Diversification is the key to long-term investment success because it can insulate you, to some extent, from losses. If you feel insulated, you are more likely to stay invested and keep investing through market volatility. Being properly diversified also enables the actions that help you during market corrections: rebalancing and tax-loss harvesting.
Investors often think they have a diversified portfolio when, actually, they don’t.
One of the common questions we get from investors who don’t use Wealthfront is: “Why shouldn’t I just invest in the S&P 500®?” They seem to believe investing in an index that gives them exposure to a broad selection of securities means they have a diversified portfolio.
Having a broad selection of securities is a good start. But it’s only one of the three dimensions of diversification.
The Three Dimensions of Diversification
In The Elements of Investing, Burton Malkiel (our Chief Investment Officer) and Charley Ellis, noted investor, author and member of our investment advisory board, outline three dimensions of diversification to improve your chances of long-term investing success.
These three ways to diversify are:
- Across Assets
- Across Capital Markets
- Across Time
Diversify Across Assets
Diversifying across assets means investing in the stocks or bonds of many companies and issuers, not just a few. Doubling down on your company stock is a glaring example of not diversifying across assets. Even if you work for Apple, Google or Facebook, owning too much of your own company stock has the potential to create serious financial problems.
In their book, Burt and Charley describe an Enron employee who invested her entire retirement savings in Enron stock through the company’s 401(k) plan, only to see her savings decimated when Enron unraveled.
This is an extreme example. The general point is that individual stock ownership represents diversifiable risk (in contrast to market or systematic risk). Diversifiable risk, by definition, is risk that can be mitigated by spreading your portfolio across a broad set of investments. In general, diversifiable risk is not expected to be rewarded by market valuation. To be diversified across assets, don’t invest a lot of your portfolio in any single stock, and don’t allow your company stock to dominate your portfolio after it has become vested and liquid.
Instead invest your money in broadly diversified index funds. For your US equity exposure, we recommend you invest in broadly diversified, low-cost ETFs like VTI, which gives you exposure to over 3,000 US stocks (including Apple, Google and Facebook!) for the measly cost of 0.05% annually (e.g. $5 annually for every $10,000 you invest).
A portfolio diversified across assets will also tend to give you higher returns. The S&P 500 does not include over 2,500 smaller companies that are included in VTI that also trade publicly in the United States. In years where those stocks outperform their larger cousins, the S&P 500 underperforms the broader US market.
Diversify Across Markets
Another important way to diversify is across the capital markets — by capital markets I mean different types of stocks and bonds, or asset classes. You can improve your risk-adjusted returns by investing in less correlated assets, because it is virtually impossible to predict in advance which asset class is going to outperform the others in any given year.
Anyone who tells you they can predict the performance of different asset classes with any reasonable consistency is either fooling herself or trying to fool you. Jack Bogle, the founder of the Vanguard Group, has a great saying — “I’ve never known anyone who could consistently time the market, nor anyone who knew anyone who could.”
To illustrate the point, scroll down and examine the interactive table below, it displays the ranking of asset class returns by year for the past 10 years. The key takeaway is each year’s winner is different.
It might surprise you to see at least two things immediately:
• Three asset classes have outperformed US Stocks in 2014: Real Estate, Dividend Stocks and Emerging Market Bonds.
• US Stocks have been the top performing asset class only once in the past 10 years (in 2013).
A portfolio diversified across asset classes will also tend to give you higher returns. It’s easy to see why. If you invested only in an S&P 500 index fund, you would miss out on the winning years of the other asset classes.
Diversify Across Time
There is one more dimension of diversification: time.
It’s better to invest as early in your career as you can to give yourself more time to compound your returns. There is nothing so magical in investing as generating returns on top of prior returns and repeating this over and over again. Albert Einstein supposedly said, “Compound interest is the eighth wonder of the world.”
In an ideal world, you would invest a large sum as early as possible. Unfortunately, this isn’t consistent with how most people earn (i.e. salary, vested company stock, bonuses) and you may need to work through some decisions before investing a large sum anyway (e.g. buying a home or paying off student loans). Moreover, investing all at once can make you more sensitive to the timing of your investments if the markets correct soon thereafter.
Unfortunately, too many investors suffer from decision paralysis: they are so afraid of picking the wrong day to invest, they end up not investing their savings in the markets, missing out on valuable time in the market to compound their savings.
Dollar-cost averaging is the most popular way to diversify across time and avoid this issue. Rather than pick the “right day” to invest, dollar cost averaging is a process where investors break up a lump sum into several amounts, and then invest a portion consistently over time. For example, an investor with a $20,000 bonus might invest $4,000 per month for 5 months.
All data in the table above for 2014 is through Dec 31, 2014.
Your Portfolio Is Bigger Than A Single Index in a Single Country
If you diversify across the three dimensions recommended in this post, you can increase your risk-adjusted returns over the long term. And in a volatile market, you will sleep better at night knowing that you have protected your portfolio across all three dimensions.
This post is an update of an original post by Jeff Rosenberger that appeared on this blog in July 2013.
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