Common Diversification Myths, Part 2

Last week I introduced three common myths about diversification. This week, I’ll finish off the series with three more. (Can two columns be a series? Call it a miniseries.)

Are you making any of these mistakes? If so, now’s as good a time as any to fix up your portfolio.

Owning ten or twenty stocks is diversified enough

This a myth that refuses to die. William Bernstein, author of the classic book The Four Pillars of Investing, debunked it thirteen years ago in a great essay, The 15-Stock Diversification Myth.

“To be blunt,” wrote Bernstein, “if you think that you can do an adequate job of minimizing portfolio risk with 15 or 30 stocks, then you are imperiling your financial future and the future of those who depend on you.”

But I still hear it all the time: “Don’t buy an index fund! Just pick 15 or 20 great companies.” It’s a terrible idea.

Even investment professionals have a hard time picking stocks: according to Standard & Poor’s, nearly 90% of domestic equity funds lagged their benchmark in the 12 months ending June 30, 2012. And you’re about as likely to outperform these guys as you are to outrun Usain Bolt.

Given that you can buy a total US market index fund or ETF and own the entire stock market for an annual expense ratio of 0.06% or less, why anyone would buy a handful of stocks—and almost certainly underperform the index fund over time—is puzzling.

As Bernstein put it, “Fifteen stocks is not enough. Thirty is not enough. Even 200 is not enough. The only way to truly minimize the risks of stock ownership is by owning the whole market.”

Owning the entire US stock market is diversified enough

This one usually goes like this: “US companies earn an increasing percentage of their revenues abroad, so when you invest in the US market, you’re really diversifying internationally whether you know it or not.”

The logic is impeccable. Unfortunately, the market doesn’t agree, and with good reason: companies based in different countries fall under different regulatory regimes and are subject to different economic threats at different times.

Since diversification is the game of trying to avoid holding a hand of all losing cards, adding international stocks makes your portfolio safer than holding only US stocks.

Put more simply: the risk of something terrible happening to one country’s stock market is higher than the risk of something terrible happening to every stock market at the same time.

Here’s a great way to visualize this: the Callan Periodic Table of Investment Returns. The chart is simple: for each year from 1993 to 2012, it ranks all major asset classes from best- to worst-performing. US stocks did great for most of the 1990s, international stocks for most of the 2000s.

There’s little evidence that US and international stocks have become more correlated since then, but even if they have, who cares?

Unless you know something the market doesn’t (not likely) and believe that international stocks will definitely underperform US stocks, why not own international stocks? You can buy a good international stock index fund or ETF for as little as 0.16% per year.

Owning the entire world stock market is diversified enough

Nope, you also have to own Mars, Venus, and I’m hearing good things about Saturn. (But I lost a bunch of money in the Pluto market in 2006.)

Just kidding. You also have to own bonds. I hear this all the time: “I’m young, I can handle volatility, and I know stocks will outperform bonds over time. So I’m going with 100% stocks.”

What’s wrong with this approach? Two things:

You don’t know what you think you know. For over 150 years in the US, stocks outperformed bonds over every thirty year period…until, for the period ending September 30, 2011, bonds won.

You think you’re in it for the long haul, but the universe may disagree. Even if you can stomach the volatility of an all-stock portfolio, you never know when an emergency will strike.

From an investing perspective, one of the worst emergencies is the one that happened to so many people in 2008 and 2009: they lost their job and had to tap their portfolio during a stock market crash.

I explained last week that diversification can’t save you from a market crash, and that’s true. But holding bonds in your portfolio can insulate you from the full brunt of a crash. For most people, the world just isn’t safe enough for an all-stock portfolio.

If your portfolio is undiversified, fear not. You can fix it. It’s time for some portfolio spring-cleaning.

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