Why Diversification Matters

January 25, 2011

Last week a friend and I were catching up on life over lunch. This particular person happens to be an extremely knowledgeable investor, and he generally enjoys trying to pin me down on what may happen with the market, economy, interest rates, and the like.

 

And while he knows my feelings about predictions, we went on to chat about what is going on in the world; and, what various circumstances may or may notmean for holding different investments.

 

At one point I asked if he was diversified, or had a plan, for whatever may happen.

 

“My portfolio is well spread out over ten stocks. I’m diversified.”

 

And over a great Caesar salad, I heard a familiar story about the value of “placing all of your money in one basket, and watching that basket.” I heard again about investor-extraordinaires who called the last downturn exactly when the market turned, and how Warren Buffett’s Berkshire Hathaway only owns a handful of stocks.

 

But beyond the same conversation we’ve had several times before, there was something else he wanted to discuss that day; a deeper reason for his needing to know what the market may do next, and I could detect a level of worry that was not always noticeable in our past talks.

 

You see, my friend is of a normal retirement age, and has been out of the workforce for the last few years. He went back to school to pursue a certificate in an unrelated field; he graduated with flying colors. The conversation we were having began to flow from investments to how his original plans involved his working again to make retirement work.

 

We went on to discuss that while he isn’t drawing on his portfolio yet, there is an ever growing likelihood he would soon. There are daily worries over any number of things that may cause that to happen; a car engine on its last legs, a furnace that needs replacing. And, while he has his health, that too was another topic of concern.

 

He knew he had saved a decent amount during his first career, but not as much as he could or should have. Due to anxiety during the downturn, he pulled out of the market close to the bottom, and returned late after the majority of the rebound.

 

I went on and shared with him how we may have our disagreements when it comes to investments, but no matter what beliefs, ideas, or philosophies an investor has, for people diversification is critical. It was the number one reason for his worries I said to him; his retirement plan had turned into a gamble over what stocks would be success stories, when the odds (and his own history) were not in his favor.

 

Still unconvinced, he presented his case… and being nervous about loss, he countered all of his own points for me.

  • The commentators are saying bonds are in a bubble and to invest in inflation hedges… but of course there has been no inflation to speak of yet.

  • And, the economy looks like it will continue to do poorly so should I pull out of my stocks… but, the market has had two above average years of growth.

  • Domestic stocks certainly won’t grow compared to foreign companies… but, it is a global economy, and look at the problems they’re having in Europe.

 

My friend’s answer to his financial dilemmas fell back on getting everything right in the market on an almost daily basis. He was watching his account performance day-by-day because his timeline, or time preference, for needing to cash in his investments may change that quickly.

 

The money managers he watches on television can have a bad week, month, or year, and can still be tops in their profession. The institutional investors whose research he reads don’t have to worry about unexpected car replacements, or health concerns.

 

As I thought about what else I could say to help, what came to mind was a simple alternative mindset about his investments. Instead of an all-or-nothing strategy, look at your savings in a ‘multiple portfolio’ approach.

 

multiple portfolio approach involves seeing the different needs for your investments within the overall structure. Picture a different bucket for every unique goal you have for your money — an example in this case being a separate portfolio for each year of retirement — with all of the buckets together making up your portfolio.

 

Knowing for the next four years my friend would need to supplement his income for $5,000 of living expenses, and $3,000 as a gift to pay for a Grandchild’s tuition, he would never invest that combined $32,000 in the market. If his car won’t make it another five years, that’s another goal to add that to the conservative piece as well.

 

I don’t know if it helped, but it seemed as though there was an ‘ah hah’ moment where the risks he was taking with the portion of his money he needed to have absolute faith would be available for use, when he needed it. And, that is why diversification matters.

 

The preceding blog was originally published by the Financial Planning Association®(FPA®). To view the original blog please visit the FPA Web site

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