Diversification

Everyone claims to understand diversification, lots of people think they have a diversified portfolio. Lots of people think that reading history will keep them from making the same mistakes other people made. After 3000 years of war, and 2000 plus years of recorded history, someone will have to explain to me how studying history prevents war.
So, now we know that what lots of people think is crap. That is, it is not just useless, what most people think is detrimental to their investment performance.
Where to people go consistently wrong in diversifying? If you look at almost any individual’s so called diversified 401k, for instance, you’ll see several different mutual fund selections. When you dig into the holdings of these different funds, you find that 40%, often more, of the same stocks are in each mutual fund. Quit looking at the name of the fund, look at what the fund buys to find out if you’re diversified. One man’s growth and income is another’s value. One manager’s growth at a reasonable price is nothing more than the typical list of big names you can find in any large cap stock portfolio.
There is NO SUCH THING as sector analysis, top down market timing, bottom up market timing, dividend plays or allocation strategies (dressed up market timing.) There is no such thing as “growth” for that matter. In a large actively followed market, any of the ones you are likely to invest in, there is no such thing as “value.”
Every actively traded stock is priced to reflect all the information that is known and can be known about it. It’s past earnings, its past earnings relative to other stock in its market, it earning prospects, its cash flow, or lack of it, its debt structure, market shares, products in development and the prospects for products in development are all known quantities. Hundreds of thousands of intelligent knowledgeable investors have put their money into it, or taken their money out of it, all based on the same factors available to everyone else. You do not possess any special information, you do not have any special ability or mystical powers. You cannot outguess the collective wisdom of all other investors. You broker can’t, money managers can’t, Zelda the mind reading dog can’t.
Within any given asset class, there is only one way to diversify, buy different things. Different, not the same 40 stocks packaged in 3 mutual funds with different names. If you insist on buying mutual funds, or if you have no choice, as in a 401k, then you have to take time to look under the hood and make sure you are really diversifying, by examining the stocks each fund holds.
For the stock portion of your portfolio, always use only ETFs, Exchange Traded Funds if possible. They have little turnover, buying and selling, unlike your mutual fund who likely can’t seem to find a stock they like for more than 6 months. Every time they change stocks, guess who pays the bill?
In stocks, there are only three kinds, no, not too hot, too cold and just right. The three kinds I’m talking about are large, medium and small. This refers to market capitalization, how “big” the company is. This only matter for one reason, risk.
Across the universe of stocks, it is generally true that big stocks have a bit less risk than middle sized ones, and small ones have the most risk. In general, then, small stocks perform better than their bigger cousins. Except that’s not exactly true. For the most part, mid size stocks do the best, go figure. I’m not going through all the proof here, you don’t believe me, go to the various ETF websites and do some hypotheticals. I’ll be here when you get back.
Therefore to diversify within your stock allocation, divide up your money into the three sizes, equally will do. You’ll understand why when I get around to rebalancing.
T o diversify in bonds is fairly simple. I’ll explain that in a special section on bond, or fixed income investing.