Diversification Is the Sane Alternative to Betting Big on One Investment
Carl Richards, Director of Investor Education
You made a huge mistake last year with your money. You know this now, right? The only investments in your portfolio that did very well were probably United States stocks. Bonds may have held their own, but everything else was just pitiful. International stocks performed horribly and emerging markets weren’t much better.
What were you thinking? Clearly you missed a big opportunity in 2014. You should have skipped diversifying and gone all in on United States stocks.
This is the problem with the diversification strategy you stubbornly insist upon. Every year you’re going to be unhappy with something in your portfolio. Most years, if you own five distinct asset classes, one or two might do well, one will sit in the middle, and two will perform badly. And you can’t tolerate that, no way. After all, why would anyone settle for anything less than top performance?
Luckily, the solution is an easy one. On Jan. 1 of each year, just figure out which asset class will do really well and move all your money into that investment. Forget diversification. Just pick the winner!
Lest you think all of the sarcasm up until this point does not reflect the worldview of many investors, I had a client in my past life whom we will call Dave. He had a lot of money. I remember having a conversation in which he was really mad over this very issue. He said to me, “This is simple. All I want you do is tell me what to buy before it goes up and what to sell just before it goes down. That’s it.” I remember replying, “Really? Why didn’t I think of that?”
But seriously, with no proven model for picking the next winner, can you really afford to bet big on any one investment? If you had to, could you even pick one, and only one, investment for the rest of this year? The answer can’t be no! Don’t you know by now who the winner will be in 2015? How can you not know?
So in all seriousness, perhaps the better choice really is to stay diversified. Yes, a diversified portfolio all but guarantees you’ll be unhappy with at least one investment each year. But the investments that make you unhappy change from one year to the next. One set of investments zigs while another set zags. Take this unhappiness as a sign you’re doing diversification right. That’s the way markets work, after all.
Plus, on a scale of 1-10, with 10 being abject misery, I’m willing to bet your unhappiness with a diversified portfolio comes in at about a 5, maybe a 6. But your unhappiness if you guess wrong on your one and only investment for the year? That goes to 11.
Beyond diversifying, there’s rebalancing, which is something else that will probably make you unhappy. You’re selling at least some of an investment that’s done well and buying more of one that hasn’t. This unnerves people. They don’t see it as buying something on sale but as trading a winner for a loser.
In years like 2014 with an obvious winner, diversification becomes everyone’s favorite whipping boy. One type of investment does so much better than the others, it seems insane to diversify, let alone rebalance.
But that’s the problem with judging a tool like diversification from one year to the next. You need to judge diversification’s value over the long term, and by long, I’m referring to decades. You’re not diversifying because of how stocks or bonds did last year. You keep diversifying because you don’t know how they’ll do over the next 10 years.
Sure, your brother or sister-in-law or some talking head on television may have tried picking the investment winner of 2014 and gotten it right. In that year. But if you try and get it wrong, make sure you have a calculator handy. You’ll need it to figure out how much longer you’ll have to keep working to make up for the loss.
This commentary originally appeared March 16 on NYTimes.com
All About Carl
Carl Richards is the director of investor education for the BAM ALLIANCE. He advises on best practices, marketing efforts and social media.
Carl is the author of The Behavior Gap and a regular contributor to The New York Times. Known for his simple sketches that capture complex investor behavior, Carl’s work has been featured in The Wall Street Journal, Financial Planning and at lifehacker.com. His work originally appeared on BehaviorGap.com.
Carl holds a bachelor’s degree in finance from the University of Utah.
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