The Last Free Lunch in Investing – Diversification

Diversification is a powerful thing in investing. The main idea behind it is simply that, you don’t put all your eggs into one basket. So, if one of the baskets has a hole, it doesn’t screw up your retirement plan.

In the same vein but slightly more technical, diversification is the only way to lower investment risk without decreasing your expected return. This makes it a pretty valuable tool box for investors and there’s arguments for and against it.

What is diversification?

The idea with diversification is that investing in broader markets and whole countries is generally safer and more reliable returns than any single company within that sector or country. If spreading money between many different investments prevents total loss of that investment, then that’s a pretty good deal.By diversifying a portfolio there’s two things that are accomplished:

1. Decrease investment risk.
2. Decrease investment risk without decrease expected return. Your investments would be expected to preform just as well as if you didn’t diversify.

This is further evident, in my opinion, by the fact that the average tenure of companies on the S&P 500 in 1964 was 33 years, by 2016 that decreased to an average of 24 years.¹ The fact is no company is immune from the creative destruction known as capitalism and innovation. And while, you could theoretically pick one of the up and coming companies that will also stay on the index longer than average, but if even the pros can’t do it, most individuals can’t either.²

Why Diversification works

There are a couple reasons why this works:

Any individual company or investment opportunity comes with a significant amount of risk. Not only does that require a lot of upfront research and/or knowledge about a market. It requires attempting to quantify and calculate long term growth of the firm/sector.

However, just because one company can fail for any given reason, the stock market, and the entire world as proven to be a pretty good investment.³

S&P500 1980-2020

Even professionals, as previously mentioned, can’t beat the market. With all their money, knowledge, and huge number of experts working around the clock to produce returns that beat the market, you’d expect at least 1-10% of them to do? Well, 99% of active managers don’t beat the market.²

So by diversifying your investments, and say, investing in the entire world’s stock market, you’re taking advantage of long term growth without the risk of any single company sinking your entire retirement plan or portfolio.

The argument against Diversification:

The main argument against diversification is that you won’t strike it rich. You won’t get in on Apple, or Tesla, or the next Google because your money is spread out over many different investments.

Even Warren Buffett suggested that if you really wanted to dedicate yourself to investing, that you should limit yourself to your best six ideas and no more.⁴ However, while he’s the greatest investor of all time. He also said in the exact same talk:

“If you are not a professional investor… then I believe in extreme diversification. So, I believe 98% or 99%, maybe more than 99%, of people who invest should extensively diversify.”

The fact is that most of people aren’t professional investors, and even the professionals suck at being professional investors – assuming their goal is to actually beat the market. And, unfortunately, it’s further compounded by the fact that individual investors get consistently lower returns than the market as a whole.⁵ Possibly because they are chasing home runs that have already happened.

In other words, it’s possible that it will happen to you, just statistically very unlikely. While diversification may not be very cool it’s the thing that will most likely lead to success in financial markets.

MCSI World Index

And long-term investors should be aiming for financial freedom, not get quick rich schemes.

Still not fully convinced?

57% of stocks do not even outperform treasury bills.⁶

“Four out of every seven common stocks that have appeared in the CRSP database since 1926 have lifetime buy-and-hold returns less than one-month Treasuries. When stated in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies explain the net gain for the entire U.S. stock market since 1926, as other stocks collectively matched Treasury bills. These results highlight the important role of positive skewness in the distribution of individual stock returns, attributable both to skewness in monthly returns and to the effects of compounding. The results help to explain why poorly-diversified active strategies most often underperform market averages.”

And as further evidence, a JP Morgan study of the 13,000 stocks that have been in the Russell 3000 since 1980-2014. 40% of them suffered a decline of 70% or more from their peak value without a significant recovery (defined as being down (60% or greater from ATH)⁷

So what can we do if not beat the market?

The simple answer is invest in index funds that are well diversified with the majority of your portfolio. Our typical recommendation is to invest around 80-90% into well diversified index funds – like the Vanguard Total World Stock Index (VT) or into things like the Vanguard Total Stock Market ETF (VTI) and Vanguard Total International Stock (VXUS). Those are either global index funds tracking the whole world as with VT, the entire US stock market as with VTI, or the whole world excluding America which is VXUS. If you invest in either VT or VTI/VXUS you’ll have an extremely broad and well-balanced portfolio that can weather any storm. Then with the extra 20-10% you make fund plays that keep you interested in investing – either your own stock picks or highly risky bets that have a good chance of paying off – which is something our newsletter can provide with Ultra Risky preferences or High Risk preferences.

But the final point of advice is to use platforms like M1 Finance or Vanguard that generally cater to long term investors and keep us from making rash decisions about our long-term financial goals. It’s difficult to fight the fear of loss and panic when there’s a market decline and M1 can help with that. But regardless of the platform in use, it’s important to keep a long-term perspective when investing. And recognize that, in general, the market knows best – or at least – out preforms 99% of people.

As always, good luck and remember to do your own research as well.

Note: the m1 referral link gives the reader $10 extra dollars to invest with if they choose to fund a taxable with $100 dollars within 30 days of opening the account or fund a IRA with $500 within 30 days of opening an account. The author of this article will receive a $10 dollar compensation as a result of the reader opening a account. The compensation for both parties occurs 30 days after the deposit occurs and assumes the full amount is retained in the account until the end of 30 days from the deposit day.

Disclaimer: InformedFinancials.com is not a registered investment, legal, or tax advisor or a broker/dealer. All investment/financial opinions expressed by InformedFinancials.com are from personal research and experience of the owner of the site and are intended as educational material. Although, best efforts are made to ensure all information is accurate, up to date, and reliable, occasionally unintended errors and misprints may occur. The content is intended to be used as informational purposes only. You should take independent financial advice from a professional and independently research any and all of our claims. The website does not accept any liability whatsoever for any loss or damage you may incur.

1. https://www.innosight.com/insight/creative-destruction/
2. https://www.ft.com/content/e139d940-977d-11e6-a1dc-bdf38d484582
3. https://jlcollinsnh.com/2012/04/19/stocks-part-ii-the-market-always-goes-up/
4. https://www.youtube.com/watch?v=wbjPiYE-F4Y
5. https://bucks.blogs.nytimes.com/2010/08/05/investors-are-still-behaving-badly/
6. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2900447
7. https://privatebank.jpmorgan.com/content/dam/jpm-wm-aem/global/pb/en/insights/eye-on-the-market/eotm-the-agony-and-the-ecstasy.pdf