March 12, 2012, 11:23 AM
By CARL RICHARDS
Article from New York Times
Carl Richards is a certified financial planner in Park City, Utah. His new book, “The Behavior Gap,” was published earlier this year. His sketches are archived here on the Bucks blog.
Many of us learned the lesson years ago: don’t put all your eggs in one basket. But when we start to call it diversification, we forget the simple things that make this concept so powerful. What follows are a few thoughts on diversification that might spark a conversation about money in your home or office.
Before we begin, let’s start with a couple of assumptions:
You’re using broadly diversified mutual funds in your portfolio.
When we mention bonds, we’re talking about bonds that are high quality and not junk bonds.
I know there’s a ton we could talk about just in terms of what those two assumptions mean, but for this post, let’s just leave them be. Now, on to the interesting stuff.
1) Asset Allocation: How you divide your investments between bonds and stocks will be one of the most important decisions you make, and it is far more important than the question of which bonds or stocks you actually choose. Sure, those things matter. But you should only address them after you decide on an allocation gives you the best shot at reaching your long-term goals.
2) Correlation: The reason we diversify is because we want to own investments that move in different directions at different times. We want one to zig when others are zagging. The reason you include bonds in your allocation is to counter the times when the stock market is down (remember, I said high-quality bonds). This is true when we talk about including international stocks in a portfolio.
The main reason to include international stocks is because they often act slightly different than domestic stocks. You can make the same argument for stocks of small companies versus large companies, value companies versus growth companies, real estate stocks and even commodities. Your goal is to consider portfolio options that act slightly differently than everything else in your portfolio. If it acts the same and has the same expected future return, why add it?
3) Temptation: When you diversify correctly, you will usually have something in your portfolio that you don’t like. Just remember that it will probably change next year. This year, maybe your international fund will do well. But that creates a temptation to get rid of everything else and move all your money to the international fund.
Resist that temptation! Things change. Next year the investment you wanted to fire might turn into your new favorite. This process is likely to repeat. So instead of making the classic mistake of moving all your money to an investment that just did well, remember that the winners in a properly diversified portfolio will probably rotate.
4) Concentration: You can make a lot of money by being concentrated instead of diversified, but you can also lose it all. Often you hear people say that diversification is overrated. It’s easy to find examples of people who have gotten insanely wealthy by laying it all on the line with their business or investments, but what we often forget is how many people lose it all doing the same thing. Betting it all might be exciting and celebrated in our society, but slow and steady still seems to be the best way for the most people to have the best chance of winning the race.
5) A Real Financial Plan: Design your portfolio based on your life and not the markets. Your asset allocation should reflect your goals. If you do it that way, you should only make changes when your goals change, not when the market does.
Despite knowing better, I continue to see people ignoring the lessons of diversification. Are you one of them?
Article from New York times
