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This is part eleven in a series that will occupy the “money hacks” slot at Get Rich Slowly during April, which is National Financial Literacy Month.
The next video in Michael Fischer’s series on Saving and Investing is about mutual funds. However, I think it would useful to have an introduction to diversification first, so I’ve bumped that video ahead in the lineup. Here’s Michael’s explanation of this important concept:
Diversification (4:35)
In his book, Saving and Investing, Michael spends a chapter explaining diversification. He writes:
Diversification means not putting all of our eggs into one basket. Research has shown that when we invest in multiple things that do not move perfectly together, that the risk/reward relationship can be improved. This is relevant when we buy more than one stock, multiple bonds, a mixture of stocks and bonds or a mixture of stocks, bonds, and commodities. The less assets move together, the better the diversification effect.
[...]
For the S&P 500 between 1939 and 2005, the average return including dividends was about 12.5%, [but] the annual returns move[d] around quite a bit. Risk-free government bonds have historically offered a low return, but the return has been less volatile. Neither investment has necessarily been ‘better’ — one has had a higher risk and higher return, the other one a lower risk and lower return — there is a trade-off.
When different assets are mixed together, the diversification provides an “evening” effect. Returns normalize, and so does risk. (Risk is, essentially, a measure of standard deviation, or fluctuation.)
The Bogleheads’ Guide to Investing also includes a chapter on diversification. The authors recommend diversifying stock market investments through the use of mutual funds, particularly index funds. (As we’ll see tomorrow, mutual funds are groups of stocks. By purchasing a group of stocks in this manner, we’re able to diversify.) But they recommend further diversifying by using mutual funds to invest in bonds and in foreign stock markets.
The U.S. Government Securities and Exchange Commission has a beginners’ guide to asset allocation, diversification, and rebalancing. This is an excellent article.
Michael Fischer spent nine years at Goldman Sachs, advising some of the largest private banks, mutual fund companies and hedge funds in the world on investment choices. Look for more episodes of Saving and Investing at Get Rich Slowly every weekday during the month of April. For more information, visit Michael’s site, Saving and Investing, or purchase his book.
This article is about Money Hacks Monday, 16th April 2007 (by J.D. Roth)
April 16th, 2007 at 8:02 pm
Saving and Investing is an all important topic and has been for the past ten years or more. The former concept has drifted too low for the average American worker. In my opinion, it is a good idea to combine investing into a capital accumulation program, particularly for younger investors. On diversification, I have seen a little too generalizations in my experience on the Street. Just from sitting in on various forums you get a sense that the average investor needs guidance on how to customize their allocations and not over fragmentize their holdings. Risk has a lot to do with knowing what works and what doesn’t. I think Michael’s statements are good. However, I am convinced that diversification, as an investment panacea, has put people to sleep. In my view, education and systematic monitoring of positions (single issues and/or funds) are the most effective way to manage risk and beat the broad markets.
April 16th, 2007 at 8:14 pm
All that trouble to talk about diversification and it misses so much. The risk/return graphs like the one he showed briefly in the clip were a staple of Bernstein’s Intelligent Assent Allocator.
Bernstein makes a huge point though that isn’t in the clip. Most of the benefit, i.e. most of the reduction in standard deviation, comes from periodic but not too frequent rebalancing. He recommended a rebalancing period of approximately 1-2 years.
If you don’t rebalance, you aren’t reducing your risk as much as you think by diversifying. It’s counterintuitive. If an investment has underperformed for the last 2-year period, it feels wrong to add yet more money to it to bring a portfolio to balance.
But it is rebalancing that actually reduces the volatility of a portfolio the most. The reduction in standard deviation just doesn’t come without it.
Jim Cramer argues for rebalancing from a non-mathematical direction. Rebalancing forces us to sell high and buy low. We lighten up on the big performers to go back to the underperformers (who can expect to have their turn in the limelight eventually and we want to be there to catch it).
February 12th, 2008 at 3:15 pm
[...] form of diversification Every investment book I’ve read says that a smart investor diversifies his portfolio, putting some of his money into each of several different types of investments. I [...]