“Diversification” may be the most overused yet misunderstood word in the investment dictionary. Virtually everyone agrees diversification is good, but many don’t understand why this is so.
Many investors implement very sound diversification plans, only to abandon them. Today we’ll consider why you might want to diversify, and how much it can cost you.
The basic concept is simple: “Don’t put all your eggs in one basket.” If you are fortunate enough to have sizable assets, you want to make sure unexpected events don’t hit everything at once.
On the other hand, you don’t want to distribute your assets randomly in every possible hiding place. Each “egg” deserves a home where it can grow on its own, apart from the other eggs. Reviewing and redistributing the eggs periodically is also a good idea.
This may sound simple in theory, but in practice, it often is not. Your periodic reviews will likely show some nests seem more fertile than others do. What happens then? You will be tempted to relocate the “idle” eggs to faster-growing nests.
All too often, this temptation pops up right about the time predators notice your high-growth nest. Moving other eggs there makes it an even bigger target. The predators strike – and your no-longer-diversified egg stash gets demolished.
This is why diversification is so hard in practice. To make it work, you have to accept that parts of your portfolio will always lag behind others.
This isn’t a flaw; it is exactly what you want to see. If everything in your portfolio goes up at the same time, it can all go down at the same time, too. Avoiding that possibility is the whole point of diversification. If your portfolio is firing on all cylinders, you are probably less diversified than you think.
Here is a common scenario. An investor receives 2014 annual report reviewing performance. He notices his S&P 500 index fund (SPY) had a great year, up 13.5%. Meanwhile his international ETF tracking the MSCI Europe, Australasia and Far East Index (EFA) lost 5.0% in the same year.
“This makes no sense,” the investor thinks. “Why should I hold all this dead weight? I’m moving that international allocation over to the SPY ETF, since i’s working so much better.”
It’s possible this could be a good move, but it will more likely prove harmful. In the first two months of 2015, EFA gained 6.5% while SPY gained only 2.6%. The money this investor moved would have made an extra 3.9% if he had simply left it alone. That’s a significant “opportunity cost.”
The investor’s more prudent move would have been to ask why he owned those two asset classes in the first place.
- If they were part of a well-designed diversification strategy, the best choice would have been to stick with it.
- If circumstances had changed so that one side or the other no longer matched the investor’s objectives, adjusting it might be correct – as long as he thinks carefully about where to go.
As you can see, diversification is both simpler and more complex than it seems on the surface. It’s simple because once you design your strategy, your main task is to maintain it. However, diversification is also complex because there are still times when you need to reallocate out of some assets and into others.
Deciding when to make these adjustments is a specialized skill. Most people who are successful in other professions don’t have this skill, nor do they have the time to acquire it. Their best move is to focus their energy on what they do best and “outsource” the investment strategy to a professional.
Our Republic Wealth process involves active diversification. We develop target allocations in asset classes that our analysis show have acceptable near-term growth potential and risks. Then we watch them closely, making adjustments as we find appropriate.
We believe this form of diversification gives investors the best chance of achieving their long-term financial goals.
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