Sketch Guy: Diversification Isn’t Broken, It Just Takes a While

It’s a classic moment in sports history. With less than 20 seconds left in Game 6 of the 1998 N.B.A. finals and the Chicago Bulls down by one, Michael Jordan goes one-on-one with Bryon Russell of the Utah Jazz. He pushes off (clearly!), Russell stumbles and the ball hits nothing but net. Game over. Bulls win.

Now let’s imagine that something different happened. Jordan misses the shot in Game 6, and Game 7 comes down to the same spot: fewer than 20 seconds left with the Bulls down by one. If you’re Phil Jackson, the head coach, do you set up the last play for Jordan, or does the ball go to someone else? Remember, Jordan missed the night before.

Of course the right strategy is to put the ball in Jordan’s hands. Just because he missed the shot before doesn’t mean it was the wrong strategy to have Jordan shooting the ball in the final seconds. The odds are incredibly high that he will make the shot even though he missed it the night before.

I bring this up because it perfectly captures the investing adage that never seems to die: diversification is “broken.” It seems as if this story pops up every year, but it’s not really about anything new. Both Joshua M. Brown at The Reformed Broker and Barry Ritholtz at The Big Picture have written blog posts about it recently. Mr. Brown quoted an adviser who said:

“Why bother diversifying at all? It’s just a drag on performance. What’s the point of owning any bonds or international stocks?”

So here’s the 2013 version of the diversification story.

Let’s say at the beginning of 2013 you finally decided you were going to stop pretending to be a trader and instead be a long-term investor. You were going to do what most of the academic research recommends and build a diversified portfolio of low-cost investments. Then you planned to hold on to it for a long time.

As part of your new plan, you put something like 30 percent of your portfolio in international mutual funds. Now seven months into the year, you’re disappointed because international has done poorly relative to your Standard & Poor's 500-stock index fund. In fact, year to date, your S.&?P. 500 index fund is clearly the only place you should have put all your money. Its gains have been twice those of almost any other major asset class.

Obviously, it was a mistake to diversify, right? Wait. Before you answer, let me share one of my favorite stories about diversification.

In 1998, the S.&?P. 500 ended the year up 28.6 percent. But nothing else was really performing. Small-capitalization stocks were down 2.2 percent, and small-cap value stocks were in the tank. The temptation to go all in on large-cap technology stocks proved to be too much for most of us. After all, nothing else was working.

Now fast forward to 2001. The tech bubble had burst. The S.&?P. 500 was down a bunch in 2000 and ended 2001 down 11.9 percent. Based on those numbers, it’s fair to assume the stock market was terrible, right? Well, it depends on which market you were talking about.

Remember those small-cap stocks that everyone was complaining about in 1998 and ’99? Sit down for this. In 2001, while the S.&?P. 500 was getting crushed, small-cap stocks returned 17.6 percent. And small-cap value stocks, down 10 percent in 1998, ended 2001 up 40.6 percent.

Wild!

I suspect your first thought to this example is, “Why not just buy things right before they go up and sell before they go down?” Let me save you a lot of money and many headaches. It’s all but impossible for investors to catch all the up while avoiding all the down. But it can be equally difficult for us mere mortals to stick with diversification because it looks as if we should be able to time the market, and, well, diversification isn’t sexy or exciting.

First, diversification works over time, and no, seven months doesn’t count. When we talk about diversification working, we’re talking in terms of years, even decades. Not just days, weeks or even months. In other words, we’re talking in investing terms, not trading terms. We don’t like things that take a long time to work. We want to know what’s working now.

Second, diversification is not exciting. It’s the investing equivalent of hitting singles and doubles your whole life, and who grows up wanting to do that? We want to hit home runs. Players who try to hit home runs every time (like timing the market) are going down swinging in a blaze of glory or knocking it out of the park. Either way, it’s cool, sexy and exciting — all the things diversification is not.

Finally, diversification can look like a mistake at any given moment. A well-designed and diversified portfolio will always have something that’s not doing well, a few things that are average, and, hopefully, one or two things that are exciting. The problem, of course, is that the investments change places about the time you’ve had enough and you decide it’s time to boot out the underperformers. It’s human nature to run from things that cause us pain and get more of the things that bring us pleasure. It’s why we look for ways to “fix” our portfolios.

It may seem counterintuitive, but if you have something in your portfolio that you’re complaining about, it’s a good sign you’ve built a diversified portfolio. And if that’s the case, you’re probably complaining right now about international mutual funds and wondering why you aren’t invested 100 percent in the S.&?P. 500. But as Mr. Brown so wisely notes, “Five months still to go, anything can happen …”

Next year, there will be a different story about why diversification is “broken,” but all it takes is looking at the year before that, then 5, 10, 15 and 20 years before that to see why you want to hit singles and doubles for the rest of your investing life. Personally, I’d rather save my energy for other things besides trying to second-guess which market will take off next. I’ve got better things to do. Don’t you?

Bucks: Let Diversification Do Its Job

Carl Richards

Investors typically set up a diversified investment portfolio to reduce their risk. Just hold a good mix of different kinds of stocks, along with some bonds and cash, and your problems are over.

Right?

Not exactly. Diversification comes with its own risk. But before we get to the risk, let’s talk about how we define this term in the first place.

When people say diversification, they’re often talking about two separate things. First, there’s equity diversification where you split up the portion of your money invested in stocks among big ones, small ones, undervalued ones, international ones and so on.

The idea behind this strategy is that you can reduce your risk, since different types of stocks often behave differently depending on market conditions.

Sometimes, it works. Dimensional Fund Advisors reported that in 1998, the large company stocks that make up the S.&P. 500 gained 28.6 percent while small-cap value stocks lost 10 percent. Then in 2001, the S.&P. 500 was down 11.9 percent, while those same small-cap value stocks gained 40.6 percent.

Since it does help sometimes, equity diversification is a useful strategy. Do it. But you have to understand that equity diversification sometimes fails to deliver exactly what you expect it to and often fails when you need it most.

We saw this in 2008-2009, when almost every type of investment fell. Granted, diversification would have saved you from making a mistake like putting everything in Lehman Brothers stock, but you still saw equity holdings plummet.

If you think back to that time, you will most likely remember hearing people say that diversification was broken, that it no longer worked. I remember thinking that myself.

But remember, when that happens and people start running around again saying diversification doesn’t work, they’re talking about equity diversification. There’s another, more important type of diversification: the way you split your money between stocks, bonds, cash and other investments.

This portfolio-level diversification is the primary lever to help you manage the risk and return in your portfolio. Each type of investment plays a different role:

Stocks provide the growth.Short and intermediate bonds provide more safety and a little income.Cash is there for liquidity and to protect your money.

The idea is to balance these investments in a way that gives up some higher returns in exchange for lower overall risk. Essentially, you’ve given up the opportunity to hit home runs for the benefit of never striking out.

With that out of the way, let’s talk about the risk of diversification.

Whenever you diversify, if you’ve done it correctly, there will always be something in your portfolio that you’re in love with and something that you want to dump (or will at least be the source of concern, as bonds are now in some circles). Some investment or asset class will be doing fantastic compared to the rest of your portfolio, and something will be doing much worse than everything else.

The trouble is, you never know when all of this will change. The thing you want to buy more of now will someday become the thing you want to sell.

Think back to the example from 1998. Having lived through it, I can tell you it was awfully tempting to move all your money out of small-cap value stocks and into large-cap stocks. But that would have been a terrible decision given how well small-cap value stocks did just two years later.

The same is true when you diversify among stocks, bonds and cash. When the stock market is tumbling like it did in 2008, you want to move everything to cash, and it’s really hard to keep money in bonds or cash when the stock market is having one of those great years.

But here is the point. The risk of diversification is that you will bail on it as a strategy at exactly the wrong time.

That feeling you get — the one that says, I wish I could dump this lame investment so I could buy a whole bunch more of this incredibly hot one — can get you into trouble fast. The temptation is greatest when it would be the most catastrophic for you to succumb.

But that feeling is actually telling you that you’ve done the right thing: You’re diversified. So remember that when the current fad ends and today’s rejects come back into style, you’ll be okay. And you’ll be awfully glad you didn’t give in to the temptation to give up on being diversified.

The next time diversification appears to not be working, remind yourself that it is a long-term strategy that can’t be judged on your short-term experience. In other words, just because something isn’t working right this minute — or even right this year — doesn’t mean it’s broken. So instead of thinking, “I am a rocket scientist and I can come up with something better,” just let diversification do its job.

Then go for a hike in the mountains instead of sitting hunched over the sell button on your broker’s Web site.