Investment advice: Reducing risk through diversification

Malkiel’s Rule 6: Never Forget that Diversity Reduce Adversity

Not only does he recommend holding the different major asset categories (cash, bonds, stocks, real estate), but also diversifying holdings within each category and over time (through dollar cost averaging). He says his advice is not new. Cervantes, in his epic novice Don Quixote, advises that one should not “venture all his eggs in one basket”.

Diversifying in the various investment categories

He includes a few horror stories of people that were doing well invested in what looked like solid investments only to lose much (e.g. Enron stock; internet stocks; Worldcom bonds; etc).

He has a great illustration in his book which is too long to repeat here but that clearly shows that diversification results in much less risk with little reduction in return on your investment. The reason to diversify is fairly simple: as good a deal as individual stock or sector appears, things can change rapidly and unpredictable for a single investment. “By holding a wide variety of stocks, you reduce the risk considerably because economic events don’t affect all companies in the same way and unfavorable company-specific events are likely to be balanced by very favorable events for other companies.”

He recommends investing as many as 100 different stocks to reduce risk. For almost all of us the only practical way to do this is via mutual funds as this is what they do: allow you as an individual investor to own pieces of lots of different stocks.

He does not think most investors need to diversify internationally as there are plenty of good options here and many American companies are global to a significant extent anyway.

He also recommends diversification in bonds (again there are mutual funds for bonds) and real estates investments (via REITs).

Diversification Over Time (dollar cost averaging)

Under his section on “Diversification Over Time” he suggests putting money into the market regularly over time and explains and illustrates something called “dollar cost averaging.” It involve regularly saving (investing) the same amount of money over the long term on, e.g. a monthly or quarterly basis. You do this when stocks are up and when they are down. When stock prices are low, this results in buying more shares; when stock prices are high, you end up buying few shares. He demonstrated that you when you save in this way, you are actually ahead when the market goes down and then returns to its original value verses a market that is constantly going up.

While I won’t take you through the numbers (there are in the book and others as well), here is a great quote he provides by Warren Buffet that helps explain the concept in words:

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

He concludes by warning that dollar cost averaging will not solve all our investment problems. The plan does not protect you if you need to take the money out when the market is down. And there is a time to alter the above. In fact, when the market is down may be the time to buy a few extra shares. The worst thing you can do is to sell when the market is down if you can avoid it.

Next up: Rule 7 – Pay Yourself, Not the Piper (controlling costs)

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see my summary.