Sound Investing 4: Diversification

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Diversify within asset classes

Asset classes are the major categories of investments, such as stocks, bonds, and real estate. When you invest in a particular asset class, making a variety of specific investments within that class gives you the best tradeoff of risk and reward. You maximize your chances of getting the rewards of investing in that class and minimize the risk of underperforming the class as a whole. You accept only the reasonable risk of investing in that class, for which you are rewarded by the class’s risk premium, but avoid the unreasonable risk of putting all your eggs in one basket.

Diversification in stock, bonds and real estate

If you invest in stock, you should normally invest in a variety of companies, since different kinds of companies do well under different market conditions. Avoid investing in only one sector of the economy (such as technology companies), or only in large companies (which are outperformed by small companies some of the time), or only in growth stocks (stocks whose prices relative to recent earnings are boosted by future earnings expectations).

If you invest in corporate bonds, also invest in a variety of companies, to limit the damage in case any one company should default on its obligations. Diversification is less of an issue for treasury bonds, since there is only one United States Treasury, and it has never defaulted on a bond obligation. There is another kind of diversification that applies to bonds, however, and that is diversification with regard to maturity, also known as “bond laddering.” You get the best protection against fluctuations in interest rates if you own bonds with a range of maturities, some much closer to maturity than others. If interest rates go down, your longer-term bonds will be more valuable, since they will continue to earn interest at the old higher rates. But if interest rates go up, your shorter-term bonds will be an advantage, because they will mature sooner, freeing up money for investment at the new higher rates. You get some protection either way.

You can get diversification in real estate by investing in a REIT (real estate investment trust). It owns a number of properties and/or mortgages on properties. REITs trade on stock exchanges, and you can buy shares in them through a broker. You can get even more diversification by investing in a mutual fund that holds shares in a number of different REITs. This can be helpful, since a particular REIT may be specialized in a fairly narrow real estate market, such as office buildings.

Diversifying through mutual funds

Whether one is investing in stocks, bonds, or real estate, mutual funds can provide excellent diversification, since they can make a much larger number of different investments than one individual could make conveniently. In general, this diversification reduces the risk that a portfolio will underperform the asset class as a whole. However, mutual funds themselves vary greatly in diversification. Some deliberately maximize diversity by buying some of everything in an asset class (a “total stock fund” or “total bond fund,” for example). Others diversify only within narrower categories, such as small companies, or certain sectors of the economy, or certain parts of the world. Some stock funds focus on “growth stocks,” stocks that are priced relatively high in relation to recent company earnings because of high confidence that their earnings will grow. Other funds focus on “value stocks,” stocks that are priced relatively low in relation to company assets or earnings because future earnings are more in doubt.

The particular focus of a mutual fund is often fairly obvious from its title, and funds are also classified by research organizations such as Morningstar. The definitive guide to a fund’s investment objectives and policies is the fund prospectus. Sophisticated investors may select a narrowly-focused fund because they believe that market conditions favor its particular approach. Less experienced investors are probably better off with very broad funds, or a combination of funds covering much of the market: growth as well as value, large-cap as well as small-cap, and so forth.

In today’s global economy, investors are probably wise to include one or more global or international funds. (“Global” funds usually include the United States, while “international” funds usually don’t.) The basic argument for going beyond one’s own country is the same as for any diversification: Don’t put all your eggs in one basket. No one knows what part of the world might experience the greatest economic success going forward. On the other hand, international investing does entail special risks, such as the risk that currency fluctuations may reduce the value of money that you make in euros, or yen, or some other currency. (Of course, foreign investments can also be a hedge against a declining dollar.) Investments in countries lacking stable democratic institutions or well developed economic markets (“emerging markets”) carry additional risks, but also have enormous potential for growth. Some analysts doubt that international investing offers a sufficient risk premium to justify the risks, since they see little likelihood that other parts of the world will surpass the United States in economic success by any significant margin. Others think that while the 20th century was the “American century,” the 21st could easily be the “Asian century,” and those who don’t invest abroad may miss out on the biggest investment opportunity of our time. I believe in investing at least a portion of your portfolio abroad.

Diversifying through exchange-traded funds (ETFs)

An exchange-traded fund is a basket of stocks or other securities that trades like a single stock. Like a mutual fund, it’s a fairly easy way of assembling a diversified portfolio. As the name indicates, ETFs trade differently than mutual funds. You can buy shares in a mutual fund directly from a mutual fund company, such as Vanguard or Fidelity. (You can also buy mutual fund shares through a broker, but the funds that are marketed that way charge sales commissions known as “loads”.) ETFs trade on an exchange and must be bought or sold through a brokerage account, usually with a commission.

Both mutual funds and ETFs have a net asset value which reflects the value at a given time of the securities they contain. The value of a mutual fund is set once a day after the markets close. The value of an ETF fluctuates all day long like an individual stock. In a very volatile market, the ability to fill an order right now rather than at the end of the day gives ETF buyers and sellers a little more control over the price of a transaction.

Owners of both mutual funds and ETFs have to pay operating expenses to cover the costs of managing the funds. On the average, ETF expenses are a little lower. However, ETF owners incur transaction costs when they buy and sell shares, due to brokerage commissions and bid-ask spreads. While the price of a mutual fund share is just the net asset value of the fund, the price of an ETF depends on what buyers are bidding, what sellers are asking, and the relative numbers of buyers and sellers. You may pay more than the net asset value when you buy and get less when you sell.

All things considered, both mutual funds and exchange-traded funds are acceptable ways of diversifying. Investors who are making frequent small investments may prefer no-load mutual funds to avoid transaction costs. Mutual funds are especially convenient for those who wish to make regular investments through payroll deductions or automatic bank transfers. Investors who are making fewer trades but holding shares for a long time may prefer ETFs because of their low annual expenses.

Diversifying on your own

You can avoid the annual expenses charged by both mutual funds and ETFs by choosing individual securities on your own. In that case, one should be aware of the different kinds of securities in each class, and be sure not to buy too much of any one thing. Many investors loaded up on computer and telecommunications stocks during the “dot-com” boom of the 1990s and suffered especially heavy losses in the bear market that followed.

The selection of particular securities is definitely a challenge, since there is no single well-established method that reliably produces favorable returns (see the previous post on risk). What we have is many different methods, each with its own advocates, but each working only some of the time. One way to learn about them is to join the American Association of Individual Investors. You can also subscribe to many expensive investment newsletters that recommend stocks. However, careful analysis of these newsletters has found that only about one out of five of them outperforms the market over the long run, and then only by a small margin. To find out which newsletters have the best track records, look into the research by Mark Hulbert. Many investors just rely on their broker to recommend stocks for them. The brokers make money on the trades whether the resulting portfolio performs well or not.

Most research suggests that small investors must be either extremely diligent or extremely lucky to achieve an above-average, “market-beating” return by selecting their own securities. But that doesn’t have to be your goal. Your success as an investor may not depend on individual security selection at all, since even an average return may be sufficient to achieve your financial objectives in the long run. The easiest way to get that average return is by investing in well-diversified mutual funds with low fees and expenses. Then you will have little risk of underperforming the market by very much. Just be sure to save and invest enough for that average return to produce the results you want.

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