Don’t put all of your eggs in one basket is the oldest adage in investing. Be sure to diversify your risk. Here’s the rub. Diversification isn’t sexy. We will not hit the stock market jackpot by buying the entire market. Market returns are average, and who wants to be average?
Hindsight is 20/20, and there is no place more tempting than the stock market to dream about striking it rich. A $10,000 investment in Amazon in May 1997 would be worth almost $12 million today. That is a life changing investment, but the ride was never certain. Amazon stock suffered multiple drawdowns of 50% or more and an extended period of lackluster returns during the mid 2000’s.
If I had been lucky enough to own Amazon and too distracted to sell when the shares collapsed in the dot.com bubble, I know I would have sold shares to buy my house, to cover expenses when I was laid off in 2009, or to start a business. It would be too tempting not to sell a winner this big.
*Historical price data from Yahoo Finance
I will admit, this is a sexy chart, especially the parabolic rise on the right. In contrast, saving $10,000/year since the same month in 1997 and investing it in a simple portfolio comprised of 80% stocks and 20% bonds, yields a portfolio worth about $550,000 today. It may not be sexy, but this is nothing to sneeze at – $200,000 of disciplined savings and $350,000 in gains. The best part about diversification is that it works.
Two-thirds of stocks lag the overall market return, and companies go bankrupt, erasing . Even if you pick decent stocks, the market averages are largely driven by a handful of the top winners. Not owning the top 10% or 25% of the market significantly erodes your return.
Thirty years ago, diversification meant owning 25-30 stocks and a laddered bond portfolio. Today we can purchase 10,000 stocks across the global in a single ETF transaction. There are asset classes we never considered investable twenty years ago – local currency denominated emerging market bonds, currency hedged international small cap stocks, risk parity funds, and funds that provide single day leveraged exposure to the inverse of your favorite index.
The endless sea of financial products and firms to sell them to you creates confusion. What exactly is diversification anyway? Perhaps one way to answer this question is to define what is NOT diversification.
Diversification is NOT –
- Opening accounts with multiple financial firms, advisors, banks, wirehouses, or custodians. They might all own the same thing.
- Buying the top 10 performing mutual funds last year. Yikes! These are all invested in the same asset class, sector, and even the same exact stocks. I wish publications would cease with creating these lists.
- Owning 30 large cap US stocks. You might be diversified by industry, but you left out a huge opportunity in small cap and the rest of the world.
- Investing equal amounts in each of the funds offered in your 401(k) plan. This is a very common error made by 401(k) participants. Most 401(k) plan lineups are heavily weighted to US large cap stocks, with very few options for bonds and international stocks.
- Placing a significant portion of your net worth in gold or other physical assets. Physical assets are difficult to convert to cash at the exact time when you need it, and the transaction costs are high.