Thank you. What's your take on the allocations? What's the math behind the 1.0/0.2/0.4 factor exposures? The thing is, I don't understand what "factor diversification" actually means. What gets diversified away by means of factor diversification? Should everybody engage in factor diversification, and does it mean that everybody should hold a combination of the riskfree asset and a single well-diversified multifactor portfolio, much like a combination of the riskfree asset and the market portfolio of risky assets in the single-factor CAPM framework?
I will be very interested to see what responses develop in response to this question.
The point is confusing and remains so to me because we have a different example of what we mean by diversify when we see how one can get the same return at less risk if we own many stocks of similar performance compared to only one stock. This is called diversifying away diversifiable risk. Fama-French theory assumes all portfolios are fully diversified in this sense. I suppose the measure of diversity in this case would be what is the standard deviation of returns for a single stock and what is the standard deviation of returns for a collection of single stocks and diversity would be what fraction of the way one is along the path from the one to the other. But that is a personal supposition. I have never read of such a parameter being used.
I'm not an expert on this but the idea is for the equity piece of the portfolio to be targeting a historical risk/behavioral premium where the potential return would be the percentage of the factor exposure you have. It involves defining what expected return you believe (educated belief) a particular factor will create. Folks talking about reduced returns owing to expensive US stocks and bonds are doing this very thing, by the way. Instead, you just apply the same logic to whatever factors desired, and that includes negative loads. For example, the small value tilter's retired mother could focus her portfolio on large cap Quality stocks, with a dose of utilities and consumer staples to target Betting Against Beta and additional term risk. To mitigate the Term risk of her bonds, perhaps she's using TIPS or I Bonds for some of it, and maybe she's taking some credit risk in place of equities for corporate bonds.
I think with diversification there's strictly idiosyncratic risk (single or tiny number of stocks, to where individual business fortunes disproportionately help or hurt you. For what its worth, I think the 100% US only stocks crowd is exposed a bit uncomfortably to this with some of the largest holdings being 1.5-3% each of the portfolio. However, even then, for every Enron, there's been a bunch of Pets.coms and other speculative ventures that have failed either honestly or sometimes dishonestly, so there's some genuine safety in the Blue Chips beyond their volatility profile. Once you get past 20-30 diverse (in terms of industry/sector) holdings, no one company will damage the portfolio for its misfortunes, depravity, or bad decisions. At a certain point, owning .008% of a company will not and by nature cannot matter, except if it spurs others to soar or collapse as well. So yes, owning say 800 stocks is not as diversified as owning 3000, in one sense, but the "undiversified risk" is relatively low and for every regret to exclude there's a "glad I didn't have this" to offset. I think the academics/portfolio guys have a term called "effective number of companies" and [for international] effective countries.
I'd define this as follows:
Idiosyncratic risk (Portfolio as a whole): "I'm ruined, because 40% of my retirement was wrapped up in Enron stokc and their pension plan."
Intra-class risk (or sub-class if you wish): Forgetting/Neglecting to buy the Pacific fund that goes with the Europe fund that's the only acceptable 401k option when you want to target
developed markets. Or it could be narrowing the investment universe in a way to where a secondary or practical limitation in the fund selected ends up wagging the dog in a way that's sideways or against your goals. For example, imagine what a small value investor would feel like if the value premium most shows up in non-dividend paying tech stocks and you've got a deep value fund where almost all tech stocks are excluded for their poor/growthy fundamentals, then you'll have missed out on much of the premium for that year/period. That same small value investor could well be making a diversified
decision if he/she is the CEO or major influencer in the small tech space and wants to diversify away from the business owner/equity stake/stock options issues. In this regard, I'd say it's a matter of subjectiveness once you're past the truly arbitrary (I don't know of a fund that excludes stocks whose names start with C and only C) as to whether the fund(s) chosen are diversified enough to reach your goals.
Extra-class asset class diversification: Home Nation Stocks (US, UK, Japan, whatever), Developed Stocks (add currency and different regulation risks to Home Nation stocks), Emerging Stocks (add political and corruption/dilution risk in addition to the developeds), Bonds, Commodities, REITs, Gold, investment properties, etc...
Pointless "diversification": When your financial advisor puts you in 5 different large cap value funds in the same account, when that advisor investing you in 3 US Treasury mutual funds, or your only equity holding is something like MENU (USCF Restaurant Leaders ETF).