Modern Portfolio Theory and Pie Charts

Let’s go back to 2012.

Fred—an investor—has studied up on Modern Portfolio Theory. He understands that he needs to buy some assets that are negatively correlated to one another. That way, as some go down, others go up. By following a “correct” allocation, Fred can construct a “diversified” portfolio that “minimizes risk.”

So Fred finds this Core Four Portfolio Pie Chart calling for 60% equities and 40% bonds. That sounds safe, so he decides to follow it. In the equity portion, Fred dutifully does what the pie chart tells him to do. He allocates 24% to total international stocks. Fred then finds the highly regarded Vanguard Total International Fund, takes 24% of his portfolio, and buys that amount of VTIAX.

Now, in 2020, we can see the impact of VTIAX on Fred’s portfolio. Fred has built in underperformance. Twenty-four percent of his wealth has been struggling up the bottom red arrow below. Meanwhile, Mr. Market has zipped along the top red arrow.

In 2020, Fred is not happy.

Pie Charts

What do all those colorful slices of an investment pie chart really mean to investors?  If they have more pies, and more slices, does this mean they have more financial security from market corrections?  Do they have greater investment diversity?

It is important to understand that portfolio diversification isn’t designed to boost returns. Regrettably, many less informed investors think that their highly diversified portfolio will outperform the market. In fact, a highly diversified portfolio hopes to mimic market performance. But most portfolios have built-in underperformance and just can’t keep up with Mr. Market.

The correct way to think about true diversification lies in the concept of correlation. It is the desire to own asset classes that are not directly correlated. The designed goal of “diversification” is to select different asset classes whose returns haven’t historically moved in the same direction and to the same degree. Ideally, diversification seeks assets whose returns typically move in opposite directions. As a result, even if part of a portfolio is declining, the other part is more likely growing or at least not declining as much. In theory, investors could potentially offset some of the impact that a poorly performing asset class can have on an overall portfolio.

Regrettably, even though an investment pie chart may make it appear that investors are safely diversified, it’s most likely not the case. By following a pie chart, their portfolios are undoubtedly burdened by underperforming assets. To make matters worse, if they own multiple different families of mutual funds, then they probably own the exact same companies across the different fund families. This phenomenon is referred to as “stock overlap” or “stock intersection.”  They may own 10 different mutual funds, but the largest holdings in each fund are the same companies.