Key Investment Insights: The Benefits of Diversification
August 17, 2014
Print This Post or Email with:
Welcome to the next installment in our series of Key Investment Insights.
In our last post, “The Myth of the Financial Guru,” we concluded with our explanation of the formidable odds you would face if you tried 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, arguably your “best” friend. After all, there is no other single action that you can take which would alleviate your exposure to a number of investment risks, while simultaneously potentially improving your overall expected returns. Is your new BFF too good to be true? Hardly; while they may seem almost magical, the benefits of diversification have been well-documented and widely explained by some 60 years of academic inquiry. The “powers” of diversification are both evidence-based and robust.
Global Diversification: Quantity AND Quality
What is diversification? In a very general sense, it’s about spreading your risks around. In investing, however, diversification is more than just ensuring that you have many holdings; it’s ensuring that you have many different kinds of holdings. If we relate this definition to the old adage about not putting all your eggs in one basket, an apt comparison would be to ensure that your multiple baskets contain not just eggs but also a bounty of fruits, vegetables, grains, meats and cheese!
This may make sense intuitively, but the fact is that many investors believe that they are well-diversified when, in reality, they are not. Yes, they may own a large number of stocks or stock funds across numerous accounts, but upon closer inspection we often find that the bulk of an investor’s holdings are concentrated in large-company U.S. stocks.
In future installments of our series, we’ll explore what we mean by different kinds of investments. For now, though, think of a concentrated portfolio as the non-diversified equivalent of many baskets filled with only plain, white eggs. If your diet consisted only of plain, white eggs, that would not only be unappetizing but perhaps dangerous to your well-being. It’s the same thing with investing; over-exposure to a single “ingredient” can be detrimental to your financial health. The lack of diversification within your portfolio can:
- Increase your vulnerability to specific yet otherwise avoidable risks;
- Create a bumpier, less reliable overall investment experience; and
- Have you second-guessing your investment decisions.
Individually or collectively, these three “strikes” can generate unnecessary costs, lowered expected returns and, perhaps most important of all, increased anxiety. Ultimately, you’re back to trying to beat, instead of play along with, a powerful market.
A World of Opportunities
Instead, consider that there is now a wide world of investment opportunities available from tightly-managed mutual funds, designed specifically to facilitate meaningful diversification. These investment opportunities offer efficient, low-cost exposure to the globe’s capital markets.
To best capture the full range of benefits that global diversification has to offer, we recommend turning to the sorts of fund managers who focus their energies – and your investment dollars – on efficiently capturing diversified dimensions of global returns.
In our last piece, we described why brokers or fund managers who are fixated on trying to beat the market are likely wasting their time (and your money) on fruitless activities. While you may be able to achieve diversification, your experience with these “gurus” would be hampered by unnecessary efforts and extraneous costs which could, ultimately, act only as a distraction to your resolve as a long-term investor. And really, who needs the hassle when diversification alone offers so many benefits?
In our next post, we’ll explain in more detail why diversification is sometimes referred to as one of the only “free lunches” in investing.