Welcome to the next installment in our Evidence-Based Investment Insights series: The Full-Meal Deal of Diversification.
In our last piece, “Financial Gurus and Other Fantastic Creatures,” we concluded our exploration of the odds you face if you try to outsmart the market’s lightning-fast prices. Today, we turn our attention to the ways you can harness these and other efficiencies to work for, rather than against, you.
Among your most important financial friends is diversification. After all, what other single action can you take to simultaneously dampen your exposure to investment risks, while efficiently investing toward your personal financial goals? The benefits of diversification have been well-documented and widely explained by nearly 70 years of research.
What do we mean by diversification?
What is diversification? In a general sense, it means spreading your risks around. In investing, this means that it is more than just ensuring you have many holdings, it is also about having many different kinds of holdings. If we compare this to the adage about not putting all your eggs in one basket, an apt comparison would be to ensure that your multiple baskets contain not only eggs but also a bounty of fruits, vegetables, grains, meats and cheese.
Global Diversification: Quantity and Quality
It is easy to believe a portfolio is well-diversified when it is not. Some investors own a large number of stocks or stock funds across numerous accounts. But upon closer analysis, we find that the bulk of the holdings are concentrated in large-company U.S. stocks.
In future installments of our series, we’ll explore what we mean by different kinds of investments. But for now, think of a concentrated portfolio as the undiversified equivalent of many basketsful of plain, white eggs. Over-exposure to what should be only one ingredient among many in your financial diet can be detrimental to your financial health. Poor diversification:
- Increases your vulnerability to specific, avoidable risks
- Creates a bumpier, less reliable overall investment experience
- Makes you more susceptible to second-guessing your investment decisions
Combined, these three strikes tend to generate unnecessary costs, lowered expected returns and increased anxiety. You’re back to trying to beat instead of play along with a powerful market.
A World of Opportunities
Instead, consider that there is a wide world of investment opportunities available these days from low-cost funds offering efficient exposure to capital markets found all around the globe.
How do we measure the world of investment opportunities? Directly comparing the market capitalizations of nations produces an indication of the weight that each country represents in terms of the global opportunity set. This cartogram illustrates equity investment opportunities around the world, with the size of each country adjusted to reflect its total relative capitalization. A country’s equity market capitalization reflects the total value of shares issued by all publicly traded companies and is calculated as share price times the number of shares outstanding.
To best capture the full benefits that global diversification has to offer, we advise turning to the sorts of fund managers who focus on efficiently capturing diversified dimensions of global returns.
In our last piece, we described why brokers or fund managers who are instead fixated on trying to beat the market are likely wasting their time and your money on fruitless activities. You may still be able to achieve diversification, but your experience will be hampered by unnecessary efforts, extraneous costs, and irritating distractions to your resolve as a long-term investor. Who needs that, when diversification alone can help you have your cake and eat it too?
In our next post, we’ll explore in more detail why diversification is sometimes referred to as one of the only “free lunches” in investing.