Common Diversification Myths

What’s important in investing? Near the top of everyone’s list is diversification, and people like me throw the word around like its meaning is obvious. I talk to ordinary investors all the time, however, and most are confused about what diversification is and isn’t.

In the fewest words I can manage: diversification means owning a lot of different assets that probably won’t all drop in value at the same time.

I say “probably” because if the history of financial crises tells us anything, it’s that at the very moment you say, “Well, now we can relax,” a threat you didn’t anticipate rises from the deep–with claws.

Here are three common myths about the big D. Next week I’ll give you three more.

Diversification means owning a lot of mutual funds

I see this one all the time. You sign up for your 401(k) at work and have to choose among a dozen or more mutual funds.

You have no idea which ones to choose, so you split your contributions equally among all of them. Bingo, instant diversification! Right?

Wrong.

If ten of those funds own mostly large company US stocks, you’re not well diversified at all. It’s like trying to make a balanced meal by choosing twelve items from the freezer case at the gas station: two Lean Cuisines and ten ice cream bars.

Instead, you have to look at what’s inside the mutual funds. This is much less fun than looking inside the ice cream bar wrappers, but more lucrative.

If you have a low-priced target-date fund in your 401(k), you might be able to get plenty diversified in just one fund.

Not sure how diversified you are or what’s inside the funds in your 401(k)?

Try Morningstar’s Instant X-ray tool. You enter the ticker symbols of the funds and how much money you’ve put in each, and it shows you what you actually own, including cool pie charts.

“Diversification is for idiots”

That’s an actual quote from a billionaire. Okay, then I’m proud to be an American idiot.

The billionaire contends that you should keep your money in cash until you see an amazing investment opportunity, then pounce on it. If this strategy worked, we would all be billionaire investors.

Maybe said billionaire is brilliant; maybe he’s lucky. I’m smart enough to know I’m neither, so I hold a diversified portfolio. At least part of my portfolio will suck at any given time.

If I knew in advance which stock or asset class would start sucking next, I would sell it in time and buy the stock I knew would soar. But I don’t, and neither do you.

Billionaires can afford to bet—and lose—$10 million on a hunch. For the rest of us, there’s diversification: we’re not going to strike it rich by doubling down on a widely popular tech stock, but we’re not going to bet it all on a certain Texas-based energy, commodities and services company (you know what I’m talking about), either.

As Carl Richards put it, in visual form: Never strike out, never hit a home run:

“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.”

Diversification makes you immune to stock market crashes

I wish. Diversification can help cushion the impact of a market crash, but the only way to avoid a stock market crash is to stay out of the stock market—which, of course, means giving up on the kind of gains you can earn in the stock market, too.

The best way to protect your portfolio from a stock market crash is by investing in high-quality bonds such as US treasury bonds or highly rated corporate or municipal bonds.

This is a form of diversification: when the stock market tanks, many investors go running for safety. They buy high-quality bonds, pushing up the price of these bonds. If you own these bonds already, you benefit from this herd behavior.

But you don’t benefit so much that you can sleep through the crash. Here’s an example. One of the most diversified funds I know is Vanguard Target Retirement 2020 (VTWNX), which owns about 63% stocks and 37% bonds.

In 2008, the worst recent year for stocks, this fund dropped 25%. That’s a lot better than the US stock market as a whole, which dropped 34%.

But if you lost your job in 2008 and had to make an emergency withdrawal from your portfolio, the fact that it was only down 25% probably wasn’t very reassuring.

If that makes it sound like I’m saying success in investing is mostly luck, well, there’s a lot of luck involved.

There is no better investing strategy than diversification and keeping costs low, but once you get that right, success or failure is often determined by factors beyond your control: market performance over your working life and avoiding unemployment and unexpected expenses.

Next week we’ll look at myths about international diversification and individual stocks.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.