Diversification
Most people understand the basic concept behind diversification: do not put all of your eggs into one basket. However, even people who are sophisticated investors can fall into investment traps. For example, many people have suffered losses because they placed a large percentage of their investment capital in their employers’ stock only to lose much of it during the recent downturn. Even though the employees may have understood that they were taking too much of a risk in doing so, they did not do anything to change their situations. Instead, they justified holding the position they had established because of the large capital gains tax they would have to pay upon selling the stock, or they imagined that the stock was just on the verge of taking off. In such instances, investors are too close to a particular stock, and they develop a false sense of comfort and overconfidence. They may rationalize that everyone with whom they work has invested in the company, and how could so many people be wrong? Similarly, they rationalize the importance of their investment in the company’s stock because they are professionally invested in the company and feel a certain sense of loyalty. Over the past year alone, many of these investors have felt the pain of such imprudent investment practices.
In much the same way, other investors believe they have diversified their portfolios effectively because they own a number of different stocks. What they may not realize, however, is that they are in for an emotional rollercoaster ride if these investments all belong to the same industry group or asset class and therefore share similar risk factors. For instance, investors in the late 1990s and early years of this decade learned that diversification among a variety of high tech stock companies was really not diversification at all. When a number of prominent technology stocks, including Cisco, Dell, and IBM, experienced billion dollar sell-offs between Friday, March 10 and Monday, March 13, 2000, the resulting chain reaction hit the entire tech industry.
Included with this article are charts (click here to view the full version of the whitepaper with attached charts) that will help investors understand how diversification dramatically impacts a portfolio. (It is important to remember, however, that one cannot directly invest in the S&P 500. This chart uses it as an index for illustration purposes only). So, imagine someone whose hypothetical portfolio consisted of a 100% investment in the S&P 500 (Portfolio 1). Between 1998 and 2007, he would have achieved a 4.38% annualized compound return and for every $1.00 invested, he would have ended up with $1.47. However, if he had merely invested 40% in a 2-Year Global Fixed Income Fund with the remaining 60% still in the S&P 500 (Portfolio 2), his annualized compound return increases to 4.72% and each dollar is now worth $1.51. Portfolio 5 shows additional diversification including investments in U.S. small and large value companies as well as in real estate. The annualized compound return of Portfolio 5 jumps to 8.9% while the growth of $1 reaches $2.15. Adding international stocks to Portfolio 10 even better demonstrates the potential of diversification because it achieves more than double the annualized compound return of Portfolio 1 (10.08%), and our investor’s $1 has now reached a value of $2.37. Explained this way, the benefits of diversifying are obvious; however, many people fail to take advantage of the potential of diversification.
- James E Wilson, CFP®
Most people understand the basic concept behind diversification: do not put all of your eggs into one basket. However, even people who are sophisticated investors can fall into investment traps. For example, many people have suffered losses because they placed a large percentage of their investment capital in their employers’ stock only to lose much of it during the recent downturn. Even though the employees may have understood that they were taking too much of a risk in doing so, they did not do anything to change their situations. Instead, they justified holding the position they had established because of the large capital gains tax they would have to pay upon selling the stock, or they imagined that the stock was just on the verge of taking off. In such instances, investors are too close to a particular stock, and they develop a false sense of comfort and overconfidence. They may rationalize that everyone with whom they work has invested in the company, and how could so many people be wrong? Similarly, they rationalize the importance of their investment in the company’s stock because they are professionally invested in the company and feel a certain sense of loyalty. Over the past year alone, many of these investors have felt the pain of such imprudent investment practices.
In much the same way, other investors believe they have diversified their portfolios effectively because they own a number of different stocks. What they may not realize, however, is that they are in for an emotional rollercoaster ride if these investments all belong to the same industry group or asset class and therefore share similar risk factors. For instance, investors in the late 1990s and early years of this decade learned that diversification among a variety of high tech stock companies was really not diversification at all. When a number of prominent technology stocks, including Cisco, Dell, and IBM, experienced billion dollar sell-offs between Friday, March 10 and Monday, March 13, 2000, the resulting chain reaction hit the entire tech industry.
Included with this article are charts (click here to view the full version of the whitepaper with attached charts) that will help investors understand how diversification dramatically impacts a portfolio. (It is important to remember, however, that one cannot directly invest in the S&P 500. This chart uses it as an index for illustration purposes only). So, imagine someone whose hypothetical portfolio consisted of a 100% investment in the S&P 500 (Portfolio 1). Between 1998 and 2007, he would have achieved a 4.38% annualized compound return and for every $1.00 invested, he would have ended up with $1.47. However, if he had merely invested 40% in a 2-Year Global Fixed Income Fund with the remaining 60% still in the S&P 500 (Portfolio 2), his annualized compound return increases to 4.72% and each dollar is now worth $1.51. Portfolio 5 shows additional diversification including investments in U.S. small and large value companies as well as in real estate. The annualized compound return of Portfolio 5 jumps to 8.9% while the growth of $1 reaches $2.15. Adding international stocks to Portfolio 10 even better demonstrates the potential of diversification because it achieves more than double the annualized compound return of Portfolio 1 (10.08%), and our investor’s $1 has now reached a value of $2.37. Explained this way, the benefits of diversifying are obvious; however, many people fail to take advantage of the potential of diversification.
- James E Wilson, CFP®
This is the fifth chapter to a seven part series on the Barriers to Financial Security. To download a full copy of the whitepaper, click here
