The Benefits and Costs of Diversification in My 403(b)

Since the semiannual review of my 403(b) account showed no need to rebalance, I’m going to discuss the benefits and costs of diversifying. I’ll use my portfolio as an example for this.

I diversify because it increases the odds of being allocated to the right asset class and asset class category at the right time.

The chart below demonstrates this. It shows the calendar-year and 2024 year-to-date returns for the funds I hold in my 403(b) account. I purposely plotted calendar-year returns instead of showing compounded growth to illustrate each fund’s volatility. The funds are:

• Vanguard 500 Index Admiral fund (VFIAX)
• Vanguard Small Cap Value Index Admiral fund (VSIAX)
• Vanguard FTSE All-World ex-U.S. Small Cap Index Admiral fund (VFSAX)
• Vanguard Real Estate Index Admiral fund (VGSLX)
• Vanguard Intermediate-Term Investment-Grade fund (VFIDX)

An additional benefit is having a stash of conservative assets I can pull from to put money into stocks during steep corrections and bear markets. I did this is in March 2020 to buy stocks during the pandemic stock market crash.

The benefits of diversification are not costless. As with anything involving investing, there are trade-offs.

Portfolios that diversify across asset classes and asset class groups are going to hold some lower-returning investments. The Vanguard Intermediate-Term Investment-Grade has a 10-year return of 2.5%. It is the price I’m paying to have the ability to rebalance back into stocks during bear markets as well as to sleep at night.

Diversification will often cause you to second-guess your decisions. Perfect hindsight shows I should have put everything into the Vanguard 500 Index fund. Its 12.9% 10-year return is well above that of the other four funds I own. Over the same time period, the Vanguard FTSE All-World ex-U.S. Small Cap has been a dud.

So why not just put everything into the Vanguard 500 Index fund now? Two words: hindsight bias. Just because we know with certainty what worked over the past 10 years does not mean we know what will work over the next 10 years.

Plus, there are factors that could favor my allocation going forward. Domestic small-cap value stocks are very undervalued relative to large-cap stocks. International stocks are incurring an unusually long period of underperformance relative to domestic stocks. Intermediate-term bonds will benefit from a drop in interest rates.

And if the S&P 500 index continues to outperform, I have exposure to that too.

My goal is not to put all of my chips into one basket. I sleep well at night knowing that I have not made any single big bets and am using rebalancing to keep any one fund from becoming too overweight.