Diversification Is the Most Commonly Violated Investment Principle

Diversification Is the Most Commonly Violated Investment Principle

| May 19, 2020
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The following is adapted from Income for Life.

When we met Ray, he already knew that he had made a huge mistake. He was scared, and he had no idea how he was going to maintain his lifestyle, let alone have a successful retirement. 

Ray’s brokerage statement showed that, at its height, his portfolio had been worth around $3 million. When we met him, it had plummeted to a little over $650,000. 

What was Ray’s mistake? Under-diversification. 

Ray thought all along he’d been investing wisely, putting his money into well-known tech funds that capitalized on the enormous market opportunity of the 1990s. However, what he failed to realize, and what so many like him fail to realize, is that diversification is a huge component of successfully weathering extreme market events. The tech funds he’d invested in were all, essentially, holding the same stocks. When the Tech Wreck of 2000 hit, his portfolio went down the drain.

At a high level, diversification is the most easily understood of all of the basic investment principles. However, there’s a caveat to that statement: diversification is also the most often violated of those principles. Don’t fall prey to Ray’s mistake. Read on to find out why you should—and how you can—successfully diversify your portfolio. 

Diversification: The Investor’s Equivalent to Baking Cookies

The best illustration we use for the principles of diversification is a food metaphor. Think back to when you were a kid, to your favorite holiday. More than likely, your mother or father prepared some kind of special dessert to mark the occasion. For the sake of this example, let’s say it was pignoli cookies.

Think of how much you loved those cookies, and how unique they were to the entire experience of your favorite holiday. The smell, the taste, and the texture were exactly as you expected—and that’s why you remember them so well and so fondly.

Why, though, were those cookies so perfectly consistent year after year? It was because they were made with the same ingredients and a precisely followed recipe. 

The same is true of a properly diversified investment portfolio. There are generally eleven main building blocks or asset classes that represent the ingredients of your portfolio. There are US Large Cap Stock, Small Cap Stock, and Mid Cap Stock, International, Emerging Markets, Real Estate, and more. 

You put those ingredients together using a thoughtful framework. The framework may call for different amounts of each ingredient—depending upon many factors, including but not limited to: personal circumstances, general economic conditions, interest rates, and domestic and international events. Having too much of one ingredient, too little of another, or leaving one out altogether, can ultimately compromise your recipe.

When an investor’s portfolio is properly diversified, we can pretty much count on two things: the investor will never make a killing, but crucially, such a portfolio is never going to get killed. When it comes to your retirement income, diversifying your portfolio properly is the key to smoothing out your ride.

Don’t Jump on the Bandwagon

Investors hurt themselves chasing after investments they feel—or have heard—are doing particularly well in a given year. It is not uncommon, as we mentioned earlier, for people to be insufficiently diversified. Without a plan and a process for when they buy and sell, they can disrupt the framework of a diversified portfolio. 

Often this disruption occurs when investors chase last year’s winners with the expectation that the winning streak will continue. What is fact, however, is that there is little consistency from year to year in what investments will be the market leaders or losers, and even less predictability. 

To illustrate this, let’s take a look back to the year 1999. In that year, Emerging Markets (one of your portfolio’s eleven asset classes) returned an incredible 66.4 percent! Now let’s take a look at that same investment the following year. In the year 2000, Emerging Markets returned a negative 30.6 percent! On the flip side, yesterday’s loser may also become tomorrow’s winner; for example, US REITs (another asset class) in the year 1999 had a negative 4.6 percent return; however, in the following year, US REITs returned a gain of 26.8 percent. 

What we can tell you is that when a particular investment asset class performs well, it creates a buzz. There can be a lot of press coverage and talk around the water cooler in companies around the nation, leading many investors to move money from lower performing investments into last year’s winning investment. These investors have now sold low and bought high, and are most likely to be disappointed the following year. They have also, by chasing returns, disrupted their thoughtfully crafted framework of diversification. 

Stick to the Recipe

No matter how much or how little risk you’re willing to take on as an investor, it is crucial to have a properly diversified portfolio. Even putting aside extreme cases like Ray’s, countless studies show that the average investor makes smaller versions of these mistakes, which add up to between 3 and 4 percent per year. That may not seem like much, but over the course of a multi-decade retirement, 3 percent can really add up. 

Simply put, we diversify because we will never know from year to year which investments will be the winners and which will be the losers. Owning a thoughtful “recipe” of all the different asset classes allows us to celebrate the “winners” without being devastated by the “losers.” 

If you want your financial cookies to turn out, you need all the ingredients, and you have to stick to the recipe. Informed decisions based on fact, research, and well-formulated strategy, are what will  yield the results you’re looking for from your investments. 

For more advice on diversification, you can find Income for Life on Amazon.

Joseph DiSalvo, ChFC, AIF and Marie L. Madarasz, AIF of Quest Capital & Risk Management, Inc. are committed to bringing their clients the clarity that will promote and enhance confidence in the future. For more than two decades they have used a proven process that helps clients think through how best to structure and manage their resources in order to produce a growing stream of retirement income for life. As experts specializing in all aspects of Retirement Income Planning, they are passionate about the coordination and integration of their clients’ income, investment, and tax planning strategies in order to help clients live the life they’ve worked hard for. Joseph and Marie are strong advocates of financial education, seeking to teach others how to achieve sustained success and lifelong prosperity.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

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