This question has been asked in a number of Blog Posts and we pussy-foot around it because there really is no definitive answer. On the one hand we need enough to give us an adequate level of diversification (whatever that means) to reduce volatility (risk) while keeping our commissions, management costs and fees to a minimum.
We maybe start out by thinking of diversification as “more is better”, progress to thinking of it in terms of different asset classes (Equities, Bonds, REITS, Commodities, Metals,…etc), then, recognizing that even this does not necessarily guarantee that we are diversified, we may look closer at correlations and “clustering”.
Also, we all have different investment styles – Strategic Asset Allocation (SAA) requires us to make discretionary decisions as to which assets to hold and the allocation to be made to each asset – Portfolio Optimization reduces the discretionary limits to a degree and calculates “recommended” allocations to different assets/asset classes – momentum tends to dominate diversification decisions to some extent and leave the discretionary decisions to allocation weightings.
I recently found the following figure in one of Gary Antonacci’s articles on “Key Momentum Factors”.
This shows that portfolio volatility drops rapidly (exponentially) as we increase the number of assets from 1-5, but that adding more assets beyond this level has little impact. On the other side of the equation, returns (based on momentum) tend to drop in a more linear manner – thus there will be an optimal balance in terms of return/risk – this provides a good explanation for the excellent performance of the Feynman Max4 Portfolio.
Let me play Devil’s Advocate and suggest that (from a “scientific” point-of-view) it may not be advantageous to construct portfolios containing more than 4 or 5 assets (remembering that these assets are already “diversified” ETFs).
This should be good for discussion – please don’t “shoot the messenger”, remember I’m playing Devil’s Advocate – disclosure – I don’t (presently) have any portfolios with so few assets.
David,
Let me ask the first question to this post. Did Antonacci mention if his graph refers to individual stocks or to index funds such as ETFs?
Lowell
Lowell,
Antonacci uses ETFs – I believe almost exclusively – at least in his articles.
David
ITA Readers: There is an excellent book that parallels the above argument. “How A Second Grader Beats Wall Street” by Allan S. Roth is all about a portfolio made up of three index funds. They are: VTSMX, VGTSX, and VBMFX. These three funds cover the entire U.S. Equities market, total international equities market, and total bond market.
Lowell
David / Lowell,
I’m an ex-Boglehead and used the simple 3 fund portfolio VTSMX, VGTSX, and VBMFX. It did fine, but got clobbered in ’08 and that’s when I decided against ‘buy and hold’ and started searching for alternatives. The BH mantra is “Tune out the noise” and “Stay the course”. Sorry, but just can’t do that, simple as it sounds.
Re: Diversification – Used to be that a 60/40 port the 40% bonds were your main diversifier. Not any longer however. So bonds are pretty much useless (to me) at this point in time. That leaves US vs Int’l equities, REIT’s, commodities etc.
I then read a couple of Sy Harding books. He has a portfolio of exactly ONE ETF; DIA. He goes ‘all in’ in mid-Oct and all out (cash) end of April. I’ve done some backtesting with this seasonal phenomenon and find, oddly enough, that his theory / practice has worked for him and others.
I then read ‘The IVY Portfolio” which uses 5 ETFS and monitors a 200 day moving average.
So, I’m in transit…. looking for the best approach to get me OUT of the market before a major fall. As for getting in, right now, things are SO overvalued that it’s hard to pull the trigger on anything. Wife and I are sitting on a huge pile of cash in our 401k’s / ROTH’s waiting for a good time to move a sizeable amount back into action.
Interesting times for investing for sure.
Charles,
On the original blog I think I might have a few entries on Sy Harding’s model. He now adds or uses a MACD overlay to his seasonal model. If you search for MACD on the original blog you will find how Gerald Appel’s MACD is calculated. Appel published these results back around 1979 and I have his original booklet on this subject. The booklet even includes instructions how to program the TI-81 to come with the results. Now we just use the Internet. (g)
Lowell
Mitch,
That’s why I spent a lot of time on Part 6 of the Feynman Study and tried to stress the importance of Risk Management. Although my personal preference is to use the SHY Filter, a MA is good too – just do something, no matter how simple, to insure the Buy and Hold. See Part 6.2.2 of the Feynman Study for an example of effectiveness with a “Buy and Hold” (although not quite at this point) Portfolio.
If an Investor (probably not you) just wants to Buy and Hold a portfolio of assets without selling anything and doesn’t have time to monitor the portfolio, it might still be advisable to buy an annual insurance policy (Put Option) for portfolio protection. It will reduce returns but at least it will avoid devastating drawdowns.
David
Mitch,
I’m doing some work on “Seasonality” right now – but it’s more focused on my Options Trading than on my (retirement) investments – just another way I, personally, bring diversification into the equation.
David
Lowell:
As I read Antonacci, including the paper you reference, and his other papers, he is talking about ETFs.
Dick
Lowell, I use MACD and RSI after getting the weighted suggestions for further evaluation.
There is nice little (FREE) excel SS here:
http://investexcel.net/4280/make-winning-trades-macd/
On my Portfolio page I have hyperlinks to saved MACD / RSI files of each ETF. Very handy.
http://i6.photobucket.com/albums/y221/ccrane/INVEST/ScreenHunter_04Oct241450_zps56795a3a.jpg
FYI, here are a couple of links… 1 to a youtube video with a walk-through on how to build the Seasonal Anomolies SS and a screenshot of Vanguard Total Stock Market using the SS and data back to 1996.
http://i6.photobucket.com/albums/y221/ccrane/INVEST/ScreenHunter_02Oct121528_zpsd5ecca5f.jpg
http://www.youtube.com/watch?v=CVl6STLqD_s&list=UUTPOMEWVghQOMKl8W18Jisw&index=10
Opps…wrong youtube, here is the one I meant to post:
http://www.youtube.com/watch?v=CVl6STLqD_s&list=UUTPOMEWVghQOMKl8W18Jisw
WELL Dang…what’s going on here ? Sure wish I could edit posts instead of having to post new ones.
Market Anomalies:
http://www.youtube.com/watch?v=CVl6STLqD_s
Charles,
Thanks for the links. I watched these videos some weeks ago and found them quite interesting.
As for editing your comment, you should see an Edit option just to the right of the time stamp near the top of your comment. See if it is available to you as it is for me.
Lowell
Lowell, I do not see and edit button / link anywhere.
That is strange as I see an Edit option on every one of these comments. That might be due to my administrative control over the blog.
Lowell
Lowell,
I think that’s the answer Lowell – I see the edit option but I also have admin control.
David
AND…the correct VTSMX screenshot: (yikes, sorry guys!)
http://i6.photobucket.com/albums/y221/ccrane/INVEST/ScreenHunter_01Oct051216_zps2598467a.jpg
Lowell,
I do not see any edit button / link anywhere here or in the forum.