Diversification is Important in Investing Because 5 Simple Reasons

Diversification is Important In Investing BecauseI think you’ll agree with me when I tell you:

Diversification is important in investing.

But do you fully understand why it’s so important?

Here’s something crazy I learned about Wall Street:

Most advisors will tell you that you should spread your money around.

But do they explain why? Not usually.

They shouldn’t keep you in the dark about these things. It’s your money!

Diversification is important in investing because of several different reasons.

Today, I’m going to show you exactly what you need to know about one of the most misunderstood topics in the financial world.

Let’s get started right now.

 

What is Diversification?

Want to know one of the biggest problems with investing?

Wall Street wants you to stay confused.

Wall Street ConfusionThey rarely ever use plain English. They like to throw around all those fancy words. It’s as if they want to constantly remind you that they know far more than you know.

One of those words at the top of their list: Diversification

What does diversify mean?

Simply put: Diversification means to spread around.

More specifically: it means to invest in different areas of the market.

And to get just a little deeper: It means to invest in areas of the market that tend to move up and down at different times.

Check out the annual stock market returns of  Large U.S. Companies & Small International:

U.S. Vs International Difference in Annual Returns

Some years: U.S. does better

Other years: International wins.

And sometimes: They do about the same.

Diversification involves understanding which areas of the market move in different directions. And once you know.. you need to hold those areas.

Now that you understand the meaning of diversification- let’s take a look at the benefits of spreading your money around.

[yellowbox] Diversification means to spread aroundKey point:
Diversification is important in investing because it helps reduce risk.[/yellowbox]

 1. Don’t Lose Everything in the Next Enron: Company Risk

Let me tell you a short story about a company named Enron:Enron

Enron was once the sixth largest energy company in the world. Everything was awesome…

… until it wasn’t anymore.

On October 16, 2001, Enron made a shocking announcement that the investing community will never forget.

They had lost $618 million in the third quarter. Most of this was due to the ungodly amounts of bonuses that they had paid to their top executives. But regardless – they went broke overnight.

Enron caused a shockwave throughout Wall Street. It’s stock price dropped from it’s peak of $90.75 to only $0.67 / share in just a short time.

enron

Many employees and other investors had bet much of their retirement savings on the future success of Enron.

Let me help you put this into a better perspective:

Imagine you had $100,000 invested in Enron at it’s peak…

… after the crash, how much would you have left? $738.

They lost everything.

Don’t do this. Don’t invest in single companies.

When you invest in just one company, you greatly increase your risk… even if you think it’s in a good industry.

Here’s a great example:old picture automobile

Imagine you were investing back in the early 1900s. You might have seen a great investment opportunity.

Automobiles.

Everybody would be driving one soon. Most investors would’ve loved to have jumped on that gravy train.

But everything isn’t as good as it seems.

The U.S. had nearly 300 automobile companies in 1909.

Throughout the years, all but three of those companies disappeared.

The three remaining victors: GM, Chrysler, and Ford.

US-Automakers

But we know what happened with two of these recently: Both GM and Chrysler filed for bankruptcy.

I’ll tell you.. that’s not a good day to be an investor. Not a good day at all.

GM stock history

My point: Only 1 company emerged victorious out of nearly 300… in an industry that saw tremendous growth over the years.

If you would have bet on any of these other -companies, then you would have been a very sad Panda.

Just because something looks promising – that doesn’t mean that the company is a good investment.

What’s the better plan? Company Diversification.

Don’t just invest in GM.

Here’s why: GM might get hit with some negative event.. such as their cars killing people

GM recall

Note: The most recent death count is actually 74… not 13.

 

 

If that happened, do you think people would just stop buying cars?

Probably not.

But they would probably stop buying cars from GM.

GM’s sales would go down, but Toyota’s sales would benefit from this negative news.

Company's market capitalization

Diversification is important in investing because it helps reduce risk.

If you own the entire auto industry, then you won’t face as much risk when one company has a financial issue.

Be sure to invest across the entire industry.

You need to own GM, Ford, Toyota, Honda, etc. That’s diversification!

auto brands

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EnronKey Point: Avoid single stocks – especially if it’s your employer.

Many employees invest in their company stock because they think they know their company.

That’s exactly what happened at Enron.

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[yellowbox]Want to give your portfolio a checkup? I’ll show you exactly how to check if you have well diversified portfolio.[/yellowbox]

2. Avoid Losing Tons of Money When the Next Bubble Bursts: Industry Risk

Now you know how to diversify your investments across an entire industry. So you’re good.. right?

Not quite small fry.

Even owning the entire auto industry is very risky, because you don’t know what the future holds for it.

Think about this:

Back in the early 1900s, you would have been considered crazy if you didn’t own stocks in the railroad industry.

Who wants stocks in the railroad industry today?!

…Well Warren Buffett. But whatever.

I still stand by my thinking that: Railroad is no longer the future. 

falling-stock-market

Innovation drives customers from one industry to the next. One of the next hot industries might not even exist yet.

Could the entire automobile industry go away overnight? Probably not.

We still have trains. They’re those annoying things that get in your way when you’re running late.

Railroads still exist, but it’s far from a booming powerhouse like it was in the past.

Here’s another problem with chasing the performance of hot industries:

We often buy into them just in time for the bubble to burst.

Here’s a very simple explanation of how the bubble cycle works:cycle

  1. Everybody hates an industry. Nobody wants to buy the stock. Therefore, the price is low.
  2. A few brave souls invest in it first… and make good returns- that drives up the price.
  3. Financial professionals see the opportunity and buy up stock and that drives up the price.
  4. The news starts reporting the recent past performance and that drives up the price.
  5. Everybody loves the industry. Nobody wants to sell the stock. Therefore, the price is high.
  6. New buying of stock eventually slows – the market corrects itself and price drops significantly.
  7. Everybody hates the industry again. Nobody wants to buy the stock.
  8. Have you ever watched the movie Groundhog Day?

 

Here’s the truth:

The best time to get into an industry is before it booms.

Here’s the problem:

You have no idea when it’s going to boom.

Predict the Future

By the time everybody is talking about a “great investment”, it’s no longer a great investment.

Instead of trying to pick the hottest industry – diversify by owning the entire market.

When you invest in a large cap index fund, it’ll usually contain good portions of all different industries.

By splitting your money across different industries, you reduce the amount of industry risk that you take.

[yellowbox]Key Point: Proper stock diversification involves owning the entire market. If you single out one industry, you run the risk of losing greater than the market if that industry goes out of style.[/yellowbox]

 

3. Don’t Let the Stock Market Keep You From Retiring: Market Risk

I doubt anybody will disagree with me:

You can lose money in the stock market.

Ditto.

Here’s a pop quiz I’m sure you’ll pass:

True or False: Stocks are considered risker than bonds

Answer: True. Stocks are far risker than most bonds.

It’s that additional risk that leads to such great long term returns.

stocks are considered riskier than bonds

But as you get closer to retirement (or your end goal), you need to slowly start moving some money out of the stock market.

If you still have 10 or more years before you need the money in your portfolio, then stock market losses aren’t a very big deal.

Over long term periods of time, stocks should at least break even.

But keeping 100% of your money in the stock market as you reach retirement is financial suicide.

One down market can devastate your retirement income.

On the bright side, you could buy yourself a new t-shirt:

results of not having a diversified portfolio

 

Thankfully- you have diversification strategy options for avoiding stock market risk.

Bonds.

And not just any bonds- I want safe bonds.

Junk in – Junk out… and that includes junk bonds. Keep those things away from me.

Two elements determine whether a bond is safe enough to use in your investments: credit quality and duration.

When you invest in bonds, you’re lending money to an organization.

The credit quality shows you the risk of investing to these organizations. You want your investment to lend to mostly all AAA companies.

The duration shows you the length of time before the company will pay you back your money. The longer the duration, the higher the risk. I typically try to keep the average duration below 5 years.

But watch out:

When you look at the returns of high credit quality & low duration bonds, you’ll notice that the returns are low.

You might be tempted to try to invest in bonds that offer higher returns.

Don’t do this.

Higher returns mean higher risk.

falling stock market

Take the lower returns for bonds because that often means lower risk.

Use the stock market for growth and the bond market for safety.

[yellowbox]Key point: The stock market gives you great returns, but it comes at the cost of short term risk. As you get closer to retirement (or other goal), be sure you move a good chunk of your money into short-term, high-credit bonds.[/yellowbox]

 

4. But Are Too Many Bonds Killing Your Retirement? Inflation Risk

Stock market fear can sometimes cause investors to put too much money in bonds.

“I don’t want to lose money… so I invest mostly in bonds.”

But check this out:

If you only invest in bonds, you’re going to hate yourself.

Stocks Vs. T-Bills

 

If you invested $1 in bonds in 1970, it would have grown to $8 by 2014.

But if you invested $1 in diversified stocks, it would have grown to $139.

And this doesn’t even take inflation into account.

Inflation refers to the almost constant dropping value of the dollar.

We see it best through prices slowly increasing everywhere.

Coke used to cost a nickel. Why doesn’t it now? Inflation.

Inflation

Bonds face great inflation risk, because your interest rate is fixed over time. And it’s unlikely that you’ll make more than the rate of inflation on bonds (sometimes you’ll make less).

Stocks give you much better protection against inflation, because you own companies.

And companies raise prices with inflation.

Therefore, earnings will typically increase with inflation.

Do you know how to diversify your portfolio? Should you own stocks or bonds?

That depends on how long until you need your money.

When you’re still a long way out: Inflation risk is your biggest risk. Fight this by owning larger amounts of stocks.

When you’re closer to your goal: Stock market risk is your biggest risk. Fight this by owning larger amounts of bonds.

Diversification is important in investing because it helps reduce both inflation risk and stock market risk.

Don’t just say that you’ll keep your money safe by owning a bunch of bonds. You can lose far more in the long run this way.

[yellowbox]Key point: You can’t escape risk completely. If you try to avoid stock market risk too much, you’ll become a victim of inflation risk. Diversification is important in investing because it helps you balance your risk between stocks and bonds.[/yellowbox]

5. Market Downturns are Rarely Global: Country Risk

Why would anyone want to invest in international stocks?

According to USA Today, it’s a mystery.

But that’s why you’re here, because I don’t just sit around asking questions.

I solve real problems.

The author of the above article pointed out that International hasn’t been doing well in recent history.

He wrote: “Since March 2009, foreign markets have been laggards.”

So basically – he’s telling us to not invest in International because it has done poorly over the past few years.

Somebody smack him across the face.

That is exactly why you should invest in international.

cycleThings work in cycles:

Lower current prices = greater expected future returns.

 

One of the most common mistakes people make is that they invest too much in one country.

The U.S. has had a long track record of having good returns: No doubt about it.

I might sound unpatriotic, but I’ve gotta say it:

The U.S. might not always be the world’s economic powerhouse.

And despite our long-term returns, this country has had significant times when international has beaten the Dow Jones Industrial & S&P 500 (both track large U.S. companies).

Here’s another thing I find funny about this author’s comment that “Since March 2009, foreign markets have been laggards.”

Foreign markets beat U.S. in 2002, 2003, 2004, 2005, 2006, and 2007.

U.S. Vs Foreign During Lost Decade

 

International completely trounced U.S. for six years straight.

Have you ever heard of the “Lost Decade”? This was the 10 year time period between 2000 – 2009 when the U.S. Stock Market had a -1.03% annualized return.

People were in a panic that the stock market was no longer a reliable place to invest money.

Do you know how much International made during the “Lost Decade”?

The Foreign Markets had an annual return of 6.32%. Not bad at all considering that this includes the 2008 recession when International lost 44.8%.

But between 2010-2014, U.S. has beaten foreign nearly each year.

Diversify: Own them both.

[yellowbox]

Key point:

Neither U.S stocks or International are dead. They both tend to move up and down at different times.

And what’s the definition of diversification in finance?

It means to invest in areas of the market that tend to move up and down at different times.

Portfolio diversification is important in investing because it helps lower risk. We need to invest in both areas of the market.

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 Let’s Review: Diversification is Important in Investing Because…

[yellowbox]

    • diversification is important to investing because it lowers riskDiversification is simply investing in areas of the market that move in different directions.
    • Avoid single company risk & industry risk by investing in funds that track an entire area of the market (Large cap, small-cap, etc).
    • Invest in an appropriate mix of stocks and bonds.
      • If you have more than 10 years before you need the money, you should have most the money in stocks to avoid inflation risk.
      • If you’re close to your goal, you need to have most of your money in bonds to avoid stock market risk.
    • U.S. stocks aren’t always on top. Don’t just invest in the Dow Jones or S&P 500. You should also invest in stock funds from other countries.

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  • Chris Gagner April 28, 2015
    Reply

    I invest in my companies stock because I believe in the direction it’s going. The company has been around for almost 100 years. The financials all look solid. I don’t see any reason to diversify across a market of companies that I don’t know when I can just own a company that I know a lot about.

    • Chris Gagner April 29, 2015
      Reply

      I understand that you think you know a lot about your company. But there’s a few problems with that line of thinking.
      1) Most financial information refers to a company’s past performance. And past performance isn’t an indication of future results.
      2) Future projections are based on a company’s best guess -usually based on sales goals. But what you don’t know is if they’ll actually reach those goals.
      3) You also have no guarantee that the financial information is accurate. I don’t mean to accuse your company of cooking the books. But some companies can (and do) post false information on their financials. Sometimes this is by accident. Other times it’s on purpose. You really have no way of knowing if it’s accurate.

      I bring up these points just to illustrate that while you think you know a lot of information about your company, you might not. And also, keep in mind that a companies age doesn’t really mean much when it comes to future success. Old companies fail too.

      If you diversify across your company’s industry, you reduce a lot of single company risk, and you’re likely to see a similar return. I’m a big advocate of taking the least amount of risk to get an expected return… and diversifying across an entire industry is much better than investing in one company. I hope that helps.