The fund being offered to Vanguard employees in their 401(k) plans is not a global fund. It focuses on U.S. stocks. But the point remains the same. As Malkiel has long argued, diversification is the only free lunch in finance.
Diversification is an incredibly simple idea, yet so many investors miss out. Here it is in a sentence: Owning a variety of stocks or bonds is safer than owning a narrow selection of securities.
The whole trick of prudent investing is to secure a reliable return while cutting risk. Put in more colloquial terms, yes, a Ferrari will get you down the road faster than an RV, but it also might leave you wrapped around a utility pole.
The Vanguard Total Stock Market fund is an RV, but it’s a tricked-out luxury RV for sure. The fund brings you thousands of stocks — 3,629 companies representing all the large stocks you get in the S&P 500 plus midcap and small-cap firms. It’s really an upgrade.
In fact, it’s surprising that Vanguard took this long to make the move. Thanks to the work of Eugene Fama and Kenneth French at the University of Chicago, we know that small-cap value stocks add return to diversified portfolios. The price of the extra return is short-run volatility, but where else are you going to follow Fama and French if not in a 401(k) plan? It’s all long-term money.
Vanguard a while back made the same move Malkiel advocates for investors in its target-date fund products, adding to holdings in foreign stocks and bonds at the expense of domestic. Again, more volatility but better long-term results.
Those funds hold a lot of money. Overall, Vanguard manages $5.1 trillion on behalf of 20 million investors. Vanguard reports that 51% of its 401(k) investors who use the company’s products own a single target-date fund. That number was 13% a decade ago.
Vanguard also projects that 75% of participants will own a target-date fund by 2022 and, of them, two-thirds will be invested in a single fund. Note that this is not just the company’s employees but everyone in the world who owns Vanguard products in a 401(k).
Climate, not weather
I really like the way Charley Ellis, another member of the Rebalance Investment Committee, explains Malkiel’s thinking on diversification. Ellis is a former chairman of the Yale Endowment and a celebrated author in his own right, of “Winning the Loser’s Game”.
Ellis likes to talk about diversification in terms of the weather. “Could you promise me that the 13th day of October is going to be a decent day? That there won’t be a rainstorm?” he asks.
“I can’t promise that sort of thing to you. And I’ll bet you can’t promise it to me. Diversification takes you toward climate and away from weather. Diversification takes you toward the normal experience. And diversification protects you from the unique, dreadful, whoever thought that something like that would happen to a nice person like me?”
You don’t have to know what day it will rain. All you have to do is make sure to have an umbrella handy in the rainier part of the year and sunglasses when it’s dry and hot. Diversification simplifies investing.
Vanguard is moving its own employees toward an umbrella-and-sunglasses way of investing, toward Fama and French, toward Malkiel’s famous free lunch.
It just makes sense.
This article originally appeared on MarketWatch on June 11, 2018.
