Best way to mitigate the top heaviness of Total Stock Market Funds

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Seasonal
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Seasonal »

vineviz wrote: Fri Oct 23, 2020 5:16 pm
absolute zero wrote: Fri Oct 23, 2020 3:25 pm I’m no expert in this, but my understanding is that diversification is important but nowhere near as important as returns during accumulation.

On the other hand, during the first 5-10 years of retirement, diversification can make the difference between going broke or being just fine. Even if two portfolios end up having the same return after 20 years, if one portfolio dips lower than the other in the early years of retirement then it can result in an irrecoverable loss of capital.
You've got it right. All else equal, a more diversified portfolio creates lower sequence of returns risk for investors who are withdrawing (decumulating) from the portfolio.

Because SORR is linked to the level of sustainable portfolio withdrawals, which in turn relates directly to the thing investors care most about (consumption), paying attention to the level of portfolio diversification is important. And too often neglected, IMHO.
Diversification is important because it relates to is returns and consumption. It's a means to an end.

Diversification is a component of portfolio construction. Other aspects are security selection, tax consequences, expenses, various tilts, etc.

A generally accepted operational definition of diversification (other than in retrospect) would be helpful.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by nisiprius »

Seasonal wrote: Fri Oct 23, 2020 2:22 pm...Fama once said that deviating from the market portfolio is a matter of taste. https://www.cfainstitute.org/en/researc ... st-summary...
:!: :!: :!: Thank you. That looks important.

A draft version of the full paper seems to be available at no cost here:Disagreement, Tastes, and Asset Prices
There does not appear to be a generally accepted operational definition of diversification.

Diversification seems a means to an end rather than an end in itself. I would have thought people want to construct portfolios with the best returns or the best risk adjusted returns. It seems odd to prefer diversification for its own sake.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by whodidntante »

vineviz wrote: Tue Oct 20, 2020 12:15 pm
bikechuck wrote: Tue Oct 20, 2020 10:38 amDiversification can be enhanced by adding a) a small cap fund b) a mid cap fund or c) some other strategy that I have not thought of. I would appreciate any thoughts about whether a , b or c would be the best method of enhancing diversification. It seems to me that holding two U.S. funds for the rest of my life is not all that more complicated than one.
Dividing your US equity allocation between a total market fund and a dedicated mid-cap or small-cap fund is low-cost way to improve your portfolio's diversification level, though it is worth noting that the improvement is going to be most impactful in retirement than during accumulation.

Using a small cap fund would produce the greatest diversification gains, but using a mid cap fund would produce less tracking error (which make be desirable from a behavior management standpoint).

There are plenty of great choices among both ETFs and open-end mutual funds. I suggest looking at:

Schwab US Small-Cap ETF (SCHA)
Schwab US Mid-Cap ETF (SCHM)
Vanguard Small Cap Index Admiral (VSMAX)
Vanguard Mid Cap Index Admiral (VIMAX)
Regular purchases of a more volatile risk asset can lead to better results, since volatile assets tend to get beaten up badly in tough times. I think Bernstein made an attempt to quantify the benefit of regular purchase of SCV.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by vineviz »

Seasonal wrote: Fri Oct 23, 2020 6:34 pm A generally accepted operational definition of diversification (other than in retrospect) would be helpful.
The textbook definition (and I mean that literally) of diversification:
''Diversification'' is a risk management technique that involves combining securities with less-than-perfectly-positive correlation in order to reduce the overall risk of the portfolio.
For a single-sentence definition, I think this covers most of the important ground. However there is an important aspect of diversification that is implied but not stated in this definition, and it sometimes trips up folks who don't think the definition all the way through.

This (also textbook) definition fills in that gap a bit:
The diversification effect is a beneficial reduction of portfolio volatility below the weighted average volatilities of the investments in the portfolio.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by D-Dog »

Seasonal wrote: Fri Oct 23, 2020 2:22 pm
D-Dog wrote: Thu Oct 22, 2020 6:31 pmIsn't it possible that diversification (whatever that means) could be part of someone's utility function? What if the OP can't sleep at night thinking about the top heaviness of the total stock market? Isn't utility about individual preferences?

It appears to me that a lot of this back and forth comes from your belief that only certain utility functions are allowed.
Fama once said that deviating from the market portfolio is a matter of taste. https://www.cfainstitute.org/en/researc ... st-summary

There does not appear to be a generally accepted operational definition of diversification.

Diversification seems a means to an end rather than an end in itself. I would have thought people want to construct portfolios with the best returns or the best risk adjusted returns. It seems odd to prefer diversification for its own sake.
I think there is some truth in what you are saying about diversification not being an end in itself. However, I think there are some nuances worth exploring.

Let me use an analogy to explain what I’m trying to say. One might say that a low cholesterol level is not an end in itself. The end is to maintain long term health or, perhaps, to avoid coronary artery disease. However, in the short term it’s hard to know how well we are doing at maintaining long term health, so instead we track cholesterol levels and other biometric measurements because we believe they will lead to long term health. For all practical purposes, these biometric measurements become ends in themselves because they are all we have that’s readily available to make decisions.

Similarly, at least for me, my end in investing is to preserve wealth (or, perhaps, avoid catastrophic loss) over, say, the next 50 years. I’m concerned more about long term “deep risks” as Bernstein would say, rather than volatility risk. Deep risks are hard to define and model because they include things that have never happened before. Therefore, I don’t really know how best to avoid those risks, but I believe that having a really well diversified portfolio across many asset classes is a good indicator that I’m doing the right thing. For all practical purposes, diversification becomes an end in itself, for me, because it’s one of the few things I can use to evaluate my portfolio right now. I will admit that diversification, for me, is mostly just based on common sense and is therefore subjective.

I would say that diversification is part of my personal utility function in the sense that it helps me have a sense of calm about an uncertain future, which is important to me.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Seasonal »

vineviz wrote: Fri Oct 23, 2020 10:22 pm
Seasonal wrote: Fri Oct 23, 2020 6:34 pm A generally accepted operational definition of diversification (other than in retrospect) would be helpful.
The textbook definition (and I mean that literally) of diversification:
''Diversification'' is a risk management technique that involves combining securities with less-than-perfectly-positive correlation in order to reduce the overall risk of the portfolio.
For a single-sentence definition, I think this covers most of the important ground. However there is an important aspect of diversification that is implied but not stated in this definition, and it sometimes trips up folks who don't think the definition all the way through.

This (also textbook) definition fills in that gap a bit:
The diversification effect is a beneficial reduction of portfolio volatility below the weighted average volatilities of the investments in the portfolio.
Given the debates about, for example, whether to weight a portfolio by market capitalization or whether to overweight small value, and which is more diversified, it would seem that we do not have a generally accepted definition.

Diversification is supposed to reduce risk. Volatility is not a great proxy for risk. It is a simplistic model and there are better models. Multifactor models appear to do a better job and have supplanted volatility for many academics and practitioners. Therefore, a definition of diversification based on volatility does not appear to capture current thinking.
Last edited by Seasonal on Sat Oct 24, 2020 8:39 am, edited 1 time in total.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by zhuyz05 »

KlangFool wrote: Tue Oct 20, 2020 10:54 am OP,


A tilt to SCV and Active Management. I do both.

A) 10% of my portfolio is in the SCV pair with another 10% in the Intermediate-Term Treasury as part of my mini-Larry Portfolio.


B) 40% of my portfolio is in the actively managed Wellington Fund (65/35).


C) Only 40% of my portfolio is in the 3-funds.


KlangFool

P.S.: My overall AA is 60/40.
Just curious why do you have such a strong conviction in Wellington Fund?
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by KlangFool »

zhuyz05 wrote: Sat Oct 24, 2020 8:36 am
KlangFool wrote: Tue Oct 20, 2020 10:54 am OP,


A tilt to SCV and Active Management. I do both.

A) 10% of my portfolio is in the SCV pair with another 10% in the Intermediate-Term Treasury as part of my mini-Larry Portfolio.


B) 40% of my portfolio is in the actively managed Wellington Fund (65/35).


C) Only 40% of my portfolio is in the 3-funds.


KlangFool

P.S.: My overall AA is 60/40.
Just curious why do you have such a strong conviction in Wellington Fund?
zhuyz05,

https://www.investopedia.com/articles/i ... n-fund.asp


A) It is one of the oldest mutual funds. It was founded in 1929.


B) It is a Large Value stock picker.


C) It picks high-quality bonds.


D) It is one of the largest mutual funds.


E) It is low-cost - 0.17%.


F) It is a balanced fund (65/35). I reduce my rebalancing need for my portfolio by placing 40% into Wellington.


KlangFool
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by vineviz »

Seasonal wrote: Sat Oct 24, 2020 8:35 am Given the debates about, for example, whether to weight a portfolio by market capitalization or whether to overweight small value, and which is more diversified, it would seem that we do not have a generally accepted definition.
That's a non sequitur.

People on this forum can (and should) have opinions about how to USE the principle of diversification in constructing their portfolios. That doesn't change the fact that 'diversification' has an unambiguous (and undebatable) definition.

Seasonal wrote: Sat Oct 24, 2020 8:35 am Diversification is supposed to reduce risk.
That's an oversimplification, which is more likely to confuse than clarify.

Seasonal wrote: Sat Oct 24, 2020 8:35 amVolatility is not a great proxy for risk.
I don't entirely agree with this opinion. My view is that although volatility is not a proxy for ALL forms of risk, but it is nonetheless a useful proxy. This can be ESPECIALLY true in a multi-factor world, in fact, where risk exists in a multidimensional space which is very difficult to conceptualize much less discuss in plain language.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by unclescrooge »

Kenkat wrote: Tue Oct 20, 2020 12:06 pm
Steadfast wrote: Tue Oct 20, 2020 11:44 am What I love about holding a single, total-market fund (Total World in our case) is that if one or more of the big heavyweights at the top of the index falls - or even if all of them did, entire industries or dominant sectors - the market stands ready to carry out the ruthless calculus about their new value and reshuffle the deck, replacing the faded giants with the rising stars. The markets do it every day. It is exactly what they are there to do. The best part is I don't have to do anything to benefit from this amazing machinery other than pay 0.08% and stay the course.
Just realize that the rising star will likely come from the small cap market segment. Yes, you will own a slice as part of the total market fund but you’d own a bigger slice with a slant towards smaller stocks. Whether this matters or not in the long run has been discussed at length and there is no right answer that can be determined in advance, so there are many valid strategies out there.
While this sounds factually correct, is it still true in an environment where companies are going public at valuations of $75 billion?
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by KeepItSimple78 »

OP, not sure it's the best way, but my way of mitigating "top heaviness" as you describe it, is to tilt toward value.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Taylor Larimore »

KeepItSimple78 wrote: Sat Oct 24, 2020 10:18 am OP, not sure it's the best way, but my way of mitigating "top heaviness" as you describe it, is to tilt toward value.
KeepItSimple78:

If there was ever a lesson about the danger of speculating in a stock market category, it is NOW.

Anyone who tilted away from total market stocks into value stocks is underperforming the market. This can be disastrous for investors.

Best wishes.
Taylor
Jack Bogle's Words of Wisdom "The beauty of owning the market is that you eliminate individual stock risk, you eliminate market sector risk, and you eliminate manager risk. -- "Never think you know more than the market. Nobody does." -- "In my view, owning the market and holding it forever is the ultimate strategy for winners." (underline mine)
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by KeepItSimple78 »

Taylor Larimore wrote: Sat Oct 24, 2020 12:46 pm
KeepItSimple78 wrote: Sat Oct 24, 2020 10:18 am OP, not sure it's the best way, but my way of mitigating "top heaviness" as you describe it, is to tilt toward value.
KeepItSimple78:

If there was ever a lesson about the danger of speculating in a stock market category, it is NOW.

Anyone who tilted away from total market stocks into value stocks is underperforming the market. This can be disastrous for investors.

Best wishes.
Taylor
Jack Bogle's Words of Wisdom "The beauty of owning the market is that you eliminate individual stock risk, you eliminate market sector risk, and you eliminate manager risk. -- "Never think you know more than the market. Nobody does." -- "In my view, owning the market and holding it forever is the ultimate strategy for winners." (underline mine)
Understood, Taylor. Thanks for the reminder.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by abuss368 »

Taylor Larimore wrote: Sat Oct 24, 2020 12:46 pm
KeepItSimple78 wrote: Sat Oct 24, 2020 10:18 am OP, not sure it's the best way, but my way of mitigating "top heaviness" as you describe it, is to tilt toward value.
KeepItSimple78:

If there was ever a lesson about the danger of speculating in a stock market category, it is NOW.

Anyone who tilted away from total market stocks into value stocks is underperforming the market. This can be disastrous for investors.

Best wishes.
Taylor
Jack Bogle's Words of Wisdom "The beauty of owning the market is that you eliminate individual stock risk, you eliminate market sector risk, and you eliminate manager risk. -- "Never think you know more than the market. Nobody does." -- "In my view, owning the market and holding it forever is the ultimate strategy for winners." (underline mine)
Jack Bogle said “Total market indexing is the gold standard of indexing. Anything else is a dilution of that standard.”
John C. Bogle: “Simplicity is the master key to financial success."
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Rowan Oak »

Taylor Larimore wrote: Sat Oct 24, 2020 12:46 pm
KeepItSimple78 wrote: Sat Oct 24, 2020 10:18 am OP, not sure it's the best way, but my way of mitigating "top heaviness" as you describe it, is to tilt toward value.
KeepItSimple78:

If there was ever a lesson about the danger of speculating in a stock market category, it is NOW.

Anyone who tilted away from total market stocks into value stocks is underperforming the market. This can be disastrous for investors.

Best wishes.
Taylor
Jack Bogle's Words of Wisdom "The beauty of owning the market is that you eliminate individual stock risk, you eliminate market sector risk, and you eliminate manager risk. -- "Never think you know more than the market. Nobody does." -- "In my view, owning the market and holding it forever is the ultimate strategy for winners." (underline mine)
Very true.

Pick an investment strategy that doesn't depend on you (or anyone else) predicting the future, because you can't. No one can. 

This rules out all market timing strategies (individual stock picking, tilting, trend following, actively managed funds, etc.).

Invest using low cost total market index funds.
Last edited by Rowan Oak on Sat Oct 24, 2020 7:24 pm, edited 2 times in total.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by DSBH »

bikechuck wrote: Tue Oct 20, 2020 10:38 am As I age and simplify my portfolio I love the idea of reducing my equity holdings to a single total stock market index fund. However I have concerns about the fact that in most of these funds 10 large companies compromise 20% of the fund value which reduces the diversification objective.

Diversification can be enhanced by adding a) a small cap fund b) a mid cap fund or c) some other strategy that I have not thought of. I would appreciate any thoughts about whether a , b or c would be the best method of enhancing diversification. It seems to me that holding two U.S. funds for the rest of my life is not all that more complicated than one.

Thanks in advance for your thoughts.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by dml130 »

I use RSP (equal weight s&p 500) as my large cap fund. I don't know if it will outperform or underperform in the future (who does?), but I think it's a reasonable enough proxy and it addresses the concern mentioned in the title of the thread.
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by Seasonal »

vineviz wrote: Sat Oct 24, 2020 9:12 am
Seasonal wrote: Sat Oct 24, 2020 8:35 am Diversification is supposed to reduce risk.
That's an oversimplification, which is more likely to confuse than clarify.
"'Diversification'' is a risk management technique that involves combining securities with less-than-perfectly-positive correlation in order to reduce the overall risk of the portfolio."
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Re: Best way to mitigate the top heaviness of Total Stock Market Funds

Post by vineviz »

Seasonal wrote: Sun Oct 25, 2020 7:40 am
vineviz wrote: Sat Oct 24, 2020 9:12 am
Seasonal wrote: Sat Oct 24, 2020 8:35 am Diversification is supposed to reduce risk.
That's an oversimplification, which is more likely to confuse than clarify.
"'Diversification'' is a risk management technique that involves combining securities with less-than-perfectly-positive correlation in order to reduce the overall risk of the portfolio."
As I said earlier, there is an important qualification that is implied by that definition (and included in the context of its original source) but which isn’t explicitly stated in that sentence.

Add “relative to the average risk of the combined securities” and you’re pretty close to a bulletproof definition.

Think about it: if you start with a portfolio of Treasury bills and add stocks, you’ve increased both diversification and “overall risk” but most any definition of the word “risk”.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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