Whoa, whoa, hold it a minute. In the last article, you basically said it makes sense to just pick asset classes with the highest expected return over long-term investment horizons. You even suggested putting up to 100% of one’s long-term focused portfolio in stocks. So how is that diversification? It’s not. In fact, it’s the very opposite of diversification. But remember, diversification is about spreading risk over a number of different investments, in order to guard against severe negative movements in any one or more of those. In other words, in order to protect against severe negative differences from a particular asset’s expected return.

Past results are no guarantee of future performance, so it is certainly possible that stocks could underperform their historical returns going forward. However, even if future stock returns disappoint, they should still outperform bonds and cash over the long run. Take another look at the section in Part 1 about time diversification, and the Jeremy Siegel data in particular. Siegel shows that stocks outperform fixed income securities and cash ~100% of the time over 30-year investment horizons. Moreover, stocks are much more likely to keep pace with future inflation than are bonds and cash. Better to have a larger percentage of your long-term portfolio in stocks, everything else being equal.

However, diversification among asset classes (stocks vs. bonds vs. cash, etc.) becomes much more important for smaller investment horizons, say less than thirty years, and for all investors who are conservative in their willingness and ability to accept risk, regardless of their time horizons. Furthermore, unless you are super risk aggressive and have enough financial reserves to afford sustaining major losses, diversification within asset classes is always important, regardless of your time horizon. For example, say you have a nicely diversified portfolio that is 40% stocks, 40% bonds, 10% REITs, and 10% cash. Now further assume the entire stock portion of your portfolio is equally invested in just two stocks. What if one or both of those companies loses a substantial part of their value? Stocks in general should achieve positive returns over time, but any particular stock could suffer significant losses. Many employees at Enron held a large part of their retirement accounts in company stock, and unfortunately, lost a major part of their retirement savings when the company declared bankruptcy in 2001.

This specific company risk is called idiosyncratic, or non-systematic risk. The stock market will always carry a certain amount of systematic risk that impacts all stocks, but this unsystematic, company specific risk can be diversified away by holding a large enough number of equities, preferably spread among companies that operate in a number of different industries.  Many experts recommend holding anywhere between 15-30 individual securities in order to achieve an optimal level of diversification. Anything above this range will still provide some additional benefits, but by a lower and lower incremental amount. It can also greatly increase transaction costs.

Purchasing so many individual securities would be far too cost prohibitive for most investors, but fortunately, there are mutual funds and exchange trade funds (ETFs) that will take care of this for you, and you do not need to hold many of them to properly diversify. I explain the differences between mutual funds and ETFs in Part 4 of this series.

 
Modern Portfolio Theory

As Fidelity.com so aptly describes, “the goal of diversification is not to boost performance—it won’t ensure gains or guarantee against losses. But once you choose to target a level of risk based on your goals, time horizon, and tolerance for volatility, diversification may provide the potential to improve returns for that level of risk.” In some cases, diversification may even actually do both: increase return and reduce risk. To illustrate, I’d like to borrow an example created by Morningstar.com.