There are three simple time-tested rules in investing. But like a lot of things, they are in need of an update. This is the first post in a three-part series covering those three rules. (For related reading, see: How to Build Your Optimally-Balanced Portfolio)
Original Rule 1: Diversify to Control Risk
Do you like to gamble with important things? Do you play Russian roulette? I hope not. And of course you shouldn’t do it with your portfolio either. Just like putting your life in the hands of one random bullet makes you fearful, so should putting your portfolio in one or just a few investments. No one diversifies to make a killing. We diversify so we don’t get killed.
Owning stock in a single company is dangerous. Concentrating your investment in one company can create massive wealth, but it is also a form of gambling. What makes you think that investing in just one company is the golden egg? In the worst case the company fails or goes bankrupt; more likely it could stagnate and the stock will not produce the returns you need. Even more risky is investing only in the stock of your employer, because if the company does poorly you could lose your job at the same time your stock value suffers. Remember Enron, Washington Mutual, Lehman Brothers and others?
Diversification isn’t as much about maximizing your returns, but minimizing catastrophic loss and regret. Few people take diversification far enough, which leads us to:
Updated Rule 1: Diversify to the Point of Discomfort
The key to diversification is to take it all the way to the point of discomfort. You should not expect everything in your portfolio to go up at the same time. To be truly diversified means that something in your portfolio will lag and that’s okay, because something else will be performing better at the same time. Diversifying by owning many stocks in the same country is still risky. The fortunes of individual countries can change dramatically over time. Look no further than the United Kingdom and the recent vote (the so-called Brexit vote) to exit the European Union. People who invested all or nearly all their assets in the U.K. experienced large losses the day after the vote and may continue to suffer in subsequent years. (For related reading, see: How to Outperform the Market.)
The same goes for those who invest almost entirely in U.S.-based companies. The U.S. only accounts for about 22% of global economic output and 36% of global stock and bond market values, yet U.S. investors have almost three-quarters of their portfolios invested in domestic companies. It’s impossible to know whether the U.S. will be the best place to invest over the coming years, or even the next several months. Just because it’s been profitable in the past does not guarantee that it will remain profitable in the future. We only have to look at this year’s election cycle to see the potential risks of investing primarily in the U.S. In order to reduce this risk, global diversification is crucial.
Diversification also means owning many different types of investments—stocks, bonds, cash, real estate, commodities, etc. These various investments don’t normally go up and down in unison, so adding them to a portfolio can create significant diversification benefits.
The Bottom Line
Don’t just go for the golden eggs—invest in eggs that are light, dark, and speckled. And don’t put them all in one basket. Make sure you put them in multiple locations around the world. Having this variety and reach may make you uncomfortable at first, but it will ensure that all of your eggs won’t be taken if a fox decides to visit your hen house. (For related reading, see: Your Financial Planning: Don't Go It Alone.)