Why Your Investment Portfolio Is Not Diversified

Posted on October 28, 2011 at 8:36 AM PST by

Some people think investing is all about picking the right stocks to “beat the market.” Peter Lynch and Warren Buffett are fabled stock pickers. Wall Street would certainly have you believe this notion because “beating the market” rings their register. And then investors are told that they should be diversified. Does that mean owning 30 stocks? Which 30? And what’s the point?

Own stock markets, not stocks. Diversification means that you own enough stocks in a “market” so that no one stock can have any kind of major impact on your portfolio. Many brokers buy their clients 30 large companies and declare, “You’re diversified!” You know, all the usual big names. So how did that work out in 2008 when the largest U.S. companies, like General Motors, General Electric, Citibank and Bank of America, dominated a portfolio? Not so well. Do you subscribe to Netflix? Reed Hastings, its CEO, was often hailed as the next Steve Jobs until last July when Netflix began falling from $300 per share down to $75 this week¬—a loss of 75 percent. Big or small, individual companies blow up. And it happens suddenly. Want to minimize the risks that come from bad things happening to “good” companies? That means owning thousands of stocks.

Look inside most mutual funds and you’ll see 100 stocks, but for all the wrong reasons. To be a successful mutual fund manager, you must concentrate your bets on your favorite stocks. It’s the only way they have a shot at outperforming the market. But mutual funds with big Netflix positions are underperforming this year. So the typical mutual fund manager figures out over time that he can lose his job trying to be a hero and turns into a “closet indexer,” exchanging job security for any chance of beating his market (and justifying his fees).

That’s why we only recommend ETFs. They get you stock diversification and save you 80 percent in fees. Want to invest in small U.S. companies? Why pick a few good companies or hire a mutual fund manager? Just own one ETF and you’ll own literally hundreds of stocks. Netflix? Let it crash! You’ll never notice.

Spread it around. And consider this: There are other stock markets outside of the United States. Germans don’t obsess about our Dow. Half of all companies are outside of the United States. And world markets tend to move quite independently. Therein lies the second secret of diversification: What causes some to go up often causes others go down.

Yale professors studied money managers over 10 years to uncover the source of their portfolio performance. They found that 90 percent of the returns came from which markets they invested in. Less than 10 percent came from the individual stocks they bought and the timing of buying and selling investments. For example, if they owned small-cap stocks and that group of stocks did well that year, the performance of that market was the source of their success—not the specific small-cap stocks they had chosen.

Markets are the ingredients of successful diversification—and the more you have, the better. Diversifying into markets is kind of like creating a prized recipe. Garlic, lemon, oregano, and thyme are not too appetizing on their own. But when skillfully combined with a host of other ingredients, the results can be spectacular.

You want to own a host of diverse markets, and not just “safe” ones. Horseradish might be dangerous if consumed by itself, but as part of an overall recipe, it delivers positive results. The same goes for adding risky markets. Adding one or two to the mix can have a leavening effect that may actually reduce risk and volatility, while adding to overall performance.

U.S. stocks and stocks in Europe, Japan, and Australia tend to move independently from each other. So allocating money to all of these markets creates instant diversification. Emerging markets like China, Russia, India, Brazil also move to the beat of a different drummer. Bonds and real estate are even further afield from stocks, so adding these markets provides excellent diversification. Every year, some market wins and others lose, and no expert can predict the future. So the answer is simple: Own them all!

With the proper mix of markets—U.S. stocks of large and small companies, foreign developed countries, emerging markets, U.S. government bonds, real estate, and commodities (using ETFs for each of these markets)—you can consider yourself fully diversified. Now that’s a good salad!