Diversification is like the broccoli of investing. You know that diversifying your holdings and eating broccoli are the prudent long-term things to do… but sometimes both are hard to consistently do. Even though broccoli is not the yummiest food, I make myself eat it. I also diversify my portfolio because both things are good for me.
Since diversification is good for you, let’s review:
- The definition of diversification; and
- Why diversifying is not always easy to do (especially this year).
There are three simple rules to investing: 1. Own equities, 2. Diversify and 3. Rebalance. Just because the rules are relativity simple, doesn’t mean that they are easy! Diversification often trips people up because most don’t understand what it really means. That brings us to review topic number one…
“The only investors who shouldn’t diversify are those who are right 100% of the time.”
– John Templeton, The Templeton Touch, 1983
What is true diversification? Many people think it means owning lots of stuff, but that is not correct. Financial academics define diversification as owning areas of the market that don’t have very much in common with each other. In technical terms, it means owning areas of the market that are not highly correlated to each other and have dissimilar price movement (meaning some zig and zag among your holdings).
What that means is that you want to own areas of the market that go up and down at different times. The example I like to use (which works in Indiana) is snowboard and swimsuit sales. Sales of swimsuits spike in the summer while sales of snowboards spike in the winter. Contrast this to swimsuits and suntan lotion – sales of both spike in the summer (no zig/zag effect). When I review people’s investment holdings, I often find lots of stuff, but the stuff is generally very similar. Many people think they are diversified, but when I analyze their holdings, I often find that they own a bunch of mutual funds that own the exact same stocks. Furthermore, what they most often own are a bunch of funds that contain mostly U.S. large growth stocks. The funds all tend to own Apple, Google, Exxon, Microsoft, etc… This is not diversification; true diversification is intentionally owning many, many more different areas of the market.
That brings us to the second point, if we know diversification is good for us, why is it not easy to do? If we go back to our example above, why would we own both swimsuit and snowboards all the time? Why not just own swimsuits in the summer and snowboards in the winter? Why would we ever want to own the area of the market that is not about to spike? The answer is that we don’t know which area of the market is going to do well in the future, so we need to own them all. Again, it sounds like being prudently diversified would be easy – but some years (like 2014 so far) are harder than others.
While past performance is no guarantee of future results, so far in 2014, the area of the market that most investors in the US own, namely large US growth stocks, has done better than many others areas that are held in a more diversified portfolio (such as small stocks, international stocks, and value stocks). Seasoned, prudent investors have to realize there are times when it is hard to be diversified and this (unfortunately) happens to be one of those times.
This year is reminiscent of another time in recent history when it was also hard to be diversified. Remember the late 90s when US stocks (tech in particular) were going through the roof? The investing mantra at the time was to not diversify and put all your assets in US tech stocks. Of course when the tech crash occurred, diversified investors were thankful. In addition, prudent, diversified investors enjoyed strong returns for the 2000s (with US large stocks contributing little to their gains).
So the point is don’t be tempted to shuck prudence and do what is good for you… diversify your investments and eat your broccoli!