Chapter 13
Buy-Hold Myth #4: Diversify Your Portfolio…That's All You Need to Do

One evening after coming home from work, Rob fell over the ottoman, righted himself, and looked up to see his wife Laura crying. “Don't worry, honey, I didn't hurt myself. You know I always trip over that darn thing, and I'm always okay.”

“That's not why I'm crying.”

“Do you want to tell me why?”

Laura sniffled. “You'll be mad at me.”

“No, I won't.”

“Oh, Rob, I've been a snoopy-nose.”

Rob waited.

“I opened your mail,” said Laura. “The letter from our financial advisor.”

“Oh, honey,” Rob said, giving her a kiss. “That's our mail, not mine. It's okay.”

“No, it's not! We're down a lot of money!” Laura said, bursting into tears again.

“Listen, don't worry. Our portfolio is diversified, so we should be fine. It's probably just a mistake. I'll call Mr. Smith tomorrow and set up an appointment. Okay?”

The next day, Rob and Laura sat in front of their financial advisor.

“Don't worry,” said Mr. Smith, “You're well diversified, and it's worked wonders for you.”

“I'm so relieved,” said Laura. “So we haven't lost any money?”

“The market dropped 50 percent, but your portfolio went down only 30 percent.”

“Thirty percent?!” Rob jumped up out of his chair. “Did you say we lost 30 percent?”

“I don't see why you're so upset,” said Mr. Smith, “I thought you'd be thanking me. As I said, you could have lost 50 percent, but…”

“But we only lost 30 percent?!!” said Rob. “We're paying you a fee to help us lose money and we should thank you?”

“Oh, Rob!” said Laura.

Many investors put their faith in diversification, believing that it will buffer their investments against bear markets. Unfortunately, as Rob and Laura found out, they're only partially right.

Put Your Eggs in Different Baskets

Don't get me wrong. Diversification is a good investment strategy. By filling your portfolio with various types of investments that behave differently in the same market environment, you can reduce your risk. In a perfect world, when one of your investments goes down a dollar, a different one goes up a little more than a dollar. This “negative correlation” is the basis of diversification. For example, bonds tend to go up when stocks go down, and vice versa, which is why it's good to have a blend of these assets in your portfolio.

We use mutual funds and ETFs to help our clients diversify their portfolios, advising a blend of U.S. large-cap growth stocks, large-cap value stocks, small-cap growth stocks, and small-cap value stocks, all of which tend to perform differently, even during the same time period. We also diversify by geography by including stocks from Europe, Asia, Latin America, and other places around the world, as they act different from the U.S. market. We include bonds in the mix, which are also diversified with U.S. treasury bonds, U.S. corporate bonds, and foreign bonds. We then balance the foreign bond section of our portfolios by choosing bonds from across Europe, Japan, and the emerging market countries. We make sure all of our eggs aren't in one basket.

By spreading your risk across various asset classes and styles of investing, you can smooth the bumpy ride of the market. Even a bull market can be an emotional roller coaster, dipping up and down as much as 19 percent. Investors who are diversified feel the downs less dramatically, since diversification tends to mitigate that downside. Take a look at the chart in Figure 13.1. You can see that a diversified portfolio (the gray line) didn't lose as much in the great bear market as the undiversified portfolio (the black line). You can also see that both portfolios went down.

Figure 13.1 Balanced Index Portfolio

Diversified Index Portfolio (60/40) is a mix of 35 percent Russell 3000 Index, 17 percent MSCI EAFE, 3 percent MSCI EM, 40 percent BarCap Agg, and 5 percent FTSE NAREIT Index. Indexes are unmanaged and cannot be invested in directly.

Source: S&P 500.

A nondiversified portfolio is like a racecar. It can be a fast ride, but boy, you really have to work that stick shift. You have to shout over the engine noise. You feel every little bump in the road. Once we retire, most of us prefer a more relaxed ride. Diversification gives us that extra bit of comfort.

Source: Randy Glasbergen.

A Junk Drawer of Investments

But most investors diversify haphazardly. They see an analyst on television who tells them they should buy ABC stock, so they do. They read an article in a financial magazine touting “the Top 10 Mutual Funds of the Decade,” so they buy the top four in the magazine's list. They listen to their bankers who advise them that the cash sitting in their accounts would be better invested in XYZ company, so they buy that stock. Little by little over the years, they accumulate a bunch of different assets. That amalgamation of assets doesn't necessarily provide investors with the risk reduction they would get from a properly diversified portfolio, but it does provide a false sense of security. They feel like they're diversified, but instead they've created a junk drawer of investments.

Even worse, investors listen to people who tell them to close the junk drawer. “Because you're properly diversified,” the buy-holders say, “you can sit back in your hammock and sip mint juleps, and your portfolio will take care of itself.” Sounds great to the investors, who then follow that advice, shut their drawers, and dream of opening them years later to find them overflowing with cash. But think about the investors who followed that advice in 2007. When they came back in 2009, their junk drawers weren't overflowing. They didn't even have the amount of money they had in 2007. In fact, some of those investors' drawers were nearly half empty.

Source: Randy Glasbergen.

Believe it or not, some financial advisors really do believe it's okay to lose money in a bad market. In 2008, I read several articles that offered advice about helping clients cope with the bear market. The number one tip? Remind clients that they are diversified. Sure, diversification did mitigate investors' losses during the bear market. But it wasn't enough. Unfortunately, it's impossible to find investments that are negatively correlated all of the time. Between 2007 and 2009, almost every asset class went down. Even a well-diversified portfolio didn't save investors who stayed in the market.

Diversification Isn't Enough

Steve and Danno were buy-holders who “invested for the long-term.” Steve had $250,000 invested in a properly diversified portfolio. Danno also had $250,000, but he had invested in an index that exactly mirrored the S&P 500.Then the 2008 bear market hit.

The chart in Figure 13.2 shows that diversification worked. Steve, the properly diversified investor, ended up with $31,520 more than Danno. But both investors still lost money. They started with $250,000, and in just one bear market, Steve was out nearly $100,000, and Danno lost over half of his investments.

Figure 13.2 Diversified Portfolio after the Fall

Note: Value on March 2009 based on $250,000 initial investment on October 2007.
See appendix for diversified portfolio allocation.

Source: GSAM; Ibbotson.

But being good buy-holders (and not having read Chapter 12), they believed their faith would be validated when they caught the inevitable rebound after the bear market was over. As the chart in Figure 13.3 shows, the rebound was fantastic. After 18 months Steve made 48 percent and Danno made 39 percent. You'll note, though, that even after 18 months neither investor had recouped their original investment.

Figure 13.3 Diversified Portfolio—The Rebound

See appendix for Benchmarks and Blend allocation.

Source: GSAM; Ibbotson.

This example didn't account for Steve and Danno taking living expenses out of their investments. Nor did it account for inflation or taxes. If they had been typical retirees who needed their investments to live on during those years, they would have been in trouble.

Buying a Drill Bit

When you go to the hardware store to buy a drill bit (the piece of metal that fits on the front end of your drill), what are you really buying? You're buying a hole. You don't really want that piece of metal. That piece of metal is a pain in the neck. You have to store it somewhere, you have to find it when you need it, it has to be the right size…You don't want all that fuss, you want the hole. The drill bit is just a tool, a means to an end.

Diversification is a tool, too. You really don't want a bunch of different stocks and bonds and treasuries. You don't even want green paper with zeros all over it. You want security, freedom, convenience—all the things that money buys. And though diversification can be an efficient tool, in bad times, it may not give you what you need. There were many periods during the past 80 years in which diversification was not enough. We experience a bear market every three years on average. Every three years, you stand a chance to experience substantial losses, losses that may be mitigated by diversification, but are still significant. Do you want to take that chance with your retirement? When it comes to your financial security, diversification is an incomplete strategy. It's a “spread-your-risk plan,” not a “get-out plan.” You need both. In bad times, cash is king. The only way to avoid losing money in a bear market is to be out of the market.

Diversification does work. You should diversify by putting your eggs in more than one basket. But you should also be prepared to grab those baskets and run if a bear comes along.