The Diversification Misconception: Why All Your Eggs May Still Be in One Basket
The adage is almost older than investing itself: Don’t put all your eggs in one basket. In other words, diversify your portfolio so that—if a particular investment tanks—you haven’t lost all your money.
So you set off to work, scattering your wealth in various locations over time. $10,000 in a Vangard mutual fund, $25,000 in U.S. Bank, 15,000 in randomly selected stocks. Here a little; there a little.
Sounds simple, right? The only problem is that this isn’t diversification. Sure, it is better than betting your entire life savings on a Kraft Mac and Cheese stock. And it may protect you against any one company going under. But—in almost every other respect—this investment strategy doesn’t leave you any better off than a one-basketeer. Why?
Because asset classes are the ticket!
Diversification is not about the variety of companies, but rather the variety of asset classes you invest in. Maybe you’ve heard some of them thrown around at dinner parties as wealthy investors brag about their business ventures: fixed income, large cap growth, international, global, etc.
But what is an asset class? In short, it is just a categorization of investments, but this definition doesn’t tell the whole story. An asset class, rather, is a category of investments with comparable characteristics that tend to behave similarly in the marketplace. If one goes up in value, it is likely that the others have gone up as well (at least to some degree). And when one plummets, check the others; they probably aren’t doing so hot either.
This means that if you have all of your money invested in one asset class, your portfolio is not diversified. If that one asset class does poorly (since all investments within the category behave similarly), your entire portfolio will suffer.
But you can’t stop there!
Haphazardly choosing various asset classes will put you far above those who are randomly selecting investments, but you must go further to truly diversify your portfolio.
It’s not just about a variety of asset classes; it is about the right variety of asset classes. Some asset classes behave very similarly to other asset classes. These pairs are considered positively correlated. The general rule is this: you don’t want pairs of investments that are positively correlated. In fact, negatively correlated asset classes are the best. Following this rule puts you in a strong position as an investor. Your investments won’t all go up and down at the same time.
Allow me to give you an example to illustrate this concept.
Imagine a friend of yours just caught a big break at work. His salary just doubled. Since he doesn’t know what to do with this expendable income, he decides to invest. The first thing he purchases is 100 shares of umbrella stock (the umbrella industry is rockin’). Then—to diversify his portfolio—he also buys 75 shares of stock in a poncho company. He’s in the clear, he thinks, but just to be sure, he goes online and buys 90 shares of stock in a company that sells rain boots.
How do you think he’s doing?
Yeah. It’s a disaster. In fact, his miniature portfolio is so imbalanced and hopelessly one-basket-ed that you internally cringe by his second purchase. You don’t need to know much about investing to know that his stocks are positively correlated. They will behave the same way! When it’s dry weather, they will all crash and burn. When it’s wet, they will likely do well.
What your friend should have done is invest in a sunscreen company to offset his investments in the umbrella company. In a basic sense, this is diversification.
Now, this is definitely an oversimplified example. Anyone can see it from a mile away. But people are doing this in the real world, with real money. Not because they are dumb, but because—in reality—correlations aren’t nearly as obvious.
In my practice, I’ve seen it all too many times. People come in for a financial consultation, thinking they have a diversified portfolio, and I find that 70% of their investments are in a single asset class. And this isn’t even taking into account the correlations!
Needless to say, it’s a scary situation. No one knows how well a particular investment is going to do from year to year. And no one knows how a particular asset class will do either. The only thing we can do is develop a well-balanced, well-rounded, well-diversified portfolio to smooth out the ups and downs, and then watch the money grow over time. It’s the time-tested, statistically- verified choice.
But as long as investors believe the misconceptions, thinking that their portfolio is diversified, they will never change the reality that their eggs are still—in fact—all in one basket.
Concerned that your portfolio isn’t diversified? Call Seniormark at 937-492-8800 for a free consultation with a Certified Financial Planner!