Do you have a truly diversified investment portfolio?

User catandmouse asked this question over at the Personal Finance and Money Stack Exchange site:

How should one structure a portfolio given the possibility that a Total Stock Market Index might decline and not recover for a long time?

It’s a common financial advice to buy an index and hold it forever. Particularly, John Bogle endorsed buying an S&P 500 index and just hold it / buy more of it during bear markets so you get rewarded when the market recovers.

However, if someone applies the same principle to the Nikkei 225, 21 years later, the market still hasn’t recovered. Maybe, a 21-year time frame is still too short but for an average investor’s lifetime, it’s already quite long.

If such is the case, how should one structure a portfolio given such possibility, however remote, can happen to any US total stock market index?

This was my answer. I deleted it from that site and brought it here. I’ll explain why after.

First, consider the source.

John Bogle is founder of The Vanguard Group. He practically invented index-based investing, and he offered it at a lower cost than anyone else.

Would he recommend index-based investing? Of course! He sells it.

Would he want you to buy index funds and hold them for the long term? Of course! Vanguard’s fees are based on invested capital, and they come out regularly regardless of whether there was appreciation or depreciation. They make money either way the market goes. And the more money you have in their index funds, the more money they make off of you.

It is true that buying more when the market is down will pay off when the market recovers. But, again, if it doesn’t, Vanguard still makes money off of you! The market recovery is just one of many what-if scenarios, and is not binding on them at all.

Next, reconsider the law of averages.

The biggest selling points of index-based investing are that following the broad market is (a) cheaper than active portfolio management, and (b) not that much worse than active investing, and better than many actively-invested portfolios.

In other words, it’s cheap to get average returns by buying the whole market because it takes less labor to maintain such a portfolio. It’s an algorithm. It’s the law of averages in action.

But now, let’s expand things a bit and look at it from the viewpoint of the investor.

It’s not particularly difficult to invest in an index fund. The minimum balance is low, and pretty much anyone with a pulse can set up the automatic withdrawals, thereby making them an “investor.”

Now, granted, some people don’t even have the means to do this much. But many, many people do. With so many people doing this, is it reasonable to think that everyone doing this will end up with a comfortable retirement? I don’t think so. The more people that get involved in index investing, the more people that are competing for the available shares. This drives their price up, and consequently reduces the return.

In other words, if you do what everyone else does, you (a) shouldn’t expect to do a whole lot better than everyone else, and (b) everyone else may not do that well anyway, because the barrier to entry is so low that it takes no special skill to enter the market.

Consider investments that have a barrier to entry.

If you reduce the number of your competitors, your returns will be higher.

I’m not advocating any particular investment, but you’ll stand a better chance of making good money on your investment if you seek out, or create, markets that not just anyone can enter.

Doing this means taking on risk, possibly in money, almost definitely in time. By way of comparison, stock market index investing is characterized as “high-risk, high-reward” because of the volatility of the stock market. But in the grand scheme, investing this way is not high-risk at all. There’s little barrier to entry, and it takes very little time to do so.

Here are some examples of high-entry-barrier investing. Again, I’m not advocating anything in particular. Also note that, except for the first one, none of these are even mostly passive means of investing. To really do well, you have to put time in. I don’t think there’s any real way around it. (If there were, wouldn’t we all be doing it? But then, it would work any more!)

  • Investments open only to Accredited Investors. Index funds are for the masses. Things like hedge funds and other partnerships are for people with lots of money, and the laws are set up to exclude people from investing in these products who don’t have lots of money. By “lots of money” this means more than $1 million (excluding primary residence) or $200,000 income in each of the previous two years. Keeping people out of these investments improves the return: fewer competitors. The barrier to entry is breaking into these high-income, high-net-worth categories.
  • Rental real estate. Barriers to entry include: (a) saving up for a down payment; (b) arranging for maintenance/management of the property, or doing it yourself (takes time); (c) knowledge of landlord/tenant requirements; (d) taxes, fees, licenses, etc. And this is on top of buying right in the first place, which is needed for any investment.
  • Low-prestige work. A good way to a good return is investment in something that most people don’t want to do. How about cleaning up pet waste or pumping septic tanks? The barrier is dealing with others’ reactions to what you do.
  • Anything that requires licensing. The license (the cost, and the time) is a barrier to entry, albeit an artificial one, set up by the people who don’t want just anyone doing what they’re doing. Some jurisdictions set up laws to prevent non-licensed persons from practicing in a particular profession. Examples: real estate agent, auctioneer, financial planner.
  • Build your own following. Produce something that people want to buy. The more specialized the product, the more people will pay, but also the more time it takes to learn the skills necessary to deliver the product. It also takes time to poise yourself as the expert so that people will buy from you. Build up your customer base. Build up your empire. (Buying index funds builds up Vanguard’s empire.)

As I said, this answer is no longer on the site.  I received a comment (from the person with the highest-ranked answer) stating that he didn’t see how what I wrote answers the question.

This was my comment response:

I take the definition of portfolio more broadly than you do in your answer. Equity in one’s own business can be just as much a part of a portfolio as equity in someone else’s. My solution is based on doing something more than writing checks and letting someone else manage the money.

Then I realized something. I wasn’t following my own advice. I counted the words in the response I had written: 890. That’s a decent-sized piece of work, and not only was it not appreciated, it was doing next to nothing for my own “portfolio” of content. I was building up Stack Exchange, Inc.’s empire, but not my own.  Now, with the extra explanation, this post has over 1,200 words.

It’s wise to think of your portfolio in broader terms to include your creative work and your skills. These are salable and leasable. More importantly, they’re yours.

If you already have a diversified investment portfolio of other people’s assets, consider developing some of your own.

John Wedding

Husband. Father. Web publisher. Musician. John has blogged at Mighty Bargain Hunter since 2005, helping people to recognize the good deals in life.

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Comments

  1. Is being a teacher low prestige work? It seems that way! I created an asset allocation that has proved to reduce the volatility somewhat and still achieves long term growth. Some of my portfolio is invested in healthcare, biotech and technology. I have been in these investments for more than 15 years.

  2. The smartest people I know are all invested in index funds. They are easy to understand, reliable, and an efficient way to invest.

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