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Dismiss Diversification at Your Own Risk — Carl Richards

Every few months, we see headlines declaring that once-hot markets have cooled. It’s time to kick these losers aside, the conventional wisdom tells us, and search out the next big deal. Of late, we’re told, both international and emerging markets have been widely criticized as weak performers and investors would be wise to move on to other markets.

If we take a look at the end of the third quarter in 2013, it’s easy to see why. The United States stock market (Russell 3000 Index) is up 21.30 percent for the year. International developed stocks (MSCI World ex USA Index) are up “only” 14.66 percent, and emerging markets (MSCI Emerging Markets Index) are down 4.35 percent. It seems as if the evidence is clear. Why would we want or need anything other than American stocks?

But wait, we all know we shouldn’t make decisions based on only three quarters, right? So let’s pull back and take a look at how these three markets performed over five years.

For the last five years (ending in the third quarter of 2013), the United States stock market had an annualized return of 10.58 percent. International developed stocks were up 6.12 percent, and emerging markets were up 7.22 percent. The numbers aren’t bad, but now it seems really clear: We’ve got five whole years of data, and they still seem to imply that we’d be better off if we were only invested in American stocks.

What are we waiting for? Well, before we pick up the phone and give the order to sell, let’s take a look at one more thing. How did these markets perform (annualized) over 10 years?

■ U.S. stocks = 8.11 percent

■ International developed = 8.18 percent

■ Emerging markets = 12.80 percent

Maybe the answer isn’t so clear after all. Ten years ago, we didn’t have any way of knowing that emerging markets, a current target for the sell-now crowd, would still perform more than 4 percent better than the United States market at the 10-year mark. For those of you keeping track, that’s Example 387 for why we shouldn’t be so quick to dismiss diversification.

Of course, some of you might argue that if an investor picked any of these three options, diversification wouldn’t matter because the performance for all three was positive.Reaching this point, however, would also require that an investor hadn’t done something silly during those 10 years, like sell everything when any one of these markets dropped off a cliff at different times.

By choosing to blend different, complementary investments (known as diversifying), we’re spreading out our risk and creating opportunities for different parts of our portfolios to zig when others zag. A diversified portfolio means that some investments will do well while a few are doing poorly and others are doing average.

That’s perhaps the biggest risk of diversification: comparison. It’s really easy to focus on the ones that are doing well and compare them with the ones that aren’t doing equally well, but that’s what makes diversification so useful to the average investor. We have no way of predicting the winners and the losers. Diversification helps us cover a range of possibilities.

Of course, diversification is an easy target for criticism when our window of time is short. Yes, if we’re judging our investing success based on the year-to-date results for the third quarter in 2013, it would seem like diversifying into markets outside the United States is unnecessary. But one quarter shouldn’t become the definition of investing success or failure for investors.

I also understand why it’s tempting to think that we don’t need diversification. It can be difficult to watch portions of our portfolios climb sky-high while others seem to be lost in the wilderness. But until the day that markets become predictable, we’re in for a bumpy ride if we dismiss the benefits of diversification. Of course, diversification doesn’t eliminate all risks, but it’s one fantastic shock absorber. So it frustrates me when I hear of investors being advised to leave this valuable tool on the sidelines.

When we diversify, we’re also setting up guardrails to help us make smart, disciplined decisions. For instance, what would we do if we were holding one particular investment after it experienced a down quarter? Odds are high we’d be looking around for a different investment that’s doing well. This approach creates the classic buy high/sell low behavior that isn’t good for any investor.

But what happens when we make use of diversification? To use a very simplified example, imagine we divide a portfolio into equal portions of three different investments. The financial plan then calls for maintaining an equal split among the three.

Now at the end of a quarter when one investment is up a lot while the other two are down, we know what comes next: rebalancing. Diversification, in combination with our financial plan, helps us behave like adults by creating opportunities to buy low and sell high.

Now maybe you can see why I’ve previously described diversification and rebalancing as the seventh wonder of the world. It’s not because we can suddenly predict what the market will do next but because we know what we need to do next.

If you still aren’t convinced, there’s no law saying you can’t dump everything into a single investment. I’ll even wish you luck because you’re going to need it. A single-investment strategy is the investing equivalent of going all in on one spin of the behavioral roulette wheel. I don’t care for those odds myself, particularly since there’s also no law saying that’s the only option open to us.

Please don’t be fooled by the headlines and by numbers that reflect a window of time that doesn’t really matter to average investors. I suspect that a well-diversified portfolio is a little bit like what Winston Churchill said about democracy: It’s the worst form of investing except for all the others.

This commentary appeared November 04 on NYTimes.com.

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Carl Richards

The BAM ALLIANCE

Carl Richards is the creator of the weekly Sketch Guy column in The New York Times and is a columnist for Morningstar Advisor. Carl has also been featured in The Wall Street Journal, Financial Planning, Marketplace Money, The Leonard Lopate Show, Oprah.com and Forbes.com. His simple but meaningful sketches served as the foundation for his first book, “The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money.”

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