Diversification makes sense, humans sometimes don't
By Gary Silverman, CFP®
Since there is always potential risk when it comes to investing (actually, hundreds of risks), rational thinking and the knowledge that comes from it proves that hedging one’s bets is a very prudent tactic when it comes to investing. The fact that stocks produce the greatest return of any common investment type makes the retiring 66-year-old want to put some money into the market. Rational thinking creates the caution that comes from knowing the stock market may go down almost immediately and may stay down for years. This then produces the prudent action of the retiree not putting all of his/her money into the market.
Most people know that diversification is a good strategy for an investment portfolio. In this post-Enron, post-Internet bubble, post financial-crisis world it has become pretty obvious that it is a bad idea to concentrate your investments in a single company or a single sector. Yet it happens quite regularly.
It might be a former manager who has 80% of her assets in her previous employer’s stock. She’s afraid of the taxes she’d face if she sold it. Another might feel disloyal to a parent who willed them a small fortune in the form of stock of a single company if they considered selling any of it. Or it could be the packing line worker who knows the importance of diversified investing but who does not know how to examine investment choices. He places his 401(k) contributions in four different mutual funds—the ones that did the best the previous year. An examination shows that all four of those funds invest in the exact same types of stocks. He has, in essence, purchased one type of investment four times. What he thinks is diversity is not.
That is why a rational thinker, in the absence of an adversary to point out flaws in individual logic will do the questioning. The former manager questions the wisdom of trying to save taxes in a way that might put a third or more of her net worth at jeopardy should the company falter and its stock fall. The inheritor questions whether the parent truly would be pleased if all of the eggs were kept in one basket to minimize potential hurt. The 401(k) investor questions whether blindly choosing investments based on a single criterion is wise and devotes time to learn about what he is choosing or to getting good investment counsel to aid him in this task.
You’ll find that rational thinking almost always leads to some form of diversification.
Proper diversification can increase returns and lower portfolio risk (well, to a point). But it is not a cure-all. When you get massive disruptions like we did in 2008 and early 2009, diversification alone will not help your portfolio avoid losses. After all, no matter how diversified you are, if pretty much everything goes down, you’ll lose money.
More on this next week.
This article was published in the Wichita Falls Times Record News on April 26, 2017.
Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing.