Isn’t Diversification Just Giving Up?

Posted on August 22, 2014 at 2:01 PM PST by

Diversification is one of those investing ideas people like to say makes sense but few really put into practice. Which is a shame, because it’s a powerful retirement tool.

People dismiss diversification as “giving up” on investing. But the truth is far different. What is true diversification? Let’s talk first about what it’s not:

  • It’s not owning 15 stocks as opposed to three.
  • It’s not holding mostly stocks and letting cash dividends pile up before buying more.
  • It’s not own seven different mutual funds that track sectors of the stock market.
  • It’s not owning an broad ETF or two as a “base” for your portfolio.

Why do these common practices fail the “diversification” litmus test? Because real diversification is owning thousands of stocks, not dozens or even a hundred.

diversification

Furthermore, real diversification is owning thousands of positions even in non-stock investments, such as bonds and real estate. In short, it’s owning the whole market, like an index fund does, and owning a mix of asset classes.

Why bother? Well, first and foremost, diversification greatly reduces the risk of a single company going under. If you own a lot of one company, probably the company at which you work or a single firm you admire because of its products or its charismatic CEO, well, you are taking on quite a lot of risk.

Companies can fail. CEOs are often overvalued by investors, who buy into the myth of their power over the market. Thing can go wrong, fast, taking your retirement down with it.

But diversification also protects you from yourself. If you own 5,000 companies in a broad ETF, it won’t matter to you if 10 companies fail or even if 100 of them fail. The successes of some other group of 10 or 100 will more than compensate.

Likewise, you shouldn’t own a clutch of mutual funds on the assumption that a variety of managers will protect you from problems. If they are all trying to beat the same benchmark, you haven’t diversified at all. You will, however, be paying their high fees and you will be subject to whatever risks they assume while managing your money.

Owning those mutual funds and then one or two ETFs isn’t the answer either. Buying an index fund or index-style ETF with a small slice of your portfolio is just window-dressing to make you feel better about the outsized risks and outsized fees you pay for active managers.

True diversification

So, what is diversification? It truly is owning whole markets through broad ETFs. And it’s owning a variety of those ETFs across several asset classes, including stocks, bonds, real estate and foreign investments.

And it’s rebalancing dutifully among those funds as the market’s bucks and churns provide you with opportunities to sell high and buy low. That way, you stay diversified even as changes in the market distort your original portfolio allocations.

It’s really simple, perhaps 10 or 12 ETFs across six or eight asset classes. That’s top-notch diversification and, ultimately, better performance, too.

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