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I'd love to see a primer for leveraged diversification for people at the Bogleheads level. A lot of people are under the impression that a three-fund portfolio

I'd love to see a primer for leveraged diversification for people at the Bogleheads level. A lot of people are under the impression that a three-fund portfolio is the pinnacle of responsible self-investing, or a target-date retirement fund. But when I dig in I see people regularly make the point that that isn't true diversification, that asset class diversification isn't sufficient, that diversification is about measuring what investments move counter to each other in different macroeconomic environments, that leveraging is good, etc. I want to know more about how to apply all that when managing retirement funds at Fidelity or Vanguard, but I'm never going to work for a quant firm.

bryanbuckley 7y ago
Check out portfoliocharts.com
darawk 7y ago
Yes, that's right. What you want to do is maximize your sharpe ratio. You can play around with this python package to get a sense for how it works: https://github.com/robertmartin8/PyPortfolioOpt https://github.com/robertmartin8/PyPortfolioOpt What you should be trying to achieve is a portfolio that earns the exact same return every single year, and you can do that in part by looking at historical covariance of the asset's time series. However, you also want to take a prospective view, and think about which asset classes may become correlated in the future. There's no universal answer here (in the out of sample case - you can solve it in-sample), however. And another huge, huge factor is tax. Making sure your investments are tax-efficient is extremely important. Nothing will do more to ruin your compounding than taxes. So whatever you do, carefully consider the tax implications of your choices. A lot of people focus on the tax rate. But what's actually quite a bit more important is the tax frequency. If you pay long term capital gains every two years on your whole portfolio...that's much worse than paying short term capital gains once at the very end (over a long period). What this means is that you want to choose things like passive ETFs, that are not taxed on their internal rebalancing. Even if you were to find a mutual fund that beat that ETF by 1% every year, the tax consequences of that fund would likely make it not worthwhile, before even considering the high fees it would likely charge you.
- wcoenen 7y ago
  > What you should be trying to achieve is a portfolio that earns the exact same return every single year Perhaps this is a dumb question, but wouldn't that mean that you end up with a 100% cash portfolio? After all, that portfolio has exactly the same nominal return every year: 0%. I would expect that I have to choose a relative weight, to tune the trade-off between maximizing expected returns vs minimizing dispersion of returns. edit: after reading a bit, it seems that changing this weight would trace out what is called the "efficient frontier".
  - darawk 7y ago
    Sorry, stable returns are not the only consideration. You want them to be as high as you can, while maintaining stability. There is obviously a tradeoff there, and yes, 'efficient frontier' is the term of art for choosing points along this optimal curve.
- tunesmith 7y ago
  This is great, thanks. I have looked into maximizing the geometric mean before, similar to Kelly Criteria, but apparently that's a very volatile approach with a long timeframe before you have a high likelihood of approaching that maximization. I'll look more into Sharpe Ratio. The general Bogle advice is for taxable accounts, pick something like a total us stock market index fund like FSKAX for fidelity. Low expense ratio, but you're right, it still has taxable long term capital gains and reinvestment every so often.

bryanbuckley 7y ago

Check out portfoliocharts.com

darawk 7y ago

Yes, that's right. What you want to do is maximize your sharpe ratio. You can play around with this python package to get a sense for how it works: https://github.com/robertmartin8/PyPortfolioOpt https://github.com/robertmartin8/PyPortfolioOpt What you should be trying to achieve is a portfolio that earns the exact same return every single year, and you can do that in part by looking at historical covariance of the asset's time series. However, you also want to take a prospective view, and think about which asset classes may become correlated in the future. There's no universal answer here (in the out of sample case - you can solve it in-sample), however. And another huge, huge factor is tax. Making sure your investments are tax-efficient is extremely important. Nothing will do more to ruin your compounding than taxes. So whatever you do, carefully consider the tax implications of your choices. A lot of people focus on the tax rate. But what's actually quite a bit more important is the tax frequency. If you pay long term capital gains every two years on your whole portfolio...that's much worse than paying short term capital gains once at the very end (over a long period). What this means is that you want to choose things like passive ETFs, that are not taxed on their internal rebalancing. Even if you were to find a mutual fund that beat that ETF by 1% every year, the tax consequences of that fund would likely make it not worthwhile, before even considering the high fees it would likely charge you.

wcoenen 7y ago
> What you should be trying to achieve is a portfolio that earns the exact same return every single year Perhaps this is a dumb question, but wouldn't that mean that you end up with a 100% cash portfolio? After all, that portfolio has exactly the same nominal return every year: 0%. I would expect that I have to choose a relative weight, to tune the trade-off between maximizing expected returns vs minimizing dispersion of returns. edit: after reading a bit, it seems that changing this weight would trace out what is called the "efficient frontier".
- darawk 7y ago
  Sorry, stable returns are not the only consideration. You want them to be as high as you can, while maintaining stability. There is obviously a tradeoff there, and yes, 'efficient frontier' is the term of art for choosing points along this optimal curve.
tunesmith 7y ago
This is great, thanks. I have looked into maximizing the geometric mean before, similar to Kelly Criteria, but apparently that's a very volatile approach with a long timeframe before you have a high likelihood of approaching that maximization. I'll look more into Sharpe Ratio. The general Bogle advice is for taxable accounts, pick something like a total us stock market index fund like FSKAX for fidelity. Low expense ratio, but you're right, it still has taxable long term capital gains and reinvestment every so often.