How Investment Diversification Makes You Rich

This article was originally published on ETFTrends.com.

What is your investment strategy? Do you even have one? Or do you just invest in whatever is hot at the moment, hoping you will crush it and be able to retire in a few weeks? Sadly, this investing strategy is ripe for failure. The only true way to “crush it” in the market is to use investment diversification to your benefit.

You might point out however that you’ve picked a hot stock here or there in the past and did end up crushing it. While that could be true, the reality is there are many more times where you invested in the stock of the day and lost your shirt.

No investor, over the long term, consistently picks the best stocks every single time. The fact that the average investor only earns 2% per year while the stock market earns 8% proves this. So while you might get lucky here and there, the better option is to invest in a well diversified portfolio.

By using this simple strategy, you can earn more money investing and even limit your losses. Sadly, 99% of investors out there ignore this and lose money as a result.

The Fallacy Of Market Timing

The vast majority of investors, including myself during my early years of investing, are market timers. They get in when the market is rising and they jump ship when it is falling. They typically give in to their emotions when they should not be listening to them.

A classic market timer probably became so scared in 2008 that they pulled everything out of the stock market and stayed out until a few years ago. They bought back in and are now worried again because people are talking about the market hitting all time highs.

While it seems simple to time the market, it is actually much harder to do in real life. Too many people will sell once the market reaches bottom and they won’t get back in until close to or at the peak of the market. In fact, investment professionals have made this cycle into a chart.

This classic scenario plays itself out over and over again. Next time you are talking with friends or family members and the topic of the stock market comes up, ask them what their strategy is. After about 30 seconds it will become clear they jump in and out of the market. Note that market timing isn’t just completely pulling out of the market. Switching investments or “chasing returns” is the same exact thing. Just look at what missing a few of the highest-earning days does to your return.

Your return is almost cut in half by missing the 10 best days! Good luck at guessing when those days will happen.

The Power Of Investment Diversification

While everyone does get lucky every now and then from timing the market, it is not a sustainable formula for success. I would even venture to say that most investors have probably lost more than they realize, they just focus on that one investment they crushed the market with. This isn’t a fault of theirs; it is how human beings are wired.

To show you that market timing doesn’t work, I want to play a little game with you. I’d like you to look at the picture below and see if you notice anything.

This isn’t a trick quiz where if you stare long enough an image appears, and it’s not a Tetris map either. Just see if you can spot a pattern.

My guess is that you did not see a pattern. This is good, because there is no pattern to be found. The colored boxes each indicate a benchmark of the stock market from 1997 through 2017, ranked by the best performing benchmark for a given year. Here is the exact same chart again, only this time with labels for you to more easily follow.

As you can see, one benchmark does not dominate the top of the chart. Each one is all over the map. Let’s look at a few examples more closely.

International Stocks: How have international stocks done over the past 20 years? Varied widely in returns is one way to put it. Here is the above chart again, only this time I am highlighting the performance of international stocks by using the red arrow.

You will see that in 1997 international stocks were the worst performers. But come the next 2 years, they were the best performers of the market. Then they plummeted to the bottom for 2 more years, only to rise once again.

U.S. Stocks: While international stocks tend to have more volatility associated with them, large U.S. stocks too are all over the map. Below is a chart of their performance over the past 20 years.

U.S. stocks do pretty well until 2000 when the market crashes. They stay at or near the bottom until 2007, only to drop again and move up and down after that.

Real Estate: One last example to show you. Let’s look at real estate. For those who do not know, the historically typical return for real estate is around 3% a year. When you hear people talking about getting rich in real estate, it typically happens through renting out the property and not through price appreciation.

This is not to say prices don’t rise, but not like they have recently. Looking at the chart below, real estate is a strong performer from 2000 through 2006. Then the bottom fell out in 2007. But in 2009 it came roaring back for a short run, only to fall again.

The Need for Investment Diversification

For many investors, riding the roller coaster of real estate or international stock returns that I just mentioned would be too much. You wouldn’t be able to sleep at night with that much volatility. So what are you left with? Here are your options:

Pick a different sector/benchmark
Stay out of the market
Investment diversification

Let’s look at each one of these individually to see if they can help you lower your risk and stabilize your returns.

#1. Pick A Different Sector/Benchmark

If you are looking for a different sector or benchmark to invest in that is less volatile but still provides your needed rate of return, you are unfortunately out of luck. As you can see from the chart, all of the benchmark returns vary widely from one year to the next.

Some might try to argue the case for bonds, since they tend to be less volatile than stocks. While it is nice to see only two years with negative returns, in most cases, bonds aren’t going to offer you the return you need over the course of 40 years to save enough money for retirement or reach your financial goals.

And even though there are few negative return years for bonds, it looks like we are entering a new period for bonds. The Federal Reserve has been pumping money into the economy, keeping interest rates artificially low.

As they slow down this stimulus and stop it, the “bubble” that has formed in bonds is going to deflate. This could lead to either negative returns or close to zero returns for a period of time.

#2. Stay Out Of The Market

Your next option would be to simply stay out of the market. This too is not a good option. For one thing, you need the return on your money that the stock market provides so you can afford retirement. If you just put your money under a mattress you are losing out to inflation each year, meaning you need to save more and more money just to get by.

Another reason this won’t work is because even if you are successful at staying out of the market for a period of time, one day you will realize you have nowhere near enough money to retire. Trying to make up for lost time, you will put everything into the stock market at either the exact wrong time or invest in assets that are way too risky for you and lose everything.

#3. Investment Diversification

The first two options are not a winning strategy, but having a well diversified portfolio is. Investment diversification is a fancy way of saying not to put all of your eggs in one basket.

The more diverse the areas of the market you invest in, the better off you will be. A classic diversified portfolio example would be to split your investable money into two equal parts and invest half in stocks and the other half in bonds. You can see the power of this idea in this post.

The reason investment diversification works is because you are hedging your losses. Not all sectors of the stock market are going to increase every year. Look at the chart again and 1998 in particular as an example. International stocks, the orange boxes, did quite well; same thing in 1999. In fact, most investors would jump into international stocks at some point in late 1999 to ride the wave.

Then 2000 happens, a loss of 14%. You think it will get better in 2001, but it doesn’t; another loss, this time of 21%. Some investors will jump ship and cut their losses, while others will try one more year. 2002 results in another 16% loss.

By now you’ve had enough and sold out. Over the next five years, international stocks perform outstandingly.

Let’s look at this in terms of your money. Let’s say you did jump in with $10,000 at the end of 1999 to ride the wave. What happens to your $10,000?

By 2002 your $10,000 dropped almost in half. You end up with $5,700. If you have the guts to stay invested for another year, you would earn back some losses and end up with just under $8,000. But the reality is most investors would have already bailed.

At the end of the day, you don’t know what is going to happen in the market. If during this same period you had invested in a diversified portfolio of 50% in international stocks and the other 50% in bonds, you would have hedged your losses.

In fact, by the end of 2002, you would have only lost $400. And if you stayed invested through 2003, you would have ended up making over $1,000. All thanks to diversifying your investments. You can see this in the investment diversification chart below.

Some might argue that you are robbing yourself of higher returns by following this strategy. This is true only in the case that you pick the winners every single year. As it stands now, I know of no investor, not even Warren Buffett, who picks a winning stock every single year without fail.

Your best bet for success in the stock market is to invest a portion of your money into each of the sectors equally so you can be diversified. By investing in a well diversified portfolio, you are guaranteed to pick the winners every year. You will also be picking the losers, but this is actually not a bad thing.

How would this investment diversification strategy look and what would your return be? I’m glad you asked. Let’s look at a diversified portfolio example.

This diversified portfolio example takes 1/7th of your money and invests it in each of the sectors listed. The chart shows that an equally weighted portfolio (the white boxes in the chart) runs in the middle of the pack, which is to be expected.

The portfolio has healthy returns and doesn’t require you to pick the winner each year. As noted above, you will be guaranteed to pick the winner each year since you will own a piece of each sector in the market.

You might look at the equally weighted portfolio and see that the annual returns vary a great deal. While this is true, the idea is that by investing in this type of portfolio you are limiting your losses. Note that I said you are limiting your losses, not removing losses altogether.

You could lose money over the short-term, this is inevitable. But you need to keep your focus on the long-term because the long-term trend of the stock market is up.

Here is how $10,000 invested in each sector would look at the end of 20 years.

In all cases you would have grown your money nicely over the past 20 years. But many of you might point out that the well diversified portfolio ranks near the bottom of the pack for those 20 years, defeating the point of an investment diversification strategy.

While this is true, you have to remember that the majority of investors allow emotions to make decisions for them. In the real world, most investors sold out after 2008 and didn’t return until 2012 at the earliest.

I point to this because when I was working at a high net worth planning firm, our new clients at the time were still not in the market and were only considering putting money back in. So what would this look like?

Let’s say you invested $10,000 in 1997, sold what was left at the end of 2008 and invested that amount back into the market at the start of 2013 through 2017. What does your return look like?

You would still have made money thanks to the recent bull market, but you would have much lower returns than if you invested in a diversified portfolio and stayed invested for the long-term.

Your Plan For Investment Diversification

So what is the easiest way for you to become diversified? While you could slice the various benchmarks like I did above, there are some much simpler options out there for you.

Step One: Know Where You Stand

Your first step is to figure out how diversified you are. The best option here is to sign up for Personal Capital. With your free account, they will show you how diversified you are, create an investment plan for you, show you how much you are paying in investment fees, and help you see if you are on track for retirement.

I love how thorough and easy to use they make checking up on my investments. My wife loves them because she isn’t a numbers person and seeing how our savings relates to our future retirement makes it real for her. Click here to learn more about Personal Capital.

If, on the other hand, you want a more manual option, you can use Morningstar’s X-Ray Tool. You will need to enter in your holdings’ ticker symbols and the amount of the investment. From there, Morningstar does the rest for you.

While this option is good, you will have to manually update the numbers on a regular basis. So unlike with Personal Capital where everything is always updated to the minute for you, with Morningstar, you will have to re-enter everything every time you want to review your asset allocation.

Step Two: Make Changes

Once you understand your asset allocation, your next step is to begin making any needed changes if you aren’t diversified enough. Using either of the services above will show you where you need to add money to better diversify your portfolio.

But it doesn’t end there. You need to make sure you stay diversified going forward as well. This is where my book, 7 Investing Steps That Will Make You Wealthy, comes in handy. It will walk you through the steps to follow to ensure you are a successful investor.

Now let’s say you understand the importance of investment diversification but don’t have the time or interest to do it yourself? Luckily there are a few options for you.

The best two in my opinion are Betterment and Wealthsimple. Both are robo-advisors that will invest your money in a fully diversified portfolio, as well as reinvest dividends, rebalance, and tax-loss harvest your holdings.

What all that means is you can be completely hands-off and they will do everything for you. You can sit back and relax knowing you are in a diversified portfolio and are invested for the long-term.

Final Thoughts

If you read the magazines dedicated to investing or even watch the 24-hour investment news channels, you will quickly become overwhelmed with all the investing options. Investing doesn’t have to be complicated and neither does investment diversification. It’s actually very simple: invest in a well diversified portfolio with low cost investments, and stay invested for the long-term.

We’ve covered the importance of investment diversification in this post, and I’ve spoken about fund expenses in my outrageous fees post.

As for the long-term, you need to stay invested in the same mutual funds or exchange traded funds all the time for many years. This doesn’t mean sell out when the market drops, or your mechanic tells you about a hot new stock. If you stay invested through the ups and downs then over time you will be in a good place financially.

Just think of your investments like a raft in the water and just ride it out. With investment diversification, the waves will be much smaller than they would be if you keep jumping in and out of the water, trying to time the waves.

The following article was republished with permission from Money Smart Guides.