DIVERSIFICATION

Diversifying your investments, if done properly, reduces risk in your portfolio.  Just about all financial professionals subscribe to the benefits of diversifying your investments.  I also think diversification is important.  But there are two kinds of diversification - one is helpful and the other kind is not beneficial.

The best way to describe diversification is using the old adage of not putting all of your eggs in one basket.  Let’s use individual stocks as an example.  

Beth is an aggressive investor who puts all of her money in the stock market because it has the highest returns in the long run.  That is the right strategy based on her age, which is 44.  But she decides to put all of her money into one stock.  She is a big believer in Apple so all of her investment funds are used to purchase Apple stock.  Apple is a great stock.  Apple is a great company.  But there is too much risk involved in holding all of your money in one stock even for a company as good as Apple.  

Large cap index funds will grow by anywhere from 8% to 11% per year over the next 30 years with dividends reinvested.  Apple has a good shot of achieving a similar or even higher growth rate over the next 30 years.  But too many things can go wrong with one stock - things that you are protected against when you hold a basket of stocks in an index fund.

• A new competitor could emerge who has better products than Apple.

• A new technology could emerge that beats Apple’s technology.

• Apple's product development could fall behind in the next 20 years.

• International political issues could severely damage Apple sales in China or other parts of the world.

• The SEC could discover financial improprieties at Apple.

• Changes in government regulations in the United States and around the world could severely impact Apple’s financial results.

• Management changes could lead to bad performance at the company.

Now, I am not predicting that any or all of these things will happen to Apple in the next 30 years, but they could.  

When you own an index fund like the S&P 500 that includes 500 of the biggest and best companies in the world, some of the bad things I listed could happen to one stock like Apple but they won’t happen to all 500 stocks in the index.  For every individual company in the S&P 500 that goes through tough times, there will be another company whose results improve dramatically.  In an index fund like this, you get results that are an average of all 500 stocks.  You get average results but the average results of the S&P 500 equals an average annual return of about 9% per year.  That is a very good return.

Owning just one stock is gambling and not investing.  You could get really lucky and hit on a big winner.  But you could also get really unlucky and lose all of your money.  Individual companies can and do go out of business which means their stock price can go to zero.

You should not gamble with your retirement account.

THE OTHER DIVERSIFICATION

Owning a basket of stocks like we just reviewed is what I call good diversification.  Everyone should follow that approach for their investments in the stock market.

There is another kind of diversification that is pushed by the financial services industry that is not good.  The investment industry has taken diversification one step further by applying the same concept to asset classes like bonds or commodities and even certain types of stock market investments.  They call this asset allocation.  

Asset allocation was invented in the 1950s and it was not effective then and it is not effective now.  Under this theory, they say that we should all own a variety of categories of stock market investments.  They say that we should own large cap index funds like the S&P 500 but that we should also own mid-cap funds and small-cap funds and international stock funds to name just a few.  That way if the US stock market is down one year and the international markets, for example, are up in that same year, your results for that year will be better.  They apply the same logic to mid-cap funds and small-cap funds.  

Unfortunately, all this approach does is lower your overall long term results.  And retirement investors should be concerned about long term results, not the results for one particular year.  International stocks and mid-cap stocks and small-cap stocks do not perform as well as large cap index funds like the S&P 500 in the long term.  Also, when the major US stock market indexes drop like they did in 2022, all stock markets fall.  And most of them fell more than the S&P 500 in 2022.

The Asset Allocators apply the same logic to bonds and commodities and other asset classes.  Bonds will earn about 4% per year on average in the long term.  The S&P 500 index funds will earn about 9% per year.  Since all of those other asset classes perform worse than the large cap stock market indices over longer periods of time, how can including them in your portfolio be a good thing for your results?   Ask your financial advisor this the next time they spread your money over all these different types of investments.  

The investment industry uses all kinds of fancy terms and charts to make asset allocation sound like a great thing, but the math doesn’t work.  They also will talk about risk tolerance and tell you that is why asset allocation is a good thing.  But asset allocation doesn’t always provide protection in bear market collapses.  Look no further than 2022 for an example of when bonds did not provide any risk benefits to portfolios.

You should definitely diversify your stock market investments across multiple stocks and the index funds do that for you, but don’t follow the industry advice of asset allocation.  Our Market Signals solution provides much better loss protection than Asset Allocation which provides only the illusion of protection.

Happy Investing,

Phil

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Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.

Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.