More Often Than Not Diversification Is an Investor’s Friend
Paul Fain, CFP®
I recently read an opinion piece that was lambasting diversification as “diworsification” (a play on words borrowed from legendary Fidelity stock manager Peter Lynch).
Warren Buffett said “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” Really? Aside from Mr. Buffet and Mr. Lynch’s impressive track records, do the professional stock pickers know what they are doing? As of January 2023, the S&P Dow Jones Indices’ scorecard shows that 85% of actively managed U.S. large company stock funds underperformed the S&P 500 stock index over a period of 10 years (86% underperformed over five years and 92% underperformed over 15 years).
The Oracle of Omaha also said, “Diversification may preserve wealth, but concentration builds wealth.” To his point, $1,000 invested in Amazon’s IPO, in 1997, would be worth $1.3 million today. That’s a tidy sum for a long-term, buy-and-hold investor, so where does diversification fit in your investment strategy?
Today, people are drawn to polar opinions, right or wrong, good or bad, this or that. What happened to “and” in our decisions? Why can’t we invest for preservation and building wealth? Dare I say it? In real time, with real peoples’ money, with real short-term and long-term life goals, it’s called diversification.
Typically, investors identify as conservative, or moderate or aggressive. Subsequently, one investor might concentrate his holdings in CDs or bonds expecting lower risk and lower returns; while another investor might concentrate her holdings in stock funds expecting higher risk and higher long-term returns. So, on balance, between safety and growth, the most important decision is how you will diversify your portfolio between asset classes with differing risk/return profiles (money funds, bonds, stocks, real estate, commodities, etc.). Diversification does not guarantee against loss, or guarantee gains, but, implemented and maintained wisely, diversification should smooth out the investment roller coaster ride to achieve reasonable returns that meet your personal financial planning goals.
Can diversification be sloppy or inefficient? Of course; for example, I’ve seen a portfolio with 60 mutual funds that were assembled without rhyme or reason. Actually, the impulse to buy was steered by Money magazine’s “funds to buy now” lists. Some investors over-concentrate in hot sectors (examples: technology stocks in 1999 and real estate in 2006) and suffer acutely in painful bear markets. In some years, diversification fails to cushion market losses such as 2008 and 2022 when stocks and bonds temporarily tanked. My father used to say, “Good diversification means you always own something you love and something you hate.”
More often than not diversification is an investor’s friend. Here are six ways to make diversification work for you:
- Allocate across multiple asset classes.
- “Concentrate” according to your risk/return needs.
- Keep portfolio costs and taxes as low as possible.
- Pay attention to your upcoming liquidity needs and your sleep-at-night quotient.
- Review and rebalance your portfolio regularly or as conditions change.
- Be patient; investing is a marathon, not a sprint.
This article originally appeared in the Knoxville News Sentinel online on October 19, 2023.
