“Diversification is a safety factor that is essential
because we should be humble enough to admit we can be wrong.”
— Sir John Templeton

My last column was focused on identifying what may well be the biggest risk when investing: human behavior.

Fear and greed can be remarkably powerful drivers of poor investment results — buying high when markets are euphoric and selling low when they are scary.

While there is no way to change the volatile nature of financial markets, diversification
can help reduce risk — “spreading your bets” knowing your predictions just might be wrong.

There are several risks we can focus on.

Single Stock Risk

The potential price range for any one stock is virtually unlimited. A single company’s stock can soar — or the company can go bankrupt.

But what if you bought stock in 500 companies (like with the S&P 500)? As a group they cannot have the highest return of any one stock — but neither can they have the worst return — and almost certainly all will not go bankrupt.

Single Asset Class Risk

History shows that results for major asset classes (e.g., U.S. stocks, foreign stocks, bonds, and real estate) change frequently and often without warning.

As an example, U.S. large cap stocks have been on an impressive winning streak with top results five of the past 10 years. But that means that other asset classes have won the other
five years.

And who can forget the mid-1980s when foreign stocks beat everything for four years in a row? Remember stories about “Japan Inc.”?

And over the past 25 years, bonds have been the winner eight times.

So, what if you gave up trying to guess and simply included a blend of each asset class in your portfolio? Consider the results over 25 years between 1978 and 2023:

• All-stock (S&P 500) account earned 12.27% return — but with a 20.38% standard deviation (volatility). Worst return: -37.60% (2008). Best return: +47.25% (2003)
• All-bond (Bloomberg Barclays Aggregate) earned a lower 6.61% — but with a much lower 5.41% standard deviation). Worst return: -13.01 (2023). Best return: +32.62% (1982).
• All-foreign stock (MSCI EAFE) earned 8.76% — standard deviation 16.79%. Worst year: 43.38% (2008). Best return: +69.44% (1986).
• Real estate (FTSE NAREIT) earned 11.22% with a standard deviation of 15.94%. Worst year: -48.16% (2006). Best year: +37.13% (2009, right after a horrible 2006).

So, what if you did not want to try and divine which asset classes would be winners/losers (you must do this ahead of time) — and simply decide to include them in your portfolio (to diversify) over the same 25-year period:

• A “balanced” 60% equity/40% bond portfolio would have earned 9.35% compounded annually (80% of an all-S&P500 account — with a standard deviation of 9.57% (just 62% of the risk). Worst year: -24.11% (2008). Best year: +22.48% (2003).
• With a 9.35% annualized return, a $100,000 investment in 1978 would have grown to $934,462 over the 25 years.

Single Style Risk

Besides being divided between the United States and other countries, markets are usually split between “growth” and “value” styles.

While definitions vary, growth stocks tend to sell at higher valuations with lower (or even no) dividends with the expectation of greater future growth — while value stocks tend to sell at lower valuations with higher dividends and expectations of more stable prices.

Once again history clearly shows that style leadership changes with last year’s winners becoming tomorrow’s laggards.

Note: Just as with asset class leadership, these changes can take several years — but they do occur, nonetheless.

One need only think back to the 1990s when tech stocks were on fire — with value stocks (and managers like Warren Buffett) seeming “out-of-touch.” Fast forward to 2000 and you can quickly see the dramatic shift.

Building a portfolio that is prudently crafted to meet your personal goals — at a risk you can honestly tolerate (“stick with”) is key to long-term investment success. Diversifying across multiple asset classes and investment styles can help smooth the ride.

If it is too risky, odds are you won’t stick with it when the going gets tough. And if it is too conservative, you might not earn a high enough return to meet your goals.

Like Goldilocks, it has to be just right.

More about this in my next column. Until then, happy planning!