Balkinization: Dilbert on Diversification

Crosspost from Freakonomics:

Scott Adams, the author/creator of the Dilbert comic strip, has some very sensible things to say about asset diversification in this great blog post, World’s Simplest Portfolio:

First, let’s assume the hypothetical money is invested entirely for retirement, so we don’t need to worry about keeping any of it liquid for college or buying a house. That assumption is just to keep things simple.
Second, we’re only talking about investments up to 10 years prior to your planned retirement…
I suggest, as a starting point for our discussion, that a perfectly adequate simple portfolio for young(ish) people might involve putting 50% of your money in an ETF from Vanguard (VTI), which captures the entire Wilshire 5000 … The fees for the ETF are a low .015% per year, and because ETF managers don’t do much buying and selling within the portfolio, it doesn’t generate much taxable income to pass along to investors…
For the remaining 50% your investments, let’s say you buy the Vanguard Emerging Market ETF (VWO) with a .27% expense ratio. That gives you a play on the best companies in emerging markets around the world, at low cost, with excellent diversity, and low taxes.

Asset diversification really can be just this easy. Adams’s advice underscores how bizarre the diversification message is in E*Trade’s “Wolf Call” commercial:

What does it mean to diversify like a wolf? In a world with low-cost stock indexes, asset diversification is downright boring. Hardly something to brag about to your girlfriend.

Adams’s post, however, makes a claim with which I take issue. He says:

I picked 50% to allocate to this investment because I contend that no expert has a good reason for picking a different figure. Some experts might tell you 25% is the right allocation for U.S. stocks, and some might say 75%. I contend that most allocation recommendations of that sort are no more defensible than horoscopes.

Adams is right when it comes to traditional allocation advice. In Lifecycle Investing, we similarly criticize the “birthday rule,” which arbitrarily advises investors to allocate “110 minus your age” in stock. The birthday rule counsels 20-year-olds to invest 90 percent of their portfolio in stock, and 60-year-olds to allocate 50 percent to stock. Adams is right that such advice has become the industry consensus without the benefit of good theory or empiricism.

But Barry Nalebuff and I derive an optimal allocation rule that maximizes expected utility for an investor with constant relative risk aversion:

Samuelson share = Return/(Risk² * Risk Aversion).

In a recent post, I showed how this allocation equation can be updated to take into account changed expectations about risk and return. Lifecycle Investing shows that this allocation equation (when properly applied to the present value of current and future savings contributions) will often lead young people to invest 200 percent of their current portfolio in stocks.

Adams’s approach still wins hands down in a simplicity contest (and in fact, before I wrote this book my portfolio emulated his advice). But we show that there are substantial gains from doing some extra work to better spread market risk across time. Historically, the Leverage Lifecycle approach can reduce risk by more than 20 percent. Or, the benefits of this new diversification technology can be channeled to safely increase your expected return by 60 percent. Until a mutual fund has the good sense to automate our system (we’re working on it), time diversification will require some additional work. But doing a better job diversifying risk across time can be worth the effort.

(Hat Tip: Joshua Gans)