Rule #4: Diversify Investments (Investing 101) (video)

– Posted in: Investing For Beginners

The fourth of the Ten Rules of Investing For Beginners is: Diversify stocks! If you fail to do so you carry uncompensated risk—because the market will not reward you for carrying risk that can be diversified away. And also, diversify stocks with bonds to get the magical benefit of uncorrelated assets. Easy, learn how! It’s investing 101.

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Read the transcript to Diversify Investments! It’s investing 101.

Learn the great advantage of owning poorly correlated assets.

Learn the great advantage of owning poorly correlated assets. This part is truly cool! “Magical.”

Previously we saw how owning many stocks eliminated “specific company risk”, which is risk that can be diversified away. Now we are going to see that it is not enough to simply own hundreds of companies. You’ll learn the great advantage of owning poorly correlated assets. This part is truly cool! “Magical.”

Diversify stocks by owning all of them

To help me show you, let’s imagine two companies: Bathing Suits Inc. and National Umbrella Company. A rainy year means sales at the Bathing Suit company fall but the umbrella company does well. In a sunny year, the bathing suit company does well and the sales of umbrellas fall.

The price of these company stocks move in opposite directions so they are negatively correlated. The Bathing Suit company is more volatile because the total annual return has an average value of 7% but a variable component of plus or minus 1%. This is both higher return and higher risk than the umbrella company which has an average return of 3.5% plus or minus 1/2%.

"No correlation" is when the value of two assets (say, stocks) don't move together.

“No correlation” is when the value of two assets (say, stocks) don’t move together. To illustrate this I’ve selected the rare situation where they two stocks move in exactly opposite directions at the same time (perfect negative correlation).

This is the magical part. Look what happens if you invest 2/3 of your money in the umbrella company and 1/3 in the bathing suit company. WOW! Adding some of the more volatile company not only increases the average return, but it lowers the variability (or risk). Pretty much a free lunch!

Here what it looks like on a risk-return chart. The Bathing Suit Company is up here with twice the expected risk and return as the umbrella company. If you owned 100% of the umbrella company you’d be here. Now if you gradually invest part of your portfolio in the more risky Bathing Suit Company, your returns increase as you expected, but your risk, as measured by the variability of that return, actually decreases. Owning both is superior to only owning either of the companies.

Further, diversify stocks with bonds

Negatively correlated companies are hard to find and still achieve diversified investments, so we look for the next best thing: poorly correlated investments. Recall that the price of bonds move in the opposite direction of interest rates. But interest rates don’t impact the sales of bathing suits and umbrellas at all, and the weather doesn’t impact the price of bonds. So we pretty generally say that the stock market and Treasury Bonds are nearly uncorrelated and we get this same magical benefit. Adding a little of the stock market to an all-bond portfolio not only increases the returns but decreases the risk.

The practical takeaway is that everybody should own between 20-80% bonds.

Surprisingly, the result is not what you would expect. Instead, you get more return for the same amount of risk (or, the same return for lower risk).

This is precisely how it works in the real world. Say you determined that 50% stocks and 50% bonds was the right level of risk for you. Instead of being here like you might expect, the fact that stocks are poorly correlated with bonds puts you here. You can think of it as less risk for a given rate of return, or more return for a given level of risk.1

What else can we do? If we take a closer look at stocks, we find out that the primary factors that determine the outcome of stock investments in the long-term are: size of the companies, whether they are a glamorous growth company or a less glamorous value company, and then what region of the world it is in.2

The S&P500 companies are so huge that this famous benchmark index is a good approximation of the entire US Stock Market. It encompasses both large Value and large Growth companies. Alternatively, choose a Total US Stock Market Index fund to further diversify with smaller companies and to now own a portion of several thousand companies!

Stocks in foreign companies are even less correlated3 with the US stock market, but are more expensive to own and have added risk from currency exchange fluctuations. Many investors make 1/4 to 1/2 of their total stock percentage a broad international stock index fund.

You’ve started a plan with goals and a saving routine that might look something like this. In the last video you choose an appropriate level of stocks and bonds that matched your ability, willingness, and need to take risk. That’s always your most important decision. So, here is what your target allocations might look like now.

Bonds are much simpler. You can keep the risk out of bonds by keeping them short- to intermediate-term, and very high quality. To diversity against inflation it is popular to make half of them US Treasury bonds called “TIPS”, for Treasury Inflation-Protected Securities.

Building an outstanding portfolio doesn’t have to be complicated at all!

Find other explanatory videos, smart tips, and links to useful resources at FinancingLife.org.

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Footnotes and Video Production Credits for Rule #4: Diversify Investments (Investing 101)

(1) The benefits of poorly correlated assets is today known as Modern Portfolio Theory for which several won the Nobel Prize. This particular Stocks & Bonds chart reproduces one in All About Asset Allocation, by Richard Ferri, 2006, p.45.
(2) The importance of company size and style (growth vs value) for predicting stock investment outcome is today known as he Fama-French Three Factor Model.
(3) The correlation of various asset classes to the S&P 500 Index is listed in The Only Guide To A Winning Investment Strategy You’ll Ever Need, 2005, by Larry Swedroe, p 144.
The opening/closing music “Because” is by David Modica from his Stillness and Movement album, published and licensed by www.Magnatune.com.
The closing photo “Trees in the Fog” is by Yann Richard under the terms of the Creative Commons BY 2.5 license.

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