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| Course 503:
Diversification |
| Diversify a Little, Diversify a Lot |
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The answers to these questions--which assets you should own and in what proportion--lie in your objectives and constraints. Return, risk, time horizon, liquidity, and taxes all play a role. A diversified portfolio will be made up of asset classes that are not correlated with each other--meaning as one asset class rises or falls, the other asset classes will more than likely not move in the same direction. This multi-asset, risk-conscious approach gives the portfolio resiliency in different market environments.
College-bound high-school seniors all worry about what college they’ll get into, but they can practice very different application strategies. Some fill out just a few applications, but labor over each; all forms are neatly typewritten and every essay is carefully crafted. Other students take a different approach, feverishly sending out applications to 15 good colleges. These students can't spend as much time on each application, but they hope that by spreading their bets around, some admissions officer, somewhere, will give them the nod.
Here’s the parallel to the investing world. On the one hand are investors like Warren Buffett and Marty Whitman, who believe that focus is key to success. Research particular investments meticulously, they counsel, and when you find one you like, load up. If you know--really know--that an investment is great, there’s little risk in devoting a huge chunk of your portfolio to it. Overdiversifying, in this view, just leads to shoddy work.
On the other hand are investors--including most financial planners and academics--who believe that diversification is the best, if not the only, way to reduce risk. The more efficient that you think securities markets are, the more you’ll lean toward this view. (Efficient-market theory says the more quickly information comes to the marketplace and the more rapidly it’s reflected in market prices, the more highly efficient is the market.) After all, if markets price stocks and bonds correctly, it’s rather foolish to waste time looking for just a few great investments.
But no matter what your view is on market efficiency, you can still argue that widespread diversification is the best policy. The human ego being what it is, it’s all too easy to convince ourselves that we’re little Warren Buffetts, able to find great investments. Humility counsels us that no, we’re not that good, and that we’re better off hedging our bets through diversification.
Next:
The Best Approach >>
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