In a link that you can read below (free tutorial for beginners), one of the ideas that I wrote is “10. Diversification is protection against ignorance“. I continue to believe that for the average joe, without a deep knowledge of the market and/or for investors that don’t have the time or the resources to follow every aspect of the stock market, diversification can be a valuable asset.
Is it Bad or Good?
There are two bad things that some often attribute to diversification:
- It will lower the returns on your portfolio
- Too much of it will increase your expenses
The argument associated with the first point is that, if you invest in an ETF of S&P500 and then compare with a single successful stock the returns will be much lower.
The second one is that if you over do it, you will have more expenses such as trading more frequently to keep your portfolio balanced, and diversified.
Returns of the last 10 years – SPY vs Amazon
Obviously if you have diversified between the biggest 500 companies in the US, the returns are far less than investing everything you had in Amazon. But this is assuming two things: That you will get absolutely right when choosing a stock (actively choosing the right stock). However, history and data show that this is often not the case for the majority of investors.
You can also “cherry pick” stock such as Enron, that once had over $100 billion in revenues and at its peak had a share value of $90.75. The year was 2000. One year later the company declared bankruptcy and its shares dropped to $0.67 in 2002. That’s a return of -99%.
Now imagine being all in Enron shares. Suddenly diversification looks like a free lunch, doesn’t it?
Expenses, expenses, and expenses
Of course, diversifying has some limitations. Let’s explore what options do I have.
- I can diversify individually picking individual stocks, bonds, certificate of deposits, options, commodities, real estate, and so on. Active funds often do this. For an individual investor? It’s expensive and will take a lot of your time and resources. Plus you won’t have a saying if a company does something wrong and then lose half of its value.
- Across asset classes. With mutual funds and/or ETFs, this is easier than has ever been in the last 100 years. I can pick an ETF with stocks that will have 60% of my money, and another with bonds with the remaining 40%. Example: SPY 60% + AGG 40%. Plain and simple.
- Across type, size, country, region. This involves more complexity. Imagine that you strongly believe in US small stocks. And in Emerging markets bonds. You already have ETF or mutual funds that manage those type of assets, but usually, the cost is higher, and the liquidity is lower. Easy to understand: There are fewer investors trading this type of assets. But if you’re willing to tolerate the higher cost/less liquidity, this is another way to diversify.
How is Diversification Working?
First of all you need to understand what this concepts means. You won’t get rich faster, because it’s nearly impossible to choose more than one asset to invest that will have superior returns (all of them at the same time).
What you’ll have is a lower possibility of losing all of your money, or taking a big hit due to a concentrated exposure. Therefore protecting the portfolio of ignorance and/or unexpected events.
A well balanced portfolio will survive anything.
On the other hand, different years have different winners in terms of asset classes. Thus a well diversified portfolio + periodically and correctly re-balancing your portfolio will maximize the exposure of those assets for the good years.
The end of 2018: Did it worked?
As you know, the last month of 2018 was very hard for stock markets. The S&P 500 almost lose -20% in a single month. Therefore a lot of investors start questioning what if this was the beginning of a severe bear market.
Obviously, we know now that it wasn’t. Let’s see what would happen in
- The return was more negative if you had a 100% stock allocation. With 40% in quality intermediate US bonds, you would have a less negative return. This is diversification at its best. Protection against an unexpected event.
- Furthermore, the volatility was almost cut in half. Investors that are in stock markets for the long run, should focus on having low volatility portfolios. They are much easier to maintain.
“The market can remain irrational longer than you can remain solvent.”
“Don’t put all your eggs in one basket” can be a valuable lesson and principle to have on your investment plan.
It will likely protect you from:
- Companies that make mistakes. Thus losing value to its stakeholders. Whether are mergers that went wrong, legal stuff, a product with problems, or simply poor management you’ll be protected.
- Black swans. Events that are classified as outliers, and can take a lot of value of your portfolio. Dot-com or 2008 financial bubble are two examples.
- Ignorance. Some people like to think that they can predict consistently the next big thing. The majority can’t.
- Low returns, after a good year. If you have a 60%/40% allocation, it means that if you had a good year in stocks you will be “forced” to sell in order to rebalance your allocation. If next year there’s a crash the impact will be lower.