Diversification matters. It’s the key to long-term investment success because, to some extent, it can insulate you from losses. If you feel insulated, you are more likely to stay invested and keep investing through market volatility. Being properly diversified also enables rebalancing and tax-loss harvesting, both of which can help you during market corrections. Unfortunately, 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 that 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.
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 the three dimensions of diversification you need to improve your chances of long-term investing success.
The three ways to diversify are:
- Across assets
- Across asset classes
- Across time
Here, we’ll take a closer look at what these three kinds of diversification are and why they’re important.
1. Diversification 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, Burton 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 systemic risk). Diversifiable risk, by definition, is risk that can be mitigated by spreading your portfolio across a broad set of investments. 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 U.S.equity exposure, we recommend you invest in broadly diversified, low-cost ETFs like VTI, which gives you exposure to over 3,000 U.S. stocks (including Apple, Google, and Facebook) for the measly cost of 0.03% annually (which means you pay $3 annually for every $10,000 you invest).
2. Diversification across asset classes
Another important way to diversify is across asset classes, or capital markets. You can improve your risk-adjusted returns by investing in less correlated assets, because it is virtually impossible to predict 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 about trying to time the market: “After nearly 50 years in this business, I do not know of anyone who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”
To illustrate this point, we put together the table below. It displays the ranking of asset class returns by year for the past 10 years. The key takeaway is that no asset class consistently wins or loses. In fact, there’s a different winner nearly every year.
You might be surprised to learn that U.S. stocks have only been the top-performing asset class in 2 out of the last 10 years (2013 and 2019). And in 2011, they were one of the worst-performing asset classes.
A portfolio diversified across asset classes will also tend to give you higher returns, and 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.
3. Diversification across time
The final dimension of diversification is time. It’s better to invest as early in your career as you can to give your returns more time to compound. There is nothing so magical in investing as generating returns on top of prior returns and repeating this over and over again. Albert Einstein reportedly 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 (like buying a home or paying off student loans) before investing a large sum anyway. Moreover, investing all at once can make you 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 at all. As a result, they miss out on valuable time in the market when their savings could have been compounding.
Dollar-cost averaging is the most popular way to diversify across time and avoid this issue. Rather than picking the “right day” to invest, dollar-cost averaging is a process where investors break up a lump sum into several smaller amounts, and then invest a portion consistently on a set schedule. For example, an investor with a $20,000 bonus might invest $4,000 per month for five months.
You can also diversify across time by using Wealthfront’s free service Autopilot, which will continuously monitor a checking account or your Cash Account for excess cash to invest. Whenever Autopilot spots at least $100 of excess cash in the monitored account, it will schedule a transfer to your Investment Account. This means you don’t have to think about when to invest.
Don’t just invest in the S&P 500
It may be tempting to just invest in the S&P 500, especially in a year when U.S. stocks are significantly up. But if you do this, you’ll be missing out on an opportunity to diversify your portfolio and your long-term returns may suffer as a result. If you diversify across all three dimensions recommended in this post, you can increase your risk-adjusted returns over the long run. And, in a volatile market, you will sleep better at night knowing you’ve protected your portfolio across all three dimensions.
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