Chapter 30
There Is No Such Thing as a Free Lunch—Except Diversification
Most people know the expression “there is no such thing as a free lunch.” An economist named Leonard P. Ayres uttered those words in 1946. Every benefit must be paid for in one way or another, directly or indirectly. With one big exception: It turns out that diversification is the only free lunch in all of economics.
By diversification we mean the strategy of combining a variety of investments of different kinds, which are specifically chosen because they are unlikely to move in the same direction at the same time. Diversification is an attempt to reduce the level of risk of an overall portfolio. The concept is as simple as the old admonition not to put all your eggs in one basket. The mathematics, on the other hand, can be mind-numbing.
The good news is that we need not do any math to use the concept. Here is an extremely simple example. If you invest in a company that makes sunscreen, you will do well in years with lots of sunshine and poorly in rainy years. Now if you make a second investment in a company that sells raincoats, you will do better when rain predominates. This is the essence of diversification. When one company does well, the other does poorly, and vice versa. You reduce your risk by investing in both companies so that in either weather you will have some success.
Why You Want to Diversify
Portfolio theory posits that proper diversification can lower the risk of a portfolio without reducing its expected return. It follows that by increasing risk, we can expect a higher return at the original risk level. In other words, we can either reduce risk and expect the same return or hold risk steady and raise return. A free lunch! Well, not totally free, since it will cost more to buy lots of investments than to purchase just a few. Luckily, there are some pretty good answers to that problem, which we will discuss later in the book.
Consider this example to illustrate the principle of the value of diversification. Two investors in the year 1999 each sought capital appreciation by buying stock in large-capitalization American companies. One asked a stockbroker for the name of a highly recommended, fast-growing, can’t-miss, large company to invest in. The broker suggested a company called Enron. The second investor, wary of risk, sought broad diversification among large U.S. companies and bought shares in an S&P 500 fund. In essence, the first investor bought shares in Enron and the second investor bought an interest in each of the 500 largest U.S. firms. As history teaches us, Enron was a fraud and eventually went under. Both investors lost money. The first investor lost all his money. The second investor, though, had perhaps 2 percent of his capital in Enron, and that is the proportion of her investment that was lost. The second investor had diversified away the risk that a particular company might fail.
Across what parameters are we seeking to diversify? We can spread risk across companies, industries, and countries. Beyond that, we can look to diversify with respect to regions of the world, types of economies, currencies, and sources of information. I will argue later that it is wise to diversify over time, as well, to avoid putting all of the eggs into, or out of, the basket all at once.
Chapter Summary
Diversification of investments can lower risk without reducing expected return.
Diversify within an asset class and also across asset classes.
When diversification can be achieved without any significant increase in costs, it is too good a deal to pass up.
Chapter 31
Diversify Across Every Asset Class
Economists rightly expect that, over very long periods of time, stock investments will probably be the highest returning asset class. There are theoretical reasons why this should be so. This hypothesis is also borne out by a very long historical record. As a practical matter, if you have unlimited time, the best investment is likely to be a diversified portfolio of stock investments.
On the other hand, there is not a human being on earth who has unlimited time. That is not the nature of our lives. Most of us invest money hoping to grow it but with the intention of eventually spending it. For those who intend to use their money soon and thus have a limited investment time horizon, stocks are a potentially terrible investment. To put it more forcefully, stocks over short periods of time are nothing more than gambling.
This conundrum, stocks for the long haul but something less risky for shorter-term money, starts to shine a light on portfolio construction.1 It is not difficult to construct a diversified portfolio, across all asset classes, based on what portion of your money will not be needed for a very long time.
For example, the Johnson family sought an investment plan that would deal with the need of two parents to retire in approximately 25 years, one child who would start college in 3 years, and another child who will not reach college for 14 years. They determined that 40 percent of their savings were for retirement, 30 percent for the older child’s college education, 20 percent for the younger child’s college needs, and 10 percent for a kitchen they had to have next year. With some guidance, the Johnsons built a portfolio with about 40 percent of their investments in diversified stock funds, approximately 30 percent in bonds expected to mature in three years, about 20 percent in balanced funds that approached a 55 percent stock/45 percent bond split, and 10 percent in cash equivalents. Of course, the Johnsons also wanted the portfolio to have exposure to all the other major asset classes, and that was dealt with by making small adjustments to the figures described above.
Be Honest with Yourself about Your Risk Tolerance
One of the greatest perils facing you as an investor is that your emotions will lead you to make wrong moves. In particular, human beings feel tremendous pressure to sell stocks when they are falling (and thus becoming more of a bargain) and to buy them when they are rising (and becoming more and more expensive). To the extent that you can somehow guarantee yourself that you will not panic and sell at the worst possible moment, a great emphasis on stocks may be warranted. Alas, it is easy on a sunny day to promise ourselves we will be calm in a storm. Our actual behavior in the churning waves and fierce winds may be a different story entirely. If, like Odysseus, you can find a way to tie yourself to the mast, then go ahead and put more into stock investments. On the other hand, consider this mantra often repeated at our firm: “If you have trouble sleeping well at night, you have too much risk in your portfolio.”
Let’s review the major asset classes that, together, comprise a well-diversified portfolio.
U.S. stock investments (all sizes of companies)
Foreign stock developed-markets investments (all sizes of companies)
Emerging market stock investments (all sizes of companies)
Real estate (both U.S. and international)
U.S. bonds issued by many types of entities and with a broad range of maturities
Foreign bond investments (including emerging markets)
Inflation-protected bonds (TIPS)
Commodities
Money market funds and short-term bond investments
How to Achieve Diversification of an Investment Portfolio
Investment portfolios that are less than fully diversified carry more risk than necessary. A prudent investor will seek opportunities to diversify away some of it. Here is an example of how you might approach that.
Let’s start by assuming that you have invested in a major oil company such as ExxonMobil. At this point, after buying only one stock, you are highly undiversified. You can increase diversification by purchasing shares in a number of major world oil companies, including Chevron and BP and Royal Dutch Shell. Now you have invested in the oil industry and reduced your investment risk by purchasing many companies within the industry, rather than a single stock. You have reduced specific company risk within that one industry.
That is one level of diversification. But why would you want to invest all your money in only one industry? You can further reduce risk by spreading out to other areas of the economy, such as technology companies, banks, utilities, c
onsumer products companies, and retailers. The ultimate reduction in specific industry risk involves buying stocks in every recognized industry group.
Why invest in some companies in each industry group when you can choose to invest in all companies? This brings us to the topic of broad index funds. These are mutual funds that try to replicate a market rather than make selections in an attempt to beat that market. So, for example, a fund that replicates the S&P 500 index does not attempt to select companies among large-capitalization U.S. firms; rather, it buys them all in their proper market weights (meaning in proportion to their market capitalization). An index fund tied to a broader index, such as the Russell 3000, replicates the performance of just about the entire U.S. stock market.
Now that you effectively own all the stocks in all of the industries in the United States, it is appropriate to consider the rest of the world. You can seek to invest in stock of a broadly diversified group of companies from all over the globe. Traditionally, these have been broken into international stocks (the countries of the so-called developed economies) and emerging markets (the countries with less developed or emerging economies). Once again, use of very broad index funds will allow you to replicate almost the entirety of these two categories.
Stocks are often divided into two broad categories: growth stocks and value stocks. Growth stocks are those companies with rapidly growing profits whose prospects look bright. They would seem to be wonderful investments, except that their stocks are already very expensive due to all the optimism surrounding their future. Value stocks, on the other hand, are those companies whose shares are on sale for some reason, such as slowing growth, poor profitability, products with a dim future, or some sort of corporate catastrophe. As you know, a properly functioning liquid market contains no bargains, so it is difficult to predict which of these two groups will do better in the short or medium term. It is best to own both. Of course, very broad index funds will accomplish this for you.
Companies are also grouped by size. This is usually accomplished by looking at market capitalization, which is the number of shares outstanding times the price of a share. One could say that the market capitalization is the value that stock market investors have placed on the company. Financial folks speak of large caps (huge companies), mid caps (relatively big companies), small caps (smaller companies), and micro caps (the smallest of public companies). Professors Fama and French believe they have proven that small companies will do better than larger ones over very long periods of time, but, to reduce risk, you want to invest in companies of all sizes.2
At this point, we have built a portfolio containing stocks of all the different sizes of companies—large-cap, small-cap, mid-cap, micro-cap—within growth and value stock categories for the United States, the developed markets, and the emerging markets. This represents an extremely broad diversification across stocks.
Now we turn our attention to other asset classes.
Diversifying Asset Classes beyond Stocks
Broadly speaking, there are three types of things you can invest in. You can have an ownership interest in a company (stock), you can be a creditor of an institution (bond), or you can own a thing that you hope will appreciate in value (commodity). Of course, these very broad categories are further broken down in the investment world. Let’s examine the investment asset classes that a prudent investor should seek to diversify across.
Bonds
You can invest in debt by buying a bond either from the original issuer (the borrower) or from another investor. There are a number of important distinctions between types of bonds. Let’s examine them briefly.
Bonds are usually classified by the type of issuer. They are issued by governments, businesses, nonprofit institutions, and other entities. Other types of bonds worthy of their own individual categories are municipal bonds (because the interest they pay is federally tax free) and inflation-protected bonds (because their principal amount is adjusted upward for inflation).
As discussed earlier, bonds are subject to default risk and interest rate risk. The dangers associated with default risk are supposed to be analyzed and summed up by the rating agencies, which assign each bond a risk rating. The different ratings result in a sorting of bonds, with the safest ones called investment grade and the riskiest bonds labeled as junk. Interest rate risk increases with the length of time until the investor recovers her money. Thus, long bonds have very high interest rate risk and short bonds have very little. The prudent investor probably diversifies across all of these risk factors.
Inflation-Protected Bonds
In light of the cost-of-living increase in principal that is a feature of Treasury inflation-protected bonds (often referred to by the acronym TIPS), they should be considered a separate asset class. These TIPS can be expected to behave differently from traditional bonds in many economic climates. In particular, they perform significantly better in periods of high inflation. Thus, investment in TIPS is a method for diversifying away some of the bond risk associated with inflation. A wise investor owns both traditional bonds and TIPS.
Real Estate Investments
The various kinds of real estate are often considered another asset class. It may behave differently from stocks or bonds in certain economic or market conditions and, thus, is helpful in further diversifying an investment portfolio.
Many families own their home. For some, this is among the largest investments they have. In many cases, this is an appropriate level of real estate investment to achieve the desired diversification. For others, though, further exposure to the real estate asset class is desirable.
An investment vehicle called a real estate investment trust (REIT) affords an opportunity to easily invest in a broad (and sometimes diversified) collection of properties. Significantly greater diversification can be achieved by investing in a selection of different types of REITS or, perhaps, a mutual fund investing broadly in many different REITS.
Commodities
Human beings have a long history of investing in things with the hope that their value will rise and a profit can be realized. From tulip bulbs to baseball cards, investors have been tempted by rising valuations. Perhaps the single commodity that has the greatest history as an investment vehicle is gold. Let’s use the example of gold to discuss the entire concept of commodities.
If the price of gold rises, an investor can make a profit. Furthermore, since gold has come to have almost the status of an alternative currency, it can hedge against the danger of declining currencies or rising inflation. There are some distinct negatives to investing in gold or similar commodities, though, and these should be considered. Unlike companies or debt or real estate, gold is not designed to bring in money. It draws no profits or interest or rents. It just sits there. Furthermore, an investment in the metal itself must be stored and insured. Thus, it costs money to hold gold.
Some of the problems of investing in actual gold can be ameliorated by investing in gold companies. In particular, firms that mine the metal are often an excellent proxy for an investment in gold itself. Applying our earlier learning, it is probably more prudent to invest in a broad range of gold miners than in a single one.
By the same principle of diversification, why invest in a single commodity when you can invest in a basketful of different commodities? The smartest way to invest in commodities is probably to buy a mutual fund that owns shares in a wide variety of mining and materials companies across the globe.
Cash
There is an asset class called cash. While individual dollar bills would qualify, that is not usually how an investment in cash is achieved. After all, the bills in your wallet do not bring any interest, whereas a bank account does.
Thus, there are a significant number of investments that are considered cash equivalents. Among these are certificates of deposit, Treasury bills, and money market mutual funds. Basically, any very-short-term debt instrument that has virtually no default risk will be considered a cash equivalent.
Althoug
h rare, there have been years when cash was among the very highest returning asset classes. This is likely to occur during a period of sharp declines for stocks, bonds, real estate, and other classes of investments.
Use Time to Further Diversify
If it is wise to divide your eggs into many baskets, it is also wise to place the eggs into those baskets over a period of time rather than all at once. This is sometimes called dollar cost averaging, and it is understood as the practice of buying an investment over time in regular, fixed intervals. Savvy investors routinely do this.
Consider this example: Instead of investing $12,000 in a broad stock market index fund on the day you finish this book, you decide to put $1,000 into the fund on the first of each month for a year. At the end of the year, you will have invested $12,000 into the fund. Rather than buying all your shares at one price, though, you will have purchased shares in 12 different lots at 12 different prices. The average price you paid for a share is likely to be similar to the average price of the fund over the course of the year. In doing this, you have decreased the risk that you might have bought at the very highest point. If a sharp drop in the price occurs at some point during the year, you will purchase further shares at a lower price in subsequent months.
If dollar cost averaging your way into investments is a wise practice that reduces risk, then dollar cost averaging your way out must be the same. And so it is. In particular, this is a good way for older folks to begin taking money out of their retirement portfolios for spending or investment in lower risk investment choices. Take a little out each month, rather than a large amount all at once.
Negotiating Your Investments Page 24