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Does Diversification Still Matter?

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Taking a casual look at my investment performance over the last few months isn't pretty. What's that you say? Yours isn't either? It seems like no one's is. I was thinking about this the other day. Did I do everything right? I diversified. I have money in US stocks both big and small. I have money in foreign stocks. I have money in bonds (but only a little since I'm in my early 30s). I have money in REITs (again only a little). I even have a very small portion in peer-to-peer lending accounts like Lending Club. Looking back and everything only Lending Club made money. In fact it was the only thing that didn't lose around 30%.

So if diversification didn't help me, and I'm guessing it didn't help you either, should we just conclude diversification is a myth? I've come close to believing this at times. Each time I do, I take a step back and look at things in historical context. In 2001 when tech stocks were crashing would diversification have helped? You betcha! The real estate market was booming. While other stocks weren't performing greatly, you definitely didn't want to be all tech stocks.

What about the Great Depression of the early 1930s? I'm not a historian of the time period and I'm not sure how much diversification there was then (how would an average person invest in all the companies in Europe back then?). Still it seems that like universally bad across the board. Perhaps the best move was just to put money in your mattress.

Here's my conclusion: Diversification is like a seat belt. It's going to help you in most accidents. However, if you are in a Smart car and get into an head on collision with a Badonkadonk at 120 miles per hour, that seat belt might not save you. It doesn't mean you shouldn't still have one on to protect you from the other more likely scenarios.

Posted on February 25, 2009.

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23 Responses to “Does Diversification Still Matter?”

  1. kosmo @ The Casual Observer says:

    Your last paragraph hit the nail on the head.

    Imagine if you had invested solely in banks and auto companies. If you picked the wrong companies, you could be looking at a 95% loss instead of 30%.

  2. Cos says:

    yup, good comparison indeed.

    sometimes i wonder if just going the route of my grandfather with regular savings and CD’s would do me better (he’s been comfortably retired for over 30 years).

    it’s frustrating at the very least.

  3. RobG says:

    Diversification helps smooth out the volatility and quick changes in a specific asset class.

    In the case of Lending Club being part of your portfolio, a new asset class that did not behave like any of the others, it helped by covering some of your losses in other areas. I told you to invest more ;-)

    Within P2P lending, diversification is key to minimize impact of defaults.

  4. I would have to disagree. With the right risk tolerance and asset allocation, diversification is your Badonkadonk.

    However, many people are finding out that calculating your risk tolerance and asset allocation isn’t as easy as filling out a questionnaire.

  5. Kevin W says:

    Well, there’s asset-class-level diversification, and there’s security-level diversification. @kosmo is exactly right — holding a total US stock index was pretty rough, but imagine if your entire portfolio was Bear Stearns or GM. It could be a lot worse.

    I also agree with @RJ. I don’t think the lesson of 2008 is that diversification is a myth. The lesson is that a lot of people were holding aggressive allocations when really their true risk tolerance is conservative.

  6. Thanks Kevin.

    It will be amazing once we look back at this 25 years from now, and decide what the real lesson is. Chances are known of us really have a clue.

  7. Michael says:

    A diverse portfolio should have included at least some precious metals. I am not talking about a ton but 5-10% can go a long way.

  8. My Life ROI says:

    Michael —

    I want to learn more about the inclusion of precious metals. It seems that their are a lot of kooks out there writing on the subject so its hard to find the good material. I have seen a lot of rebuttals about how people who bought gold in the 80s bought into a sinking ship when you look at purchasing power (but I didn’t fact check it as I don’t see myself buying gold at the moment..).

    Any compelling reads?

  9. DebtKid says:

    We are told from a young age, “diversify! fund your roth! buy stocks!” and while that works for some investors, for others, they would be much better off looking at other types of investments.

    I’m not even just talking about Lending Club here (although that is an excellent new asset class). I’m talking about a new way to look at what is an investment. The so called “stock experts”….99% of them got killed last year. It’s just crazy.

    Sorry for the rant.

    dk

  10. shadox says:

    I read somewhere this week that diversification will help you in 80% of cases, we just happen to be in a 20% case… :-)

    Seriously though, it has been demonstrated that diversification does not work as well in severe crashes, and this one is as bad as they come.

  11. plonkee says:

    I think I agree. Diversification is a good strategy because it reduces risk, it doesn’t eliminate it though – if everything is down then what can you diversify into?

  12. Goal Hunter says:

    Those who believe in the standard idea of diversification also believe that the most you can ever earn over the long run is the “Market Return”. Diversificiation lets you earn that return with a lower risk. Remember that you still have the risk of the market you’re in.

    It’s sound, not a myth. The market crashed so you can’t diversify your way out of that!

  13. Ted says:

    I enjoyed your post on diversification, it is more important than ever right now. I wrote a similar piece for my blog about the true risk of investing in stocks over the long run:

    http://capitalideas.blogspot.com/2009/02/true-risk-of-stocks-for-long-run-part-1.html

    Thought your readers might find it interesting.

  14. Chad @ Sentient Money says:

    I must say I have to disagree. Diversification is almost worthless. It’s more like having a bag of sand in your trunk for bad weather, but you live in Dallas. Sure a freak snow storm comes along once in a while, but the rest of the time it just costs you gas. Diversification is just something the financial advisors can sell you.

  15. Boomer says:

    You mentioned REITS. However, what is missing from your diversified portfolio is investment real estate. In my case, I have a small rental property cashflowing about $3,500 a year. Not much by any standard. And the market might be in hand-wringing mode all around me but my annual cash-on-cash returns continue at 20%+. This definitely softens the 40%+ losses in my equity investments!

    Were I in my early 30’s again in this RE market I would be scoping out a duplex to buy. Live in one side, rent the other.

  16. kosmo @ The Casual Observer says:

    One of the nice things about gold is that is it an excellent conductor of electricity and heat and it very malleable and ductile.

    So even if the demand for gold as jewelry and currency were to completely dissipate, many industrial uses would still exist.

  17. Lazy Man says:

    I agree with you Kosmo. I think it would probably be worth 2-3 times what copper is based on it’s industrial uses. That would be a huge financial loss from today’s current prices.

    Diamonds are kind of the same way. They are priced far about their practical value.

    This is why I argue for oil or agriculture stock. I think dollar for dollar there’s more industrial value built into them.

  18. Lazy Man says:

    Boomer,

    We have investment properties, but they aren’t making money. I would say that REITS are the easiest way to diversify into investment property.

  19. Michael says:

    If you want to learn more about precious metals investing look at silverinvestor.com or watch some Peter Schiff videos on You Tube. These are good places to start. The Schiff videos have a lot of other economic info in them also. He predicted this crash and has been buying gold for many years. If you want to see how completely full of crap most TV pundits are, watch the video “Peter Schiff was right.”

    Gold has been used as money for many thousands of years, so it is very unlikely that people are going to stop treating it as such. Governments hate gold because it provides an alternative to the funny money they print out of thin air. The demand for gold as currency is not going away anytime soon. Gold doesn’t go up and down in value, the dollar does.

  20. kosmo @ The Casual Observer says:

    “Gold has been used as money for many thousands of years, so it is very unlikely that people are going to stop treating it as such.”

    Yes … I was just yanking your chain :)

  21. Actually focusing on dividends did improve my stock performance slightly in 2009. Focusing on fixed income such as CDs or treasuries in 2008 also helped. Diversification should not only mean different types of stocks, but also different types of asset classes.

  22. Dan says:

    Aren’t you understating the diversification value of bonds (even if you’re young)?

    Aggregate Bond Index earned 5.24% in 2008. Vanguard’s Inflation Index bond fund even did relatively well at -2.85%. If you had a 40% of your portfolio allocated to bonds and split evenly between these two funds, yes 2008 still would have been brutal, but not nearly as bad as you describe.

    Disclosure: I was 84% equity in 2008 and my personal returns were every bit as bad as you describe.

  23. Chris says:

    Gold is NOT money, it is a store of value, but I digress. I’d suggest adding a basket of commodities; agri, PMs, base metals, oil, etc.. Look at a low-cost ETF or mutual fund like DBA or DBC. JMHO

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