Eggs in Baskets: A Few Words About Portfolio Diversification

Any even slightly savvy investor knows about the need for diversification. Put simply, it's the financial version of the classic Aesop moral to not put all your eggs in one basket. But when it comes for picking the right strategy for making sure you have your nest egg in a relatively stable set of baskets, it's (surprise!) not always so simple. 

In this clip from Motley Fool Answers, Alison Southwick and Robert Brokamp answer a listener question about diversification strategy, specifically whether he should balance his individual stocks and his market-weighted index ETF with a fundamentally weighted index ETF. Learn exactly what the difference is between the two, why one might be preferable to the other, and what might be the best way to hedge portfolio risk. 

A transcript follows the video.

This podcast was recorded on June 21, 2016.

Alison Southwick: Today's question comes from Chris from northern Minnesota, who, at this exact moment, is milking a cow.

Robert Brokamp: Do we know that for sure?

Southwick: We do know that, because Chris is a dairy farmer and he listens to Motley Fool podcasts ...

Brokamp: Oh, that's nice. Hi, Chris!

Southwick: ... while tending to his cows.

Brokamp: Say hi to Bessie for us.

Southwick: Chris writes: "I buy individual stocks but have been diversifying with buying a Vanguard S&P 500 ETF. I was just wondering if it would make sense to diversify that market-cap-weighted index with a fundamentally weighted index." Bro, define some terms for me here.

Brokamp: Well, first of all I'd like to say to Chris that I think you're doing a very smart thing in that you're buying individual stocks but also diversifying into an index ETF. You're hedging your advisor risk, which is the risk that your retirement is riding on the investment skills of one person -- in this case, you -- so I think that's smart.

The S&P 500 is a market-weighted index. What that means is bigger companies have a bigger weighting. For example, if you were to put $1,000 into an S&P 500 index fund today, about $32 of that would be invested in Apple, the biggest company in the index.

Southwick: Oh, OK.

Brokamp: The smallest company, Diamond Offshore Drilling -- you'd have a grand total of about a dime. In other words, you'd own 331 times more Apple than Diamond Offshore Drilling. And this has led to some criticisms about market-weighted indexes.

First of all, the performance is really driven by the biggest 50 to 100 stocks, so it's not really as diversified as some people will say, and the performance of the small companies really have no effect. Your Diamond Offshore Drilling could double in price, and your $0.10 holding is now $0.20. It's essentially meaningless.

But also, as a company's share price goes up, it has a bigger influence on the performance. It's sort of like buying a stock after it has already gone up. A big concern about that is some stocks go up way too much, and that exposes more people to these stocks when it might be time for a bubble.

For example, if you look back at 1999 at the top holdings of the S&P 500, right before the tech bubble crash, among the top 10 stocks were Microsoft, Cisco, Lucent, Intel, America Online, and IBM. So of those top 10 stocks, only one, IBM, is worth more today than it was way back in 1999. It was the same right before the Great Recession. In 2006, among the top 10 holdings of the S&P 500 were Bank of America, Citigroup, and AIG, which then went on to lose 99% of its value. So several folks have said that we should change this and weight things differently.

One easy way to do that would be to take the 500 stocks in the S&P 500 and just put an equal amount in each of them. You can do that with a Guggenheim ETF. It's called the Equal-Weight S&P 500 ETF.

Southwick: As advertised.

Brokamp: As advertised. But then there are other methods where people say we should weight the index according to a company's fundamentals, like its sales. Its profits. Its dividend. These have become known as fundamental indexes.

Southwick: OK.

Brokamp: So instead of saying, "I'm going to build an index based on the market cap of a company. I'm going to build it based on sales, so that the company with the most sales is the one that has the biggest holding." Or the biggest dividend yield. Or something like that. And one of the first ones to come out was the PowerShares FTSE RAFI US 1000.

Southwick: Woo-woo-woo! That sounds exciting!

Brokamp: Exciting. It's been around for about a decade. So when you look at the performance of these -- because it is relatively new to do these sort of alternative ways to weight indexes -- they actually do outperform the S&P 500.

Why is that? Because what you're generally doing, relative to the S&P 500, is you're taking some of the money away from big companies and investing in small companies. You're also putting less money in more growth-ier types of companies and more ...

Southwick: Growth-ier? Is that the technical term?

Brokamp: That is the technical term. And putting more money into companies that are cheaper by some metric, like price-earnings ratio. Over the long term we know small caps generally beat bigger companies. Value-oriented stocks, as a group, tend to beat expensive companies.

So I'm all for the theory of fundamental indexes. I think it's a smart idea to diversify your individual stocks into something like this. But you can accomplish something very similar by just buying a small-cap index fund or a value-oriented index fund. I wouldn't abandon the S&P 500 totally, because despite its flaws, history has shown the vast majority of mutual fund managers and the vast majority of individual investors just can't beat it.