In our last piece, “Investment 101: Part 3 – Financial Gurus and Other Unicorns,” we concluded our exploration of the formidable odds you face if you try to outsmart the market’s lightning-fast price-setting efficiencies. Today, we turn our attention to the many ways you can harness these and other efficiencies to work for, rather than against you. Among your most important financial friends is diversification. After all, what other single action can you take to simultaneously dampen your exposure to a number of investment risks while potentially improving your overall expected returns? While they may seem almost magical, the benefits of diversification have been well-documented and widely explained by some 60 years of academic inquiry. Its powers are both evidence-based and robust.
What is diversification? In a general sense, it’s about spreading your risks. In investing, that means that it’s more than just ensuring you have many holdings, it’s also about having many different kinds of holdings. If we compare this to the adage about not putting all your eggs in one basket, an apt comparison would be to ensure that your multiple baskets contain not only eggs but also a bounty of fruits, vegetables, grains, meats and cheese. While this may make intuitive sense, many investors come to us believing they are well-diversified when they are not. They may own a large number of stocks or stock funds across numerous accounts. But upon closer analysis, we find that the bulk of their holdings are concentrated in large-company U.S. stocks. In future installments of our Investment 101 series, we’ll explore what we mean by different kinds of investments. But for now, think of a concentrated portfolio as the undiversified equivalent of many baskets-full of plain, white eggs. Over-exposure to what should be only one ingredient among many in your financial diet is not only unappetizing, it can be detrimental to your financial health. Lack of diversification:
Combined, these three strikes tend to generate unnecessary costs, lower expected returns and, perhaps most important of all, increased anxiety. You’re back to trying to beat instead of play along with a powerful market.
Instead, consider that there is a wide world of investment opportunities available these days from tightly managed mutual funds intentionally designed to facilitate meaningful diversification. They offer efficient, low-cost exposure to capital markets found all around the globe.
To best capture the full benefits that global diversification has to offer, we advise turning to the sorts of fund managers who focus their energies – and yours – on efficiently capturing diversified dimensions of global returns. In our last piece, we described why advisers who are instead fixated on trying to beat the market are likely wasting their time and your money on fruitless activities. You may still be able to achieve diversification, but your experience will be hampered by unnecessary efforts, extraneous costs and irritating distractions to your resolve as a long-term investor. Who needs that, when diversification alone can help you have your cake and eat it too?