It’s funny how things come full circle. A while back, I appeared on the PBS show “WealthTrack” alongside Burt Malkiel, the Princeton professor who wrote the perennial investment best seller “A Random Walk Down Wall Street”.
Malkiel and I have a professional relationship. He is a member of the investment committee of my firm, and we are both believers in the promotion of prudent, commonsense, low-cost investment principles.
The host of the show, Consuelo Mack, asked Malkiel and me to name a single investment for long-term diversified portfolio. He said he’d buy a global stock fund and I did him one better, naming the fund I would choose, the Vanguard World Stock Fund VT, +0.43% .
Malkiel’s reasoning was simple. He said: “Well, if I had only one thing that I could buy, I would buy a world equity stock fund. That is, a stock fund that had U.S., that had Europe, that had Japan, that had emerging markets, that had the entire world.”
Now Vanguard itself has come around to the same thinking for its own employees, known as “crew members” (sailing is a big theme around there). The company has dropped the S&P 500 index VINIX, +0.32% from its lineup and instead is offering the Vanguard Total Stock Market VTI, +0.38% VTSMX, +0.34% VTSAX, +0.33% .
Read: Vanguard employees won’t have an S&P 500 fund in their 401(k) plan
Free lunch
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 SPX, +0.39% 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.
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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).
Read: How ‘easy’ target-date funds can endanger your retirement
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?”
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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.