What is Investment Diversification and Why Should I Care?
If you’ve had any experience with investments, you’ve probably heard the term “diversification”. Maybe you’ve heard it from a financial advisor or a 401(k) rep at work, or maybe you’ve read or heard it from the investment news media. What usually comes next is the “not putting all of your eggs in one basket” explanation.
It makes sense. Putting all of your eggs in one basket is always a bad idea. That seems simple. It should be easy to do…right?
Unfortunately, it’s not as simple as it sounds and some investors are getting it all wrong.
What baskets are we talking about? How many baskets should you have? And, where should your baskets be to keep them safe? There are hundreds of thousands of investments options out there – how do you do it right?
Safety in Numbers
Sir John Templeton of Templeton Growth Fund fame said, “Diversify. In stocks and bonds, as in much else, there is safety in numbers….” When you diversify, you own a varied enough group of investments, that if a few of your investments have a significant loss in value, the rest of them can reduce the sting of that loss.
For example, imagine a time when Artificial Intelligence gets so smart that the public starts to fear technology of all kinds and there is a mass movement to eliminate IT. If you have investments in IT companies like Google, Amazon, Intel, and Nvidia, their value will drop like a rock. But if you’ve been smart, you’ve diversified across industries and your International Paper, Neenah Paper, and Orient Paper investments are going to smooth out your IT losses, as the general public will be buying paper calendars, notepads, and bound books hand over fist. That’s diversification in action.
A word of caution: although diversification does limit downside risk, no amount of diversification will eliminate the risk of loss. Without risk, there is no potential for gain. Nevertheless, with diversification, your downside risk is less because there is some safety in numbers.
Sell High and Buy Low
Diversification also allows you to sell high and buy low through rebalancing. Over time, some investments grow faster than others, and some investments lose value. If you are properly diversified, your investments will eventually be out of balance because of those changes in value. When that happens, you can sell investments that have grown and buy investments that have fallen in price in order to rebalance. You’re selling high and buying low – exactly what you’re supposed to do. In the words of Warren Buffet, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it’s marked down.” Everybody likes a sale and you’ll get the sale price because you’ve diversified and rebalanced.
Focus on What Really Matters
You will never hit it big with diversification. You’ve spread out your money enough that you have less downside risk, but because of the spread, your upside potential is also dampened. But look, this gives you the opportunity to focus on what really matters. If you are a plumber, or you work in IT, or you’re a minister or a small business owner, your cash flow comes from your salary. You’re not a professional investor, so you don’t need extraordinary gains. You love what you do, and you don’t need to give up on your dreams or passions to spend 8+ hours a day researching, investigating, and reading financial statements in search of the next best investment. You won’t hit a home-run with diversification, but you can focus on your life and still get a return that will meet your retirement and investment needs. Your upside potential is reduced, but then again, you’re not tempted to chase that one big win at the expense of your precious time and attention.
Investors Are Getting it Wrong
So, you understand the concept of diversification and you understand what it can do for you, but don’t jump the gun. As I said, some people get it wrong. They’ve checked off the diversification box, but in fact, they are about as diversified as a church potluck – lots of dishes, but’s it’s all casseroles.
Let’s take a look at two common ways investors think they are diversified when they really are not.
Too Many Advisors
Hoping to protect their investments, investors will give their money to multiple investment advisors. They’ve tried to avoid putting all their eggs in one basket, but instead what they’ve done is put too many cooks in the kitchen. Naturally, those multiple advisors are not going to be sharing information and they may be approaching investing in very different ways. Advisor A, B, and C may diversify the investments, but the total investments aren’t going to be on target for any one particular investment strategy. There is going to be investment overlap, and unintentionally, diversification as a whole is going to be out of balance.
The investor may attempt to ensure there is no overlap, but they end up spending more time, effort, relationship capital, and, potentially, money for no additional gain. They end up drained trying to balance multiple advisors. Instead, they should pick one trustworthy, competent advisor and let their investments hit the diversification target the first time with less effort and resources.
It’s all the Same Thing
A second way that people try to diversify but miss the mark is by investing in multiple mutual funds that hold the same or similar underlying investments. Mutual funds are an efficient and inexpensive way to diversify investments. However, if an investor buys a healthcare-focused mutual fund from Fidelity and another from T. Rowe Price, or three S&P 500 Index funds from Vanguard, Schwab, and iShares, they have not diversified their investments. It’s like when you go to the doctor and he says, “You need to start eating a more diverse diet.” You say, “It is pretty diverse. I eat McDonald’s on Mondays and Wednesdays, Burger King on Tuesdays and Thursdays and I go to Wendy’s on Fridays for the chili and a salad.” All you’ve bought are different brand names, but it’s all the same thing.
How to Get it Right
So, how can you do it right?
First, diversify across all business sectors. Currently, eleven different sectors make up the S&P 500. You want to have a bit of every one of those categories – health care, consumer discretionary, real estate, industrials, information technology, materials, communication, financials, energy, consumer staples, and utilities. Each category gains and loses at different times and at different paces, but if you hold some of all of the categories, it’ll smooth out your ride. You don’t have to have a mutual fund for each one. You can find mutual funds that have acceptable exposure to each sector.
Second, diversify by investing internationally and not just in the United States. The S&P 500 is five hundred very large companies headquartered in only one country – the US. The Investable Market Index is much wider, at forty-seven countries and 8,653 stocks. Buying outside the United States can smooth out your ride even further. Maybe you’re concerned about investing outside the United States. Don’t worry: we’re talking about companies like Nokia, Toyota, Royal Dutch Shell, and Nestle. You know these companies and you’ve probably used some of their products. Like with business sectors, you don’t need to buy multiple mutual funds for each geographic region. There are mutual funds that provide a broad, balanced approach to international investing.
Third, you will want to diversify across company sizes. As mentioned earlier, the S&P 500 contains very large companies; we are talking businesses valued at $5.3 billion or more. But there are perfectly good small and mid-sized companies out there. When I say “small” or “mid” I mean valued between $300 million to $4 billion. These aren’t mom and pop shops that are going to fail because Johnny goes off to college and doesn’t want to bake bread the rest of his life. These are companies like Brinks, ReMax, and Bed Bath & Beyond. Again, you don’t need to buy separate mutual funds that touch each one of these company sizes. There are mutual funds out there that have a balanced level of exposure to each size.
Fourth, you should diversify across investment markets. Rebalancing works especially well when you have exposure to both the stock market and the bond market. Bond markets don’t tend to move as high, as low, or as fast as the stock market. If the stock market takes a huge dip, your bond investments generally won’t take the same dip. You can use some of the money invested in the bond market to buy stocks when those stocks are relatively low-priced. Again, you’re buying low and selling high. And again, there are good mutual fund options out there that diversify across the bond markets. You don’t need lots of funds to get the right amount of exposure, so don’t feel pressured to buy multiple mutual funds from different brands or advisors.
Do it Yourself or Find an Advisor
If you feel like you can’t do the above four things by yourself in a balanced and prudent way, find an advisor that can. Google some articles about interview questions you should ask an advisor before hiring one. Go out and interview a couple of advisors before committing to one.
Good advisors are out there. They’ve done their homework. They want you to have a good investment experience and to reach your goals. They can give you the tools that you need, or they can do the investing for you. You can sit back, relax, and enjoy life a little because you know you have appropriately diversified your investments. All of your eggs aren’t in one basket. You can become financially confident and you can have a better investment experience.
- Tim Bacus, EA