Simply put: diversification means allocating your money to different opportunities. For a stock investor, this can mean buying stocks from many companies in different industries. For a retirement saver, diversification can mean investing in a mix of stocks and bonds.
“There ain’t no such thing as a free lunch.”
The idea that you don’t get something for nothing is true with most things, but not diversification. In fact, diversification has been called “the only free lunch in finance” for its ability to give an investor a benefit—for free!
Why should I diversify?
Diversifying your investments reduces your risk. Owning one asset by itself means you’re subject to more extreme fluctuations in value than if you owned a well-rounded portfolio.
Let’s say your family has owned stock in a large American oil company for years. Over time, this stock has done extremely well and now you have inherited the shares. What do you do with it?
In this example, you are concentrated in the stock of the oil company. If the price of oil plummets, your stock will be far more affected than companies in other sectors. Likewise, the CEO could resign, consumer preferences may change, or a myriad of other events could occur to cause this company’s stock prices to drop.
Let’s say you decide to sell part of your oil company stock and buy shares in a different sector, like technology. Now you’ve helped diversify your portfolio away from the risks unique to oil (a decline in price) and the risks unique to this one company (the CEO resigning).
Diversifying your stock portfolio this way gives you your “free lunch”. You benefit from lower risk without giving up potential return. In a broader sense, investors may benefit from decreasing their stock market risk by investing in other assets like bonds, real estate, or annuities. These assets have lower correlations to each other—meaning they don’t move up and down in tandem.
Insure against an unknown future
Diversification also insures you from an unknown future. We can look at market history and current prices to estimate expected investment returns. However, no one knows how things will unfold or what the best performing asset class will be. Professional and amateur investors would love to pick the next Amazon. But this is hard to do–hard enough that buying insurance for the unknown future may be best.
How do I diversify?
Use mutual funds and ETF’s
The first step to having a diversified portfolio is using mutual funds and exchange traded funds (ETF’s). These allow anyone to invest in a diversified portfolio of stocks or bonds (or both) without needing to buy each stock or bond separately.
The next step is a global portfolio.
Too often, investors exhibit home country bias—favoring stocks in their own country over others. There is no research to support the benefits of having an entirely domestic portfolio.
First, a global portfolio has less risk than one invested solely in one country. Stocks in India, Germany, or Japan will perform differently year-to-year than American stocks. Because they aren’t entirely correlated, your swings will be less volatile.
Second, a global portfolio allows you to capture growth—wherever that growth is! Consider this: since 1998, the United States has never been the top performing stock market in a year. While the US and international stock markets go through cycles of market leadership, research has shown no predictable pattern of performance. If you own stock in GM or Ford (in your mutual fund, preferably!), why not also own Toyota? If you own Kraft, why not own Nestle?
What diversification is not
Some investors may think they are diversified because they own multiple mutual funds. It’s the types of mutual funds that are important. For instance, owning two S&P 500 funds does not provide additional diversification over owning one by itself.
Other investors maintain accounts at multiple brokerages, thinking the location of their account means diversification. This just means you have to keep track of more online passwords, tax forms, and statements.
Earlier, I mentioned that diversification isn’t always easy to implement. This is because our emotions often get in the way. Once you’re diversified, adjust your expectations and stick with your plan. When you own multiple asset classes, there will always be something in your portfolio that you won’t like!
“I spend about half of my time wondering why I have so much in stocks and about half wondering why I have so little.” -John Bogle, founder of Vanguard
As a professional investor and founder of the world’s largest mutual fund company, John Bogle wasn’t immune to feeling FOMO when stocks were surging or feeling anxious when stocks were falling. However, he understood why he was diversified and didn’t change his investment plan.
Too often, investors fall victim to performance chasing. This is a well-documented (and wealth-destructive) behavior where people move money out of poorly performing asset classes to well-performing ones. Returns tend to revert back to the mean, leaving investors selling low and buying high. This will leave you frustrated (and poorer).
Lastly, a wise adviser will make sure your investments are properly invested for your financial plan. An adviser will help answer questions like:
- How does a market downturn affect my financial goals?
- What level of diversification is best?
Without a financial plan, your investments may not be working most efficiently for you. Diversification is there for the taking. It’s not a fail-safe against loss, but it can make your investment journey a whole lot smoother.