This morning I reviewed the highly-regarded The Four Pillars of Investing, in which author William Bernstein makes the case for diversification and investing in index funds. At the end of chapter three (“The Market is Smarter Than You Are”), he summarizes his arguments (which I’ve reformatted to be more readable in this context):

Obviously, a concentrated portfolio maximizes your chance of a superb result. Unfortunately, at the same time, it also maximizes your chance of a poor result. This issue gets to the heart of why we invest. You can have two possible goals:

  • One is to maximize your chances of getting rich.
  • The other is to minimize your odds of failing to meet your goals or, more bluntly, to make the likelihood of dying poor as low as possible.

It’s important for all investors to realize that these two goals are mutually exclusive. For example, let’s say that you have $1,000 and want to turn it into $1,000,000 within a year. The only legal way that you have a prayer of doing so is to go out and buy 1,000 lottery tickets. Of course, you will almost certainly lose most of your money.

On a more mundane level, let’s say that in order to retire in ten years, you need to obtain a 30% annualized return during that period. It is quite possible to do this: 113 of the 2,615 stocks with ten-year histories listed in the Morningstar database have had ten-year annualized returns in excess of 30%.

Of course, 496 of those 2,615 stocks had negative returns and that doesn’t count the bankrupted stocks missing from the database. In fact, only 885 of the stocks had returns higher than the S&P 500.

In other words, concentrating your portfolio in a few stocks maximizes your chances of getting rich. Unfortunately, it also maximizes your chances of becoming poor.

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Failing to diversify properly is the equivalent of taking that uncertain return and then going to Las Vegas with it. It’s bad enough that you have market risk. Only a fool takes on the additional risk of doing yet more damage by failing to diversify properly with his or her nest egg. Avoid the problem — buy a well-run index fund and own the whole market.

Some people complain that an index fund dooms you to mediocre investment returns. “Absolutely not,” Bernstein replies. “It virtually guarantees you superior performance. Over the typical ten-year period, most money managers would kill for index-matching returns.”

You might say that I’ve found the index fund religion, and that The Four Pillars of Investing has only strengthened my faith. I used to find the idea of picking individual stocks appealing — it was like a game in which I might beat the market. Unfortunately, that never happened. Palm, Celera Genomics, Countrywide Financial, The Sharper Image — I’ve lost thousands of dollars playing with individual stocks over the past decade. Sure, sometimes I’ve obtained positive returns (General Motors, Microsoft), but not enough to compensate for my losses.

I’ve reached a point in my life where I’m happy to embrace diversification and index funds.