This is the fifth column in Pennywise's "Investing for Retirement" extravaganza, earlier installments of which may be read here, here, here, and here.
In the immediate aftermath of Wall Street's disastrous performance in 2008, Pennywise was startled to take note of a lot of instant chatter here and there to the effect that diversification no longer works.
Everyone, it seemed, had an opinion about investing at that desolate time. One night in early 2009, Pennywise had dinner at a Chinese restaurant. My fortune cookie stated, "Don't worry about the stock market. Invest in family." When fortune cookies are dispensing investment guidance dismissive of stocks, it should almost certainly be taken as a contrarian indicator—and so, too, the commentary against diversification.
Diversification is the time-honored principle that one's money should be distributed across multiple categories known as asset classes, such as stocks, bonds, and cash. (Many additional asset classes exist, but those are the basics.)
The abnegators of diversification noted that even "well diversified" portfolios lost money in late 2008 as real estate, commodities, corporate bonds, and many other asset classes besides stocks plunged. Rather than behaving differently, as they were supposed to do, those asset classes were increasingly "correlative," meaning they moved in the same direction as stocks. Often the naysayers of diversification concluded that investors should eschew buy-and-hold, diversified investing in favor of moving money quickly in and out of assets with the best-performing prospects.
Of course, many things were wrong with that pop analysis.
First, diversification never promised to eliminate risk. It proposes to manage risk and smooth returns.
Second, a single quarter of results (particularly in the midst of one of the worst financial crises in 100 years) was a ridiculously short-term basis upon which to question the validity of diversification, which in its buy-and-hold expression is predicated upon very long-term horizons.
Third, diversification never posited that different asset classes must necessarily or always move in opposite directions. Au contraire, diversification presumed that, in the long run, all asset classes appreciate in value. Otherwise, there would be no reason to invest in them. The point was rather that they do so at differential rates, sometimes at direct variance.
Fourth, not every asset class plunged during the financial crash. Those who allocated at least some of their portfolio to boring old cash looked like Einsteins, as did those who owned federal-government bonds (or Treasuries, in the biz). In short, the financial crisis, far from disproving diversification, proved that diversification works.
Fifth, while diversification cannot guarantee against short-term losses, nothing can.
Finally, the alternatives proposed by the critics of diversification—who often turned out to be brokers or traders—were often so much worse. They usually touted "tactical" approaches that amount, in essence, to speculation. The problem with moving money into what will do well next is pretty obvious: Who knows what will do well next? None of us has a crystal ball to inform us on a consistent, reliable basis when and where to plunk down all our money in such a way as to outperform all other asset classes. Wouldn't it be nice if we did?
Once in a while, granted, someone gets rich by taking on huge risk, but, by the same token, once in a while someone wins Powerball. Buying Powerball tickets is not exactly a winning retirement strategy. Countless studies have found that investors are very poor at hazarding guesses about market trends. They tend to derive impressions from current mass enthusiasms—bubbles—and are, therefore, very likely to buy high, sell low, and rack up big trading costs in the process, reducing their returns.
Let's look again at the aftermath of the financial crisis. After 2008, many investors, having had their fingers burnt in the stock market, took flight to safety, moving all their money into bonds and cash. By February of 2009, for the first time since 1997 when records began to be kept, Americans had less than half of their 401(k) money in stocks. But that was precisely the moment when they should have been buying stocks, not selling them. In May of 2009, Barron's reported U.S. stocks to be at a 41-year, inflation-adjusted low point, a screaming buy. Over the following two years, the value of the S&P 500 index, a gauge of top U.S. stocks, nearly doubled—outperforming cash and bonds by a long shot.
As Pennywise warned at the time, "to sell in disgust might be the mistake of a lifetime" because "this may actually be a buying opportunity for the lionhearted."
Now, as stocks begin to be more than fairly valued, investors are, on average, just starting to put money back into the market, making the reverse mistake.
The point is not that Pennywise knows with certainty which way things are heading. No one does. Humility is a crucial investing disposition. But so are perseverance and sanity. And to Pennywise the crisis confirmed, rather than refuted, the need for diversification. In those days of shock and awe in 2008-9, I was busy ploughing what little money I could gather together into as many broad-based stock index funds as possible, in part out of realization that the market was at a historic low-water mark, and in part to rebalance my asset allocation. (More on rebalancing next month.)
At the very least, a portfolio should include stocks, bonds, and cash, though not in equal proportions, since historically the return of those asset classes has been one of descending magnitude. A simple form of asset allocation, then, would be a 60-40 split between stocks, on the one hand, and bonds and cash, on the other. That proportion was recommended by the late Peter L. Bernstein, a financial writer, and is perfectly serviceable.
Note, however, that what makes for an ideal asset allocation is the subject of much discussion and divergence of opinion. The answer—and this is not at all evasive—is this: Whatever is right for you.
Next month we'll explore options in asset allocation, the mechanism that helps you achieve adequate diversification. But for now, know that investors are served very well, on average, by a strategy of diversification in their retirement investments.
Diversification does not eliminate market risk. No investment strategy does. A well-diversified asset allocation does, however, reduce a portfolio's volatility. Diversification also protects against excessive risk-taking and excessive caution when investors may otherwise be disposed in one of those self-defeating directions. Diversification helps one avoid market fads and make sure that, at least some of the time, one buys low and sells high, rather than the reverse. And diversification balances the competing desires for capital preservation and growth, or minimal risk and maximum reward.
As a result of all that, diversification helps investors stay the course for the long term rather than be distracted by market manias or panics. The naysayers are wrong: Diversification is here to stay.
