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Why bother diversifying?

Kyle over at Amateur Asset Allocator recently had a few words to say about this yahoo finance article [Update: The article has since been taken down.] claiming that diversification is no longer an effective strategy.

Kyle did a great job explaining why diversification is still a wise strategy, and I had initially planned to leave it at that. But after reading the original article, I decided that I wanted to get in on the fun too. (What could be better than taking easy potshots at a poorly constructed article, while simultaneously highlighting a few worthwhile lessons?)

If you’re going to diversify, do it properly.

The author of the article, Simon Maierhofer, argues that diversification failed us in the recent crisis because even a diversified portfolio put up a 48% loss from the 2007 high to the March 2009 low. Take a look at the “diversified portfolio” in question, and see if you can spot any issues:

  • 16.7% in U.S. equities
  • 16.7% in equities in developed non-U.S. markets
  • 16.7% in equities in emerging markets
  • 16.7% in commodities
  • 16.7% in REITs
  • 16.7% in bonds

While that’s certainly diversified, I don’t think many people would make the case that it’s in any way conservative. Having as much money invested in emerging markets as you have invested in fixed income seems rather aggressive to me. So it’s not really a surprise to see that such a portfolio could decline significantly during a sharp market downturn.

Lesson: If you’re attempting to construct a low-risk portfolio, you need not only to diversify, but to pay attention to how much you’re putting in each asset class.

Diversification during Crises

One of the major points that the article makes is that diversification did not save investors in the current crisis, and that–because asset classes are becoming increasingly correlated–diversification offers little in the way of protection going forward.

The problem with this argument is twofold:

  1. This phenomenon is nothing new–it’s fairly common during crisis-type scenarios for correlation among certain asset classes to spike upward.
  2. Diversification will still protect us from any number of other situations in which only one asset class performs poorly.

Why bother diversifying?

The article also included this valuable nugget:

“Rather than investing in a dozen asset classes…investors may want to consider investing in only one or two areas that offer the biggest and most likely profit potential.”

Brilliant! Rather than diversify, invest only in those asset classes that are going to put up the biggest gains! 😉

I can’t get over how frequently this idea is used as an argument against diversification. The entire point of diversification is accepting the fact that we don’t know which asset classes are going to perform the best over the period in question.

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Comments

  1. I certainly wouldn’t put the same amount of money in emerging markets as I would US equities that’s for damn sure. I’d also do maybe 5% reits, no commodities, and less bonds (hey I’m young).

    That portfolio was diversified the same way GM was.

  2. It’s funny, how does one expect to effectively argue against diversification but still expect to buffer loss? How will that loss be buffered if there is no diversification? Also, as you said, how to know which asset class will perform.

    Maybe the author had writers block that day but still had to meet a writing quota? I can think of no other explanation.

  3. Miranda says:

    If that’s the diversification used, no wonder it failed! What about risk diversification? That portfolio is almost entirely all high risk!

  4. Dave C. says:

    “Wide diversification is only required when investors do not understand what they are doing.”
    — Warren Buffet

    But since it is safe to assume that compared to Warren Buffet most of us practically know nothing, diversification is still probably wise.

  5. Once again, you’ve made some excellent points. I am confused about one thing…..

    I’ve understood that you strongly believe in equities for most folks with a long investment time horizon. Are you saying here that you believe in diversification (which might include debt)?

  6. Weakonomist: “That portfolio was diversified the same way GM was.” lol! Also, agreed: As much in emerging markets as in U.S. equities seems a bit extreme to me.

    Matt Jabs: Good to see you here. Thanks for stopping by to comment. Also, I think you may be on to something regarding the motivation behind the article. 😉

    Miranda: Yep!

    Dave C: I like this video in which (70 seconds into it) Buffett explains precisely who he thinks should be in index funds and who should be picking stocks.

    Wealth Pilgrim: If we’re going to be evaluating a portfolio for its performance over a period of less than 2 years (like the referenced article is doing), then I’d definitely be in favor of a conservative allocation.

    Or, to put it differently, I don’t necessarily think that the allocation above is a bad one. I just see it as quite aggressive. Therefore, to say that it–and, purportedly, the entire concept of diversification–“failed us” because it went down significantly during a down market seems absurd.

  7. Rick Francis says:

    >consider investing in only one or two areas that offer the biggest and
    >most likely profit potential

    Maybe he is planning on selling a newsletter that tells what those most profitable areas are going to be with the help of his crystal ball?

    -Rick Francis

  8. Dave C. says:

    Awesome, thanks for the video link! I’m going to save the whole series to my YouTube playlist.

  9. My view is that diversification is generally a good thing, but not always.

    I am a big believer in taking valuations into consideration when setting your stock allocation. If you do that, I think it makes sense to diversify because that way you are sure to get something close to the market return (if you are adjusting your allocation for valuations, getting the market return works).

    However, if you feel strongly that you need to be heavily invested in stocks at all price levels, then I don’t see diversification as a good thing at times of high prices. From times of high prices, your long-term return is likely to bee poor if you obtain the general market return. However, if you know of a sector or stock likely to do better than the general market, you might be able to do well with a high stock allocation even at a time of high prices. In that case, avoiding diversification helps you out.

    Rob

  10. Niklas Smith says:

    @Rob: taking valuations into account makes sense, but do you have any suggestion on how investors could do this? There needs to be a rule of thumb otherwise people will leave it to instinct and suffer the same problems as stockpickers.

  11. Rob: taking valuations into account makes sense, but do you have any suggestion on how investors could do this?

    I have a calculator at my site that you might want to check out, Niklas. It’s call “The Stock-Return Predictor.” It performs a regression analysis on the historical stock-return data to tell you the most likely 10-year return from the purchase of a broad U.S. stock index. At high valuations, the 10-year return is very low (sometimes even negative). At low valuations, it is extremely good. At moderate valuations, it is plenty good enough. Knowing that information, you can obtain far higher returns than would be available from a Passive strategy by making one allocation change every 10 years or so. I call this approach “Valuation-Informed Indexing.”

    Here’s the URL for the Return Predictor:

    http://www.passionsaving.com/stock-valuation.html

    Rob

  12. Mike, I didn’t even think to point out just how aggressive the example portfolio is, but you’re right. It would be insane to assume a portfolio with only 16.67% of its assets in bonds wouldn’t be volatile. Raise that bond allocation to 40% and he might have had a point.

  13. pkora94 says:

    Diversification is a waste of time. Buy assets that look reasonably priced and are likely to appreciate in value over the long term. Every thing else is a complete waste of my time.

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