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?

Sketch Guy: Some Investing Stories Sound Good Until You Analyze Them

Making smart money decisions is an incredibly difficult way to behave. So after my post last week about buying a house based on your situation, my jaw dropped when I saw an article in The Wall Street Journal about young home buyers.

“A new generation is skipping the ‘starter home’ and betting heavily on high-end real estate.”

Seriously? We’re back to “betting” on real estate?

Now, the stories are incredibly persuasive, but hidden within them is something else. When asked why they are buying an expensive home, or even buying multiple expensive homes to rent, young buyers say they are doing it as an investment strategy.

“Buying real estate has grown more attractive, these young buyers say, compared with the stock market, which appears riskier to a generation that entered the work force during a market correction,” the article in The Journal says.

This reminds me a lot of what I have referred to before as “that guy.” It’s the guy at a neighborhood barbecue or in the office who always has a story to share about how easy it is for him to make money. The problem is he only talks about the times he made money, not the times he didn’t.

The stories of these young real estate buyers, like Matt Winter, follow a similar theme.

“?'I have always felt that having your money in property is the safest and best thing to do if you want to grow your personal wealth,’ says Mr. Winter, who founded his design company at 23. None of Mr. Winter’s assets are in the stock market — he says the market ‘spooks him’ and that he prefers to invest in real estate,” the Journal article reads.

Stop and think about this for a minute. Mr. Winter is now all of 28, and the story he is telling is that property is the safest place to increase your wealth. But I suspect that if you ask anyone dealing with real estate in the last 10 years (or who is over 40), they would disagree with the idea of it being safe. So why is our attention caught even though our experience tells us something different?

When we hear stories like this one, about young, beautiful people spending a lot of money, it’s easy to go with the assumption that they must be making smart decisions, too. After all, who doesn’t want to buy a house on the beach? And in our desire to be like what we see in those glossy beauty shots, we ask the question, “Shouldn’t I be doing that, too?”

We remind our children all the time, “If your friend jumped off a cliff, would you?” And yet when we ask that question, we are engaging in similar herd behavior. We need to recognize that we aren’t those people, and whether they are making a good decision isn’t the point. All that matters is whether it is actually a good decision for us, and these stories can make it difficult to reach this conclusion.

So lest you think I’m picking on these people only because they are young, beautiful and wealthy, let’s take a look at what are some flat-out questionable arguments.

Buying real estate is a safe way to build wealth. Because most people don’t hand over a sweaty wad of cash, real estate usually involves leverage in the way of a mortgage. While leverage can be good, it’s a double-edged sword. There are certainly home buyers in Phoenix and Las Vegas who would argue with the idea that property is the safest investment.

You will get hurt in the stock market. I get why real estate looks so attractive, especially to younger buyers. As the article noted, it is hard to trust the stock market if what you have seen to date hasn’t been wonderful. But it takes a willingness to ignore history to go with the story that real estate represents a sure thing in comparison to the stock market.

It makes sense to buy a second property as an investment. If you’re thinking about becoming a landlord, think again. Barry Ritholtz captured the problem with the rental market perfectly: There are a lot of rental properties just sitting on the market. And with a lot of people playing the rental and investment game at the moment, can you afford to have your investment property sitting empty? Don’t assume that a home you have bought to rent will actually generate rent every month to justify the purchase.

Buying real estate may turn out to be a great decision for the people profiled in The Wall Street Journal. But the notion of real estate as being somehow a better or safer investment than the stock market doesn’t add up based on what we know.

We know that the weighty evidence of history tells us that having a low-cost, well-diversified portfolio has been the better investment in the long run. We know that we probably don’t want to become landlords, either. And most important of all, we know what matters most when it comes to investing success: behavior.

So the next time you see stories like this one, keep in mind that you know better. You know what questions you need to ask before buying a house. You know what kind of investments you need to reach the goals that matter to you. And you know that what might work well for someone else isn’t guaranteed to work for you.

Sketch Guy: It’s Not Everyone’s Time to Buy a Home

My family and I are renters, and most of the time that feels fine. But last week I found myself in a state of temporary panic when I read this Twitter post from the financial journalist Felix Salmon: “John Paulson: if you rent, buy. If you own, buy a second home.”

When I read it, I immediately felt anxious. I recognized the feeling. It’s the feeling you get when you think you have to act on something right away or you’ll miss out. After all, if John Paulson, the guy who made “The Greatest Trade Ever,” was saying I should rush out and buy a house, I’d better get on it!

After allowing myself to get all worked up about this, I did what I’ve done several times before. I pulled out a piece of paper and a pencil and worked through the emotions and the numbers. In the end, I was reminded of something incredibly important.

John Paulson doesn’t know me or my situation.

There is absolutely no reason I should be making decisions based on something he said. The same is true for any other “expert” who decides to share his guess about what he thinks will happen next in the housing market.

The same holds true for the other three people who just happened to express similar concerns to me about buying right now. Two were convinced that if they didn’t buy a house now, they’d be priced out of the market, and maybe they will be. But I heard that argument a lot in 2005-6.

Then there was the third conversation I had.

It’s time for this person to downsize to a different home. The children have all moved out and the house just takes too much work. But even though it’s the right decision to sell now (given her individual situation) and buy a smaller home, a decision has been made to wait because the news, the forecasts and even the guesses are implying that the house could be worth substantially more sometime in the next 12 months.

This is madness!

Buying a home is one of the biggest financial decisions that most of us will make in our lifetimes. And yet it’s often a decision in which the person with the most knowledge about what makes the most sense gets overlooked: You.

There’s a simple way to fix this problem. As I was reminded last week, all it takes is a piece of paper, a pencil and some time. So if you’re struggling with this decision to buy (or sell), take a minute to think through these questions and write down the answers, because I suspect you’ll need to refer back to them the next time somebody decides to share what he thinks will happen with housing market. This list is not meant to be prescriptive. It is meant to get you thinking about something other than forecasts and guesses.

¦ Can you afford it, and do you have enough saved for a down payment? Make sure you include the cost for things like property taxes, homeowner association fees and utilities.

¦ Can you qualify for a loan? If the answer right now is no, then you can stop torturing yourself, because it doesn’t matter if the market is about to take off. You can’t buy a house.

¦ How long do you plan to live in the home? There’s some debate about the minimum time you should live in a home for it to be worthwhile, but if it’s less than five years, forget about it.

¦ What guess are you making about housing prices? It is a painful reality that the one variable that makes a huge difference in this decision is unknowable. What is going to happen to housing prices in the short term is anyone’s guess. But for your own sanity, just assume that housing prices will continue to increase by about the long-term average of inflation, or 3 percent. You really can’t afford to buy a house if the decision depends solely on what the house might one day be worth.

The answers to all of these questions will depend on you and your individual situation. And that’s the point. Hopefully it’s clear now how ridiculous it is to buy a house based on some stranger’s advice.

Through this process, you may discover that buying and owning a house isn’t for you, and that’s O.K., too. But these questions can also help end your anxiety around what is probably the biggest financial decision you’ll make. Don’t you think that’s worth a piece of paper, a pencil and a little time?

Carl Richards is a certified financial planner in Park City, Utah, the director of investor education at the BAM Alliance, and the author of "The Behavior Gap.” You can also view an archive of his sketches for The New York Times.