10 Can’t-Fail Lessons of Diversification
Reprinted courtesy of MarketWatch.com.
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In real estate, the bottom line is “location, location, location.” A similar mantra about investing should be “diversification, diversification, diversification.”
If you diversify properly and sufficiently, you’re well on your way to getting favorable returns at a reasonable level of risk.
What is diversification? Investorwords.com defines financial diversification as “reducing non-systematic risk by investing in a variety of assets.” A much simpler definition is “not putting all your eggs in one basket.”
Here are 10 important diversification lessons that every investor should know:
One: Diversification is likely the only “free lunch” that investors will find on Wall Street. Think for a moment about owning individual stocks. According to academics who have studied the matter, the expected rate of return of a single large-cap growth stock is the same as the expected rate of return from owning all large-cap growth stocks.
In other words, there’s no statistical benefit from having zero diversification.
However, the risk of owning a single stock is vastly higher than the risk of owning thousands of stocks. One company could fail, but the risk of all companies failing is virtually nonexistent.
Two: When I got into the investment industry in 1966, the conventional wisdom held that proper diversification could be achieved by owning 10 to 20 stocks. Today, the academics believe proper diversification requires investing in multiple asset classes, and owning 100 or more stocks in each of them.
Three: In 1966, only the wealthiest individual investors could even consider having this level of diversification. Now almost all investors can have it, through index funds.
Four: Meaningful diversification requires more stocks in relatively non-liquid asset classes. U.S. large-cap blend stocks are very liquid and easy to sell without making a meaningful impact on the market. This asset class can be adequately represented by 500 stocks. For example, the Vanguard 500 Index Fund VFINX +0.51% replicates the Standard & Poor’s 500 Index.
But to gain adequate diversification, you need to own many more stocks in a less liquid (and riskier) asset class such as international small-cap stocks or emerging markets stocks. Each of the funds I own in those two asset classes holds more than 3,700 stocks.
Five: Diversifying among asset classes is more beneficial than merely owning many stocks. I have spelled this out in detail in an article that I have been updating annually for more than 15 years.
In that article, I give the evidence, going back not just years but decades, of the indisputable benefits from creating a portfolio that includes large stocks and small stocks, value stocks and growth stocks, U.S. stocks and international stocks, real estate investment trusts and emerging market stocks.
This may be the most important article I’ve ever written, and I recommend it to you without reservation. If it doesn’t convince you of the value of diversifying, I don’t know what else possibly could.
Six: As I mentioned above, I believe index funds are the most effective way to control your portfolio’s diversification and the most efficient way to invest. Why do I love index funds so much? Let me count the ways — 30 of them, to be exact.
Seven: Not all diversification is good diversification. As noted above, I recommend only asset classes with long track records of success in providing what investors want and need: productive long-term returns with reasonable risks.
Some investments, even though they sometimes achieve great popularity, cannot meet that test. This includes technology stocks, gold, sliver and commodity funds. (Sorry, brokers: What you’re so eagerly peddling just doesn’t make the grade.)
Eight: If you diversify properly, I guarantee you will underperform some investors. (However, I also guarantee you will outperform others.) Your diversified portfolio will deliver a composite return made up of many asset classes beyond the popular stocks that are regarded as “the market” and which comprise the Standard & Poor’s 500 Index and the widely reported (and very undiversified) Dow Jones Industrial Average.
When these large-company U.S. stocks are performing well, it can be frustrating to hold a diversified portfolio that isn’t measuring up in the short term. But over the long haul, diversification has always won. Diversification requires faith and persistence.
Nine: If you own a properly diversified portfolio, you’ll always be represented in the current market-leading asset classes. No matter which major asset class is making the headlines, you’ll own some of it. You won’t be left out.
The obverse of this is also true. Whichever asset class is currently lagging will also be in your portfolio. This may test your faith. But this phenomenon is an essential part of the ultimate success of diversification. Leaders and laggards change places, and if you do diversification right, you can watch them wax and wane in peace.
In that way, proper diversification will help you reduce your emotional involvement with your investments. That, in turn, makes you much more likely to succeed in the long term.
Ten: Diversification applies beyond equities. Almost every investor beyond a certain age (perhaps 35 to 40) should hold some bond funds to mitigate the ups and downs of the stock market — even the ups and downs of a properly diversified equity portfolio.
The market bust in 2008 wiped out many investors who bet everything on stocks. But those who had invested 30% or more of their portfolios in fixed-income funds were less likely to feel compelled to bail out. And investors who stayed the course were able to get the benefits of the amazing (and largely unexpected) equity recovery in 2009 and 2010.
How much you should have in bonds is a question worth its own discussion. You’ll find that discussion here.
In the meantime, I hope you’ll remember this rule: Whatever else you do, diversify, diversify, diversify.
Richard Buck contributed to this article.