Diversification Does Not Work

This is one of those times where it is tempting to conclude that diversification does not work. Most diversified portfolios are kind of flat to slightly up on the year 2018. It makes you think you are doing something wrong. However, you would be wrong about that. Diversification does work. The people who conclude that it does not work are only looking at the upside and not the potential downside risk. Over a normal period of time when the markets are up and down, the diversified portfolio will typically win out most all of the time or at a minimum be close in performance to a higher risk portfolio.

Let's look at an example case. For simplification purposes, let's assume Investor A invested 100% in the stock market and made 12%, 15% and 20% for the last three years. Assuming $100,000 invested, Investor A's account would have grown to $154,560. In year 4, the market drops 20% and now Investor A ends up with $123,648.

Investor B is diversified and invests the same $100,000 and earns 8.4%, 10.5% and 14%. At the end of three years, Investor B's account would have only grown to $136,551.48. However, because Investor B is diversified, he/she is not as affected in a market decline. With a 14% decline because Investor B is only taking 70% of the risk of Investor A, Investor B ends up with $117,434.27.

Well, Investor A wins right? Maybe, maybe not. What does every investor do when they look at their accounts? They remember how high their accounts were. Investor A will remember that their account was $154,560 and it lost $30,912 in one year! Thirty thousand, almost thirty one thousand dollars! This is what they will focus on. Then they will look at their financial advisor like he or she is an idiot for losing nearly thirty-one thousand dollars and look for another financial advisor and repeat the same process all over again. Or, perhaps, they will be an even worse fool and think they can invest it better themselves.

Investor B's account only dropped $19,120.21 which is 14% when the overall market lost 20%. They will feel as though they made out better than the overall stock market and they will be glad that they were diversified. They will thank their financial advisor for keeping them diversified and on track towards their financial goals. Investor B also knows that if the following year, the market goes down again, then they will be close to the performance of Investor A without all the headaches.

The problem with diversification is that everyone wants immediate gratification. They assume that the stock market is always going to go straight up and never go sideways or down. Plus, when they do comparisons, they make faulty assumptions about the future direction of the stock market.

The truth is that investing needs to incorporate both up and down markets and there is really only two ways to do this. One is to try and jump in and out of the markets which is a fools errand. The other is to be diversified and sacrifice a little return in exchange for having a plan, a process and a professional, my three P's of investing.

You never thought about diversification this way, did you? Perhaps you should.