15%
  •       Small International 5%
  •       Emerging Markets 5%
  • 25% Bonds
  •    Nominal Bonds (G Fund) 12.5%
  •    TIPS 12.5%

Physician on FIRE

Here's the latest investment portfolio shared by Physician on FIRE:

JL Collins

I'm a bit confused by how JL Collins describes his holdings, but I think he claims to be currently holding:

  • 75%-80% VTSAX (Total US Stock Market)
  • 25% VBTLX (Total US Bond Market)
  • 5% "cash"

What benefits might diversifying investments conceivably provide?

If you happen to be a fan of these bloggers, trust me when I say I'm not trying to "criticize" these investment decisions. In an era of comprehensive historical market data and cheap or free backtesting data, I'm sure these portfolios have a higher (lower?) Sharpe ratio (or whatever) than my portfolio, and if that's what you want then you can build such a portfolio yourself, or copy one of theirs.But unless you know why you're constructing your portfolio in the way you are, it seems to me vanishingly unlikely such a portfolio is the straightest path towards achieving your investment goals.Of course, there's no sense in talking about "diversifying" a portfolio unless you have a portfolio in the first place, so I'll use as a "baseline" portfolio the Vanguard Total Stock Market Index Fund, VTSAX, a fund that all three of the bloggers above use as their largest single holding. Why might a well-informed investor/blogger deviate from that portfolio?

  • The belief that another asset class will provide a higher return on investment. This appears to be the logic behind the White Coat Investor and Physician on FIRE portfolios, with their addition of small-cap, mid-cap, and value funds to the core VTSAX holding. The investors appears to believe that such funds will generate higher returns than the market-cap-weighted total stock market index.
  • The belief that an additional asset class will provide a more stable account balance. I don't know why an investor would be interested, in general, in the stability of their account balance, but it is a fixture of financial writing that this is something people are, in fact, deeply interested in. This is how JL Collins explains his bond holdings: "Bonds provide income, tend to smooth out the rough ride of stocks and are a deflation hedge. Deflation is what the Fed is currently fighting so hard and it is what pulled the US into the Great Depression. Very scary" (emphasis his).
  • Tax-loss harvesting. As Physician on FIRE explains, "Some of the complexity comes from tax loss harvesting, which results in me holding four funds in the taxable account, rather than two." In other words, he does not believe that his added diversification will improve returns and he doesn't believe it will lead to a more stable account balance, he diversifies solely for the purposes of not having substantially similar funds in his taxable account so he can trade them against one another for tax reasons.

If you want to diversify, first figure out why

After all the research I've done into investing, I was personally shocked to learn this, so don't be surprised if it's a shock to you as well: diversification doesn't increase long-term returns. Diversification only increases long-term risk-adjusted returns, which is to say, returns adjusted for volatility in your nominal account balances. If you don't care about your nominal account balances, diversification away from equities is a pure drag on your investment performance.You may, in fact, be the kind of investor that cares deeply about your account balances, in which case, frankly, I don't have any recommendation besides a heavy allocation to cash (here's a great resource for high-interest checking accounts you might consider).But if you're a long-term investor who doesn't care about your nominal account balances, you should diversify away from broad market indices only with caution and only when you have good reasons for doing so.