Evidence-Based Investing Insights: The Full-Meal Deal of Diversification

Welcome to the next installment in our series of Oasis Wealth Planning’s Evidence-Based Investment Insights:  The Full-Meal Deal of Diversification.

In our last piece, “Financial Gurus and Other Fantastic Creatures,” we concluded our exploration of the formidable odds you face if you (or your hired help) try to outsmart the market’s lightning-fast price-setting efficiencies.  Today, we turn our attention to the many 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 reduce your exposure to several investment risks while simultaneously improving your investment efficiency on the road to your personal financial goals?  The benefits of diversification seem almost magical. but they have been well-documented and widely explained by nearly 70 years of academic inquiry.  Its powers are both evidence-based and robust. 

Global Diversification:  Quantity AND Quality

What is diversification?  In a general sense, it’s about spreading your risks around.  In investing, it means more than just owning many securities, it means also owning many different kinds of securities.  This sounds a bit like the adage ‘don’t put all your eggs in one basket,’ with one key improvement:  you should be sure that your multiple baskets contain not only eggs but also a bounty of fruits, vegetables, grains, meats, and cheese. 

While this may make intuitive sense, many investors come to us believing they are well-diversified when they are not.  They may own a large number of stocks or stock funds across numerous accounts but, upon closer analysis, we find that the bulk of their holdings are concentrated in large-company U.S. stocks.  Sometimes, they own a fund that they consider ‘diversified’ but it is, in fact, quite concentrated.

In future installments of our series, we’ll explore what we mean by different kinds of investments.  For now, think of a concentrated portfolio as the undiversified equivalent of one or more baskets full of chicken eggs.  Owning too much of one ingredient is not only unappetizing, it can be detrimental to your financial health.

Poor diversification:

1.  Increases your vulnerability to specific, avoidable risks
2.  Creates a bumpier, less reliable overall investment experience
3. Makes you more susceptible to second-guessing your investment decisions

These three strikes tend to generate unnecessary costs, lower expected returns and, perhaps most important of all, increased anxiety.  You’re back to trying to beat a powerful market instead of using its wisdom to your advantage.

A World of Opportunities 

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.  

Your Take-Home 

To best capture the full benefits that global diversification has to offer, we advise turning to the sorts of fund managers who focus their energies – and yours – 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.