De-worse-ification?

A business school classmate once offered the following tip: "Whatever you do, don't diversify your investment portfolio. Diversification should really be called de-worse-ification because it guarantees mediocre results."

Like most investing tips, this one sounded good but wasn't worth much. Diversification never looks good through the retrospectascope. Over the past decade, shares of Cisco Systems appreciated 75,203%. A mere $5,000 invested in this stock in 1990 would be worth over $3.7 million today. So why not just invest in the next Cisco and forget about diversifying? The obvious fallacy in this thinking is that we have no way of knowing which companies will emerge as the top gainers of the next ten years. By diversifying, we are attempting to minimize our risk without reducing our expected gains.

The benefits of diversification are highlighted by the recent debacle in technology stocks. After several years of superior performance (driven by high-flyers like Cisco), the technology-laden Nasdaq Composite Index has dropped over 45% since March of this year. The average Internet stock has plunged over 75% over the same time frame. Many investors plowed their life savings into tech stocks over the past few years only to endure a painful reality check in recent months. Meanwhile, other sectors of the market, such as food companies, have performed beautifully this year.

The whole point of diversifying is to iron out the ups and downs by spreading your investments around. Well-diversified portfolios contain a mix of foreign and domestic stocks, bonds, mutual funds, and cash equivalents like Treasury bills or money market funds. You can also diversify within asset classes. For example, a domestic stock portfolio should not be too focused on any particular sector or industry group, but should reflect the overall composition of the U.S. stock market.

Diversification also means regularly evaluating your assets and realigning the investment mix. For example, if stocks have a great year, they will end up comprising a larger percentage of your portfolio than you had originally planned. You should therefore periodically rebalance your portfolio to maintain appropriate asset weightings.

The best way for most investors to diversify is with index funds. These are passively managed mutual funds designed to match the investment performance of a specific target index. A variety of index funds representing all the major asset classes are available from companies like Vanguard and Dimensional Fund Advisors. Index funds have three main advantages:

1. They provide better investment returns over time than actively managed funds.
2. They are typically more tax-efficient than actively managed funds.
3. They tend to have lower management fees than actively managed funds.

The Nobel Prize-winning economist, Harry Markowitz, revolutionized the field of academic finance when he discovered that by owning a diversified portfolio you can reduce risk without sacrificing expected returns. Should it really be called de-worse-ification? On the contrary, diversification provides the only free-lunch in economics: the ability to mitigate company-specific risk at no cost.

December 1, 2000

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