And so it goes, in a stock-happy world where mouse potatoes rule. Never has prudence seemed so pointless or classic investment advice so wrong. In recent years, you could double and redouble your money–easy, one-hand–even without owning Internut stocks. All you needed were large and prospering U.S. companies, such as Intel, General Electric and Microsoft.
The record shows that, from 1995 through 1998, big U.S. growth stocks did better by far than a typical diversified portfolio (big stocks, small stocks, internationals). From 1970 through 1998, they did about the same, as measured by Standard & Poor’s 500-stock average. So why break your head about how to allocate your assets? Why not buy an S&P index fund and be done with it?
Two reasons. First, history says that such super performance will not last. A stock group that rises this high, this fast, will struggle during the market’s next phase, and the change will not be announced in advance. Second, the S&P’s 30 percent returns since 1995 can distort your long-term view.
Triple play: Investors don’t understand how exceptional these recent years have been, says finance professor Richard Marston of the Wharton School in Philadelphia. The S&P has risen by nearly triple its historical rate. If you go back to 1970 and measure only through 1994, the S&P loses to the diversified stock portfolio, which also carries less risk.
Coming into the ’90s, no one knew that the big U.S. growth stocks were going to shoot the moon. The ’80s belonged to the international stocks, and the ’70s to smaller stocks. The best academic research showed that value stocks (stocks whose prices are beaten down) did substantially better than growth stocks.
“Back then, big growth stocks were for absolute dummies, the most conservative people out there,” says John Rekenthaler, research director of Morningstar in Chicago. “And 10 years later, what made the most money? Big growth stocks.” That’s also why you diversify–because you have no idea what will happen next.
Marston has an idea as to why today’s investor doesn’t diversify. He says it’s because we’re getting rich on the easiest stocks to own. Every country has a bias toward its own best-known stocks. When they soar, investing looks like a cinch.
But think about it: what if the big European stocks had been rising by 30 percent a year? Would you say, “Sell everything else, owning Europe is enough”? No way–and the very same principle applies to big growth stocks in the United States.
As a practical matter, you haven’t diversified when you own a portfolio of individual stocks. You won’t buy the right number and type to cover all the bases–the value stocks, growth stocks, small stocks and proper, global-industry sectors. “People buy what’s hot,” says financial planner Harold Evensky of Evensky, Brown & Katz in Coral Gables, Fla. “They don’t know what they’re doing.”
Naturally, people feel smart when stocks go up. But does your IQ drop when stocks go down? Either way, I call it luck.
Diversification steers away from luck. To make it work, choose mutual funds–especially index funds, which track different kinds of markets. At Vanguard, you could diversify with just three funds–Total Stock Market (for big and small stocks), Total International Stock and Total Bond Market. Professionals often use the funds constructed by Dimensional Fund Advisors. A 401(k) is a tougher nut. You do your best with the choices you have. At the very least, avoid loading up on your company’s stock, even if it’s been doing well. In a different market, one-stock investors are going to get killed.
You don’t diversify to outperform the S&P, although that can happen. You diversify to reduce your risk, says Ernest Ankrim, director of portfolio research for the investment-consulting firm Frank Russell in Tacoma, Wash. You won’t do as well as the best market in the world (discovered only in hindsight). But neither will you lose a big piece of your savings when a market drops.
A baseline: There’s no “right” investment mix for everyone. A baseline might be 30 to 40 percent bonds, 30 percent big U.S. stocks, 20 percent smaller U.S. stocks and 10 to 20 percent internationals, including 5 percent in emerging markets. If you’re older or more conservative, you’ll hold more bonds. If you’re younger or aggressive, you’ll hold more stocks. As one test of how much risk you can bear, ask yourself this: if stocks dropped by half, would I still be OK? If the answer is no, you’re too exposed.
Some diversifiers pick a comfortable mix of stocks and bonds and stay there most of the time, rebalancing when their portfolios get out of line. Some switch around, trying to pick “undervalued” sectors. Today, that might be internationals and smaller stocks, although maybe there’s something else that we fail to see.
Gary Brinson, chief investment officer of Brinson Partners in Chicago, picks a baseline mix for a particular objective, shifting only when he thinks that markets have reached an extreme. This is one of those times. He has moved away from U.S. and international stocks and gone heavily into bonds. Here’s the pitch for quality bonds, either Treasuries or municipals. They preserve a piece of your principal, if the market or the economy goes bad.
Once you’ve calmed your twitchy mouse finger and diversified, there’s a final step. You have to treat your investments as a single unit. Say, for example, you’re two thirds in stocks and one third in bonds. When stocks decline, you won’t lose as much as you would with an all-stock portfolio. But you won’t fully understand that you’re better off–and should stay the course–unless you average your stocks and bonds together. If you look only at the stocks, you might panic and sell, just when you should be buying, instead.
Diversification can save you from losing your nerve.
