Allan Roth: The Myth of Overdiversification

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Random Walker
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Allan Roth: The Myth of Overdiversification

Post by Random Walker » Mon Dec 02, 2019 3:21 pm

https://www.advisorperspectives.com/art ... sification

This is a good article. It makes the case for owning total market (I would say at least total asset class) index funds. One can own 30-50 individual stocks and get the portfolio volatility down to that of the entire market. But since the performance of the market (or an asset class) is overwhelmingly due to a few winners, there is a very high likelihood the 30-50 stock portfolio will underperform the market (asset class). The median return of stocks in the market is far less than the mean return.
Allan also does a good job of displaying volatility drag: how increasing volatility increases the difference between average annual return and the compounded return.

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Re: Allan Roth: The Myth of Overdiversification

Post by nedsaid » Mon Dec 02, 2019 3:29 pm

This article is a good argument against the so-called Focused Funds where an active manager keeps the portfolio down to 20 of his best ideas. The manager takes on the additional risk of added volatility with fewer stocks and also increases the odds of missing out on the best performing stocks in the market.
A fool and his money are good for business.

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Re: Allan Roth: The Myth of Overdiversification

Post by afan » Mon Dec 02, 2019 4:44 pm

Also a strong argument for simple, low cost, cap weighted index funds.

Among many things to like about Roth is his straight talk on investing. It is difficult for advisors who charge AUM fees to sell clients on 1%, or even much less, to do nothing but watch a three fund portfolio. As someone who charges by the hour, he has no motive to create complicated portfolios that clients do not understand.

There is a current thread on "Why I left Wealthfront" detailing the challenges of getting out from under a direct indexing portfolio.

There is also a thread by a client whose AUM manager invested in interval funds. The client wants out but the funds are only redeeming 5% per quarter. It was not clear whether it was 5% of the shares held at the time of the request- in which case it would take "only" 5 years. It may have been 5% of the shares or dollar value held at each time- in which case it will take forever.

Roth's clients don't have these problems.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

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Re: Allan Roth: The Myth of Overdiversification

Post by Random Walker » Tue Dec 03, 2019 9:45 am

Yes, this article is strong argument for low cost passive index funds, but it also emphasizes the value of diversification across uncorrelated sources of return: bring compounded return closer to average annual return by narrowing portfolio SD. And that can be achieved by diversifying into sources of risk beyond the market risk provided by TSM.

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Re: Allan Roth: The Myth of Overdiversification

Post by CULater » Tue Dec 03, 2019 11:12 am

He also mentions he's not a fan of factor investing; same issues as with focused funds in general.
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Re: Allan Roth: The Myth of Overdiversification

Post by fortyofforty » Tue Dec 03, 2019 11:31 am

Good article, so thanks for posting. No mention of international bonds, though, but that seems to be the unloved member of the "diversification" family. Not sure what Allan Roth thinks about including them as part of the bond portion of a well-diversified portfolio.
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Re: Allan Roth: The Myth of Overdiversification

Post by JBTX » Tue Dec 03, 2019 12:09 pm

I've always thought the "over diversification" argument was bunk. But, if one believed that in some cases active management was better, then the argument is that a fund manager may be able to identify "alpha" on a couple dozen stocks, but doing more than that dilutes the alpha.

In sports gambling vs spread I've heard the absolute best only get up to 57% correct. I think it takes a about 53% just to break even given the casino take, maybe a little less. I heard one of the best say that he only bets a few games a year where he thinks he sees an obvious opportunity in spreads. Betting every game just waters down his take.

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Re: Allan Roth: The Myth of Overdiversification

Post by garlandwhizzer » Tue Dec 03, 2019 1:08 pm

Excellent article. Alan Roth is a gem. The proof of success in low cost cap-weight market index funds lies in the fact that as the time frame for comparison gets longer and longer (5, 10, 15, 20 years) a greater and greater percentage of alternate approaches of all types, active, factor or whatever, underperform this cheap simple tax efficient alternative. It appears that investors are becoming more and more aware of this as every year now. Active managers have been crying, "Today is a stock picker's market," for decades even as the data continued to accumulate that two things happen. First, the average alternate approach fails to beat the index. Second, there is no reliable way to prospectively pick alternate approach winners in advance. Outperformance in past periods often begets underperformance going forward. The odds are weighted in favor of passive approaches.

Garland Whizzer

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Re: Allan Roth: The Myth of Overdiversification

Post by stlutz » Tue Dec 03, 2019 2:27 pm

While I agree with the fundamental point of the article, the supporting information just isn't that good.

Randomly pick 30 stocks from the Russell 3000 and you have a lot of very, very small companies. What is being compared is not 30-50 stocks that are are representative sample to the cap-weighted market, but instead a non-representative sample vs. the market.

Also, the whole claim that some super small percentage of stocks being responsible for all gains is also misleading. If I subtract out the 10% of the hottest days in Washington DC each year I'd conclude that DC is actually a cold-weather city aside from some outliers. Really?

If one selects 30 stocks from among the 200 largest companies, they will end up with a very reasonable portfolio. Is there any advantage to doing so vs. just buying VTI? Not that I can see unless you have some super-secret (or not so secret) formula for selecting only the good stocks. VTI works better, but the difference is not like deciding between boots and flip-flops when there is two feet of snow on the ground.

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Re: Allan Roth: The Myth of Overdiversification

Post by rasta » Tue Dec 03, 2019 2:46 pm

as charlie munger once said:

“The idea of excessive diversification is madness.”

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Re: Allan Roth: The Myth of Overdiversification

Post by patrick013 » Tue Dec 03, 2019 2:48 pm

I think the article is convincing but not as dramatic as it may seem.

If there is deflation, a lengthy low or negative growth economy, subsequent
devaluation, all the bad things that can happen with a decrease in business
activity and earnings the indexes with 1000's of stocks may have the worse
performance.

A high quality index (above average growth and below average LT debt) with
only 100 stocks could save the day if one existed. The creme of the crop so
to speak. Not even 500 but just 100 stocks. A much more selective index in
the low growth economy.

It seems a lesser number of stocks anyway could be better if a no growth economy
occurs. Without thousands of no growth stocks included just because the index
needs that many stocks due to it's methodology.

Too many stocks can potentially water down any index's performance.
age in bonds, buy-and-hold, 10 year business cycle

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Re: Allan Roth: The Myth of Overdiversification

Post by pdavi21 » Tue Dec 03, 2019 2:52 pm

stlutz wrote:
Tue Dec 03, 2019 2:27 pm
While I agree with the fundamental point of the article, the supporting information just isn't that good.

Randomly pick 30 stocks from the Russell 3000 and you have a lot of very, very small companies. What is being compared is not 30-50 stocks that are are representative sample to the cap-weighted market, but instead a non-representative sample vs. the market.

Also, the whole claim that some super small percentage of stocks being responsible for all gains is also misleading. If I subtract out the 10% of the hottest days in Washington DC each year I'd conclude that DC is actually a cold-weather city aside from some outliers. Really?

If one selects 30 stocks from among the 200 largest companies, they will end up with a very reasonable portfolio. Is there any advantage to doing so vs. just buying VTI? Not that I can see unless you have some super-secret (or not so secret) formula for selecting only the good stocks. VTI works better, but the difference is not like deciding between boots and flip-flops when there is two feet of snow on the ground.
+1
These articles always start from the assumption of an equal weight portfolio. That's why they typically advocate small cap tilting. However, this article oddly uses an equal weight portfolio to advocate total index investing.

I disagree slightly with your choosing 30 stocks because part of maintaining a reasonable portfolio would require that the 30 stocks remain in the top. If you let the size drift, you may end up with a very unreasonable portfolio. Also, 30 might not be enough. The largest 30 stocks in VT is only about 19% of VT and gives you a 90/10 US/INTL split. EDIT: Oops you said VTI. The top 30 is about 34%.

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Re: Allan Roth: The Myth of Overdiversification

Post by Taylor Larimore » Tue Dec 03, 2019 3:11 pm

Bogleheads:

Allan Roth, CPA, CFA, is a member of the Boglehead's Panel of Experts at Boglehead Conventions. Allan knows what he is talking about. His Second Grader (Three-Fund) Starter Portfolio continues in first place for 3-yrs, 5-yrs, and 10-year returns in the MarketWatch Lazy Portfolio's Contest:

Total Returns For 8 Lazy Portfolios

Best Wishes.
Taylor
Jack Bogle's Words of Wisdom: "The Three-Fund Portfolio will help you to develop a sound asset allocation strategy, make smart investment selections, and guide the implementation of your plan."
Last edited by Taylor Larimore on Wed Dec 04, 2019 10:13 am, edited 2 times in total.
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Re: Allan Roth: The Myth of Overdiversification

Post by pshivvy » Tue Dec 03, 2019 3:28 pm

So, I am new to investing and such. I sort of understand the article but not really. Could someone maybe simplify it more?

I am specifically confused on how the geometric rate is 8.17% for a year with 30% increase and the next with 10% decrease.

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Re: Allan Roth: The Myth of Overdiversification

Post by rasta » Tue Dec 03, 2019 4:02 pm

Taylor Larimore wrote:
Tue Dec 03, 2019 3:11 pm
Bogleheads:

Allan Roth, CPA, CFA, is a member of the Boglehead's Panel of Experts at Boglehead Conventions. Allan knows what he is talking about. His Second Grader (Three-Fund) Starter Portfolio continues in first place for 1-yr; 3-yrs, 5-yrs, and 10-year returns in the MarketWatch Lazy Portfolio's Contest:

wait, i thought "nobody knows nothing". so how can you have a panel of experts?

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Re: Allan Roth: The Myth of Overdiversification

Post by Random Walker » Tue Dec 03, 2019 4:15 pm

pshivvy wrote:
Tue Dec 03, 2019 3:28 pm
So, I am new to investing and such. I sort of understand the article but not really. Could someone maybe simplify it more?

I am specifically confused on how the geometric rate is 8.17% for a year with 30% increase and the next with 10% decrease.
It’s called volatility drag or variance drain. After a loss, there is less money available to grow when the market bounces back. The compounded or geometric average return is always less than the simple average return due to volatility. Simple examples include that it takes a 33% gain to break even after a 25% loss, a 50% gain to break even after a 33% loss, and 100% gain to break even after 50% loss. If two portfolios have the same simple average return, the one with less volatility will have the greater compounded return and thus greater terminal value. An equation that approximates this phenomenon is Geo Mean = Simple Mean - 1/2SD^2. Check out this thread.

viewtopic.php?t=199092

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Re: Allan Roth: The Myth of Overdiversification

Post by Forester » Tue Dec 03, 2019 5:31 pm

Total stock market has performed slightly worse than the Dow Jones 30, I think the "diversification value of 3,000 stocks" is a comforting story. White lies like this are OK if they get individuals to stay the course.

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Re: Allan Roth: The Myth of Overdiversification

Post by abuss368 » Tue Dec 03, 2019 6:26 pm

Thank you for sharing. We have long preferred total market index funds.
John C. Bogle - Two Fund Portfolio: Total Stock & Total Bond. "Simplicity is the master key to financial success."

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Re: Allan Roth: The Myth of Overdiversification

Post by Ocean77 » Tue Dec 03, 2019 6:36 pm

Random Walker wrote:
Mon Dec 02, 2019 3:21 pm
But since the performance of the market (or an asset class) is overwhelmingly due to a few winners, there is a very high likelihood the 30-50 stock portfolio will underperform the market (asset class).
The Dow Jones Industrial Index, which consists of only 30 stocks has shown a very similar performance over the decades as the S&P500.

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Re: Allan Roth: The Myth of Overdiversification

Post by columbia » Tue Dec 03, 2019 11:01 pm

This borders on fear mongering:

“ Even at 500 stocks, there is only about a 48.4% probability of getting the return of the entire market.”

A large cap fund is going to clock in at 500-600 stocks. Large cap trailed total market by 0.04%/year from 1972-present:
https://www.portfoliovisualizer.com/bac ... ion2_3=100

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Re: Allan Roth: The Myth of Overdiversification

Post by JoMoney » Tue Dec 03, 2019 11:14 pm

columbia wrote:
Tue Dec 03, 2019 11:01 pm
This borders on fear mongering:

“ Even at 500 stocks, there is only about a 48.4% probability of getting the return of the entire market.”

A large cap fund is going to clock in at 500-600 stocks. Large cap trailed total market by 0.04%/year from 1972-present:
https://www.portfoliovisualizer.com/bac ... ion2_3=100
:thumbsup

Real world examples show empirically that as long as the portfolio is predominately large cap stocks, modest diversification is plenty.
The Dow 30 has done just fine, the Russell Top 50 Index has done just fine, Bridgeway's Blue Chip 35 fund BRLIX has done just fine.
If there is fear to be mongered, it may be justified in showing the risk of picking a small number of small-cap stocks, but otherwise it just makes the author look silly.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Allan Roth: The Myth of Overdiversification

Post by danielc » Wed Dec 04, 2019 2:55 am

Taylor Larimore wrote:
Tue Dec 03, 2019 3:11 pm
Bogleheads:

Allan Roth, CPA, CFA, is a member of the Boglehead's Panel of Experts at Boglehead Conventions. Allan knows what he is talking about. His Second Grader (Three-Fund) Starter Portfolio continues in first place for 1-yr; 3-yrs, 5-yrs, and 10-year returns in the MarketWatch Lazy Portfolio's Contest:

Total Returns For 8 Lazy Portfolios

Best Wishes.
Taylor
Jack Bogle's Words of Wisdom: "The Three-Fund Portfolio will help you to develop a sound asset allocation strategy, make smart investment selections, and guide the implementation of your plan."
I note that Allan's is by far the simplest portfolio in the group. I recently modified my portfolio by removing all the tilts that I had and embracing a Vanguard-like Four Fund portfolio. I'm very happy with the simplification, and it has allowed me to mirror the portfolio across all my retirement accounts which creates a series of other simplifications.

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Re: Allan Roth: The Myth of Overdiversification

Post by buckeye7983 » Wed Dec 04, 2019 6:55 am

Random Walker wrote:
Tue Dec 03, 2019 4:15 pm
pshivvy wrote:
Tue Dec 03, 2019 3:28 pm
So, I am new to investing and such. I sort of understand the article but not really. Could someone maybe simplify it more?

I am specifically confused on how the geometric rate is 8.17% for a year with 30% increase and the next with 10% decrease.
It’s called volatility drag or variance drain. After a loss, there is less money available to grow when the market bounces back. The compounded or geometric average return is always less than the simple average return due to volatility. Simple examples include that it takes a 33% gain to break even after a 25% loss, a 50% gain to break even after a 33% loss, and 100% gain to break even after 50% loss. If two portfolios have the same simple average return, the one with less volatility will have the greater compounded return and thus greater terminal value. An equation that approximates this phenomenon is Geo Mean = Simple Mean - 1/2SD^2. Check out this thread.

viewtopic.php?t=199092

Dave
I understand that volatility drag decreases returns with a static portfolio. However, I have always thought that volatility was a good thing when accumulating, at least early in the accumulation phase when new contributions are not dwarfed by the size of the portfolio. This allows purchase of more shares when the asset price is low and fewer shares when the asset price is high. Am I correct? If not, can someone explain the math?

Thanks!

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Re: Allan Roth: The Myth of Overdiversification

Post by Forester » Wed Dec 04, 2019 7:09 am

The Myth of TSM Diversification

Image

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Re: Allan Roth: The Myth of Overdiversification

Post by nolesrule » Wed Dec 04, 2019 7:20 am

The Dow 30, isn't the same composition as it used to be.

Isn't there real world turnover cost? The DJIA hasn't stayed the same, and some of those companies no longer exist. There's less room for managing turnover in a tax efficient manner when you only hold 30 companies.

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Re: Allan Roth: The Myth of Overdiversification

Post by columbia » Wed Dec 04, 2019 7:30 am

JoMoney wrote:
Tue Dec 03, 2019 11:14 pm
columbia wrote:
Tue Dec 03, 2019 11:01 pm
This borders on fear mongering:

“ Even at 500 stocks, there is only about a 48.4% probability of getting the return of the entire market.”

A large cap fund is going to clock in at 500-600 stocks. Large cap trailed total market by 0.04%/year from 1972-present:
https://www.portfoliovisualizer.com/bac ... ion2_3=100
:thumbsup

Real world examples show empirically that as long as the portfolio is predominately large cap stocks, modest diversification is plenty.
The Dow 30 has done just fine, the Russell Top 50 Index has done just fine, Bridgeway's Blue Chip 35 fund BRLIX has done just fine.
If there is fear to be mongered, it may be justified in showing the risk of picking a small number of small-cap stocks, but otherwise it just makes the author look silly.
To take it further (to global investing): the IOO ETF exists; one can own the 100 largest global companies through it. One of the things that will never happen:

Someone’s investing plan fails, because they’ve owned IOO, but would have succeeded if they had owned VT. (IOO is costly, which is the main reason to choose a fund like ACWI or VT over it.)

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Re: Allan Roth: The Myth of Overdiversification

Post by beyou » Wed Dec 04, 2019 7:38 am

rasta wrote:
Tue Dec 03, 2019 4:02 pm
Taylor Larimore wrote:
Tue Dec 03, 2019 3:11 pm
Bogleheads:

Allan Roth, CPA, CFA, is a member of the Boglehead's Panel of Experts at Boglehead Conventions. Allan knows what he is talking about. His Second Grader (Three-Fund) Starter Portfolio continues in first place for 1-yr; 3-yrs, 5-yrs, and 10-year returns in the MarketWatch Lazy Portfolio's Contest:

wait, i thought "nobody knows nothing". so how can you have a panel of experts?
If a show about nothing can be so successful, why not a panel of experts about nothing ?

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Re: Allan Roth: The Myth of Overdiversification

Post by CyclingDuo » Wed Dec 04, 2019 8:58 am

Taylor Larimore wrote:
Tue Dec 03, 2019 3:11 pm
Bogleheads:

Allan Roth, CPA, CFA, is a member of the Boglehead's Panel of Experts at Boglehead Conventions. Allan knows what he is talking about. His Second Grader (Three-Fund) Starter Portfolio continues in first place for 1-yr; 3-yrs, 5-yrs, and 10-year returns in the MarketWatch Lazy Portfolio's Contest:

Total Returns For 8 Lazy Portfolios

Best Wishes.
Taylor
Jack Bogle's Words of Wisdom: "The Three-Fund Portfolio will help you to develop a sound asset allocation strategy, make smart investment selections, and guide the implementation of your plan."
Don't get me wrong, our household loves the diversity and simplicity of the Three Fund Portfolio (Second Grader Starter Portfolio)!

This has been pointed out before regarding the Lazy Portfolios in the link above which are being tracked at MarketWatch.com, but the AA is not the same for each of those Lazy Portfolios.

The Second Grader Starter Portfolio is indeed in the lead for all but the recent 1 year measuring stick. However, keep in mind that it has an AA of 90% equity/10% bond which accounts for its performance over the years (higher risk, higher reward) compared to the others.

Here are the AA's of those particular Lazy Portfolios being tracked at MarketWatch.com:

90/10: Second Grader/Three Fund Portfolio
75/25: Dr. Bernstein's No Brainer (75% equity/25% bonds)
70/30: Aronson Family
67/33: Margaritaville
60/40: Ultimate Buy & Hold
55/40/5: Dr. Bernstein's Smart Money (55% equity/40% bonds/5% REITS)
50/30/20: Yale U's Unconventional (50% equity/30% bonds/20% REITS)
50/40/10: Coffeehouse (50% equity/40% bonds/10% REITS)
"Everywhere is within walking distance if you have the time." ~ Steven Wright

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Re: Allan Roth: The Myth of Overdiversification

Post by Random Walker » Wed Dec 04, 2019 10:20 am

buckeye7983 wrote:
Wed Dec 04, 2019 6:55 am
Random Walker wrote:
Tue Dec 03, 2019 4:15 pm
pshivvy wrote:
Tue Dec 03, 2019 3:28 pm
So, I am new to investing and such. I sort of understand the article but not really. Could someone maybe simplify it more?

I am specifically confused on how the geometric rate is 8.17% for a year with 30% increase and the next with 10% decrease.
It’s called volatility drag or variance drain. After a loss, there is less money available to grow when the market bounces back. The compounded or geometric average return is always less than the simple average return due to volatility. Simple examples include that it takes a 33% gain to break even after a 25% loss, a 50% gain to break even after a 33% loss, and 100% gain to break even after 50% loss. If two portfolios have the same simple average return, the one with less volatility will have the greater compounded return and thus greater terminal value. An equation that approximates this phenomenon is Geo Mean = Simple Mean - 1/2SD^2. Check out this thread.

viewtopic.php?t=199092

Dave
I understand that volatility drag decreases returns with a static portfolio. However, I have always thought that volatility was a good thing when accumulating, at least early in the accumulation phase when new contributions are not dwarfed by the size of the portfolio. This allows purchase of more shares when the asset price is low and fewer shares when the asset price is high. Am I correct? If not, can someone explain the math?

Thanks!
I’m not sure I’d go as far as saying volatility is a good thing. Volatility is one form of risk, and of course there is no reward without risk. So it’s one of the prices you pay to experience the good times. Volatility is a drag on returns. With regard to accumulation phase, I think there is a distinction between volatility drag issue and the potential of a rebalancing bonus. Volatility drag refers to the fact that money already invested falls, and there is less of it present to experience the gains when they subsequently occur. Some people believe there is some extra bang for the buck when one has a static asset allocation and the investor adheres to it during accumulation phase. His new contributions are going into the assets that have performed least well recently to maintain the asset allocation. This is rebalancing with new money. I’ve sort of thought of it in the past as dollar cost averaging on steroids. In my mind this should add some juice to returns over the long run. My understanding though is that it is a bit more controversial than this. For example making new additions to bonds throughout a continuously upward equity market would hinder returns.

Dave

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Re: Allan Roth: The Myth of Overdiversification

Post by Taylor Larimore » Wed Dec 04, 2019 10:32 am

Cycling Duo:

Thanks for graciously catching my mistake for 1-year returns. I edited my post.

It is true that Mr. Roth's 3-Fund Portfolio has the highest stock/bond ratio but it does not detract from the fact that investors in Mr. Roth's 3-Fund Portfolio are very pleased that they have been leading seven other well-known professional investors for over 10 years.

Best wishes.
Taylor
Jack Bogle's Words of Wisdom: "The Three-Fund Portfolio will help you to develop a sound asset allocation strategy, make smart investment selections, and guide the implementation of your plan."
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: Allan Roth: The Myth of Overdiversification

Post by nedsaid » Wed Dec 04, 2019 10:50 am

columbia wrote:
Tue Dec 03, 2019 11:01 pm
This borders on fear mongering:

“ Even at 500 stocks, there is only about a 48.4% probability of getting the return of the entire market.”

A large cap fund is going to clock in at 500-600 stocks. Large cap trailed total market by 0.04%/year from 1972-present:
https://www.portfoliovisualizer.com/bac ... ion2_3=100
There is such a thing as statistical sampling, are folks unaware of that? How does one think that polling is done?
A fool and his money are good for business.

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Re: Allan Roth: The Myth of Overdiversification

Post by pdavi21 » Wed Dec 04, 2019 1:21 pm

nedsaid wrote:
Wed Dec 04, 2019 10:50 am
columbia wrote:
Tue Dec 03, 2019 11:01 pm
This borders on fear mongering:

“ Even at 500 stocks, there is only about a 48.4% probability of getting the return of the entire market.”

A large cap fund is going to clock in at 500-600 stocks. Large cap trailed total market by 0.04%/year from 1972-present:
https://www.portfoliovisualizer.com/bac ... ion2_3=100
There is such a thing as statistical sampling, are folks unaware of that? How does one think that polling is done?
I think they are aware, but perhaps confused to why the smallest and largest stocks are compared as equals within the same data set. The 500 largest stocks are much more likely to match the market than the 500 smallest stocks. That's true whether the portfolio is updated or not. Very simple Math that often seems to be ignored.
"We spend a great deal of time studying history, which, let's face it, is mostly the history of stupidity." -Stephen Hawking

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