Investing Basics: What Is Diversification?

Posted on October 9, 2015 at 7:05 AM PST by

You know the old proverb: “Don’t put all of your eggs in one basket.” Nobody ever asks about the efficiency of multiple baskets for egg carrying, but there’s a reason we say this.

It makes sense. Spreading risk is fine idea and it sounds like good advice. But what does that look like in a retirement plan, and how much risk spreading is enough?

When you put your eggs into different baskets in an investment plan, what you’re really doing is diversification. It means owning a variety of investments and owning a lot of different versions of investments.

diversification

Let’s break this down a bit. You can diversify your retirement portfolio by:

  • Owning multiple investment types, such as stocks, bonds, real estate, commodities and foreign equities and debt.
  • Owning a variety of each investment type, so inside the stocks portion you might own domestic and foreign stocks, large caps and small caps, dividend payers and growth companies with no dividends. Inside the bond portion you’d have government and corporate bonds, foreign and domestic and each at differing maturities.
  • Even so, in each sub-asset class you’d own not a dozen but hundreds and perhaps thousands of individual investments. So, for the large-cap stock portion,  you would own an index fund representing several hundred big U.S. firms. For small cap, hundreds more.

And so on, until instead of a basket or two you literally have thousands of baskets with an egg or two (your retirement savings) in each.

Why go to such extremes? Because it’s possible to do so cheaply using index funds. There’s really no reason to focus on which stock to buy or which bond to avoid when you can virtually erase risk by owning them all.

The research has shown, over and over, that exposure to asset classes is what matters, not security selection. A lot of people labor under the delusion that they can pick stocks better than the professionals.

What they should admit to themselves by now is that even the full-time stock and bond pickers are grasping at straws. Wall Street routinely gets it wrong on earnings, on macro events, on what will move the markets next.

There’s just too many factors driving money in and out of individual securities, many of them unaccounted for and, frankly, most of them impossible to account for.

Diversification effect

That’s why pension plans and university endowments focus heavily on portfolio construction instead of bothering with stock picking. They get it. Lower costs, focus on risk management and let the assets generate compounding return.

Add to that disciplined rebalancing and it’s pretty hard not to make a decent return and, importantly, you don’t have to worry about a given company’s quarterly numbers or the risk of a specific bond defaulting overnight.

If you are diversified enough — if you have enough baskets for all those eggs — a lot can go wrong and have no practical effect on your retirement. You can relax and focus on things that matter more, which if you’re truthful is just about anything else in your life besides money.

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