When the stock market is “hot”, everyone is an expert telling you where you should invest your money, and when the stock market turns south, everyone is an expert as well, telling you why to get out. (Of course, very few of these “experts” have IMCA’s CIMA designation, certifying them to manage investments.) They tell you where you should invest your money, or even if you should be pulling everything out of the market. The interesting thing about this is that the average investor only earns about 2% per year whereas the market earns roughly 8%. The question is, if all of these experts know what to invest in, why is their return so poor? The main reason is because they use luck as their investment strategy. I will show you why this is a losing formula for investing success and why a simple strategy can help you to earn more money investing and even limit your losses.
The vast majority of investors, including myself during my early years of investing, are market timers. They get in when the market is rising and they jump ship when it is falling. They give in to their emotions when they should not be listening to them. A classic market timer became so scared in 2008 that they pulled everything out of the stock market and stayed out until recently. They bought back in and now are worried again because of the recent volatility.
While it seems simple to time the market, it is actually much harder to do in real life. Too many people will sell once the market reaches bottom and they won’t get back in until close to or at the peak of the market. It’s a classic scenario and it plays itself out over and over again. Next time you are out and talking with friends or family members and the topic of the stock market comes up, ask them what their strategy is.
After about 30 seconds it will become clear that they were jumping in and out of the market the whole time. Note that market timing isn’t just completely pulling out of the market. Switching investments or “chasing returns” is the same exact thing. Just look at what missing a few days does to your return:
Your return is almost cut in half by missing the 10 best days! Good luck at guessing when those days will happen
Strategy vs Luck
Some might be reading this, ready to tell me how they have made huge amounts of money by market timing. While everyone does get lucky every now and then, it is not a sustainable formula for success. I would even venture to say that you probably have lost more than you realize, you just focus on that one investment that you crushed the market with. This isn’t a fault of yours; it is how human beings are wired.
I’d like you to look at the picture below and see if you notice anything. No, this isn’t a trick quiz where some people will see black and blue boxes while others will see white and gold, and it’s not a Tetris map either. Just see if you can spot a pattern (note that you can click on the image to enlarge it).
My guess is that you did not see a pattern. That is good, because there is no pattern to be found. The colored boxes each indicate a benchmark of the stock market from 1994 through 2014, ranked by the best performing benchmark for a given year. Here is the exact same chart again, only this time with labels for you to more easily follow. Again, you can click on the image to make it larger to read.
As you can see, one benchmark does not dominate the chart. Let’s look at a few examples more closely:
International Stocks: How have international stocks done over the past 20 years? Varied widely in returns is one way to put it. Here is the above chart again, only this time I am highlighting the performance of international stocks by using the red arrow. You will see that in 1994 (the far left), international stocks were hot – the best performers. But come the next 3 years, they were the dogs (worst performers) of the market. Then they raced to the top for 2 more years, only to fall again. (Again, click to enlarge.)
US Stocks: While international stocks do tend to have to volatility associated with them, large US stocks don’t. Below is a chart of their performance over the past 20 years. Here, US stocks do pretty well until 2000 when the market crashes. They stay at or near the bottom until 2007, only to drop again and move up and down after that. (Again, click on the chart to enlarge.)
Real Estate: One last example to show you. Let’s look at real estate. For those that do not know, the typical return historically for real estate is around 3% a year. When you hear people talking about getting rich in real estate, it most times means through renting out the property and not through price appreciation. Not to say prices don’t rise, but not like they have recently. We can see this in the chart below. In the middle of the chart you can see real estate as a strong performer from 2004 – 2006. Then the bottom fell out in 2007. But in 2009 it came roaring back for a short run, only to fall. Last year, it rose again. (Again, click on the chart to enlarge.)
The Need for Investment Diversification
For many investors, riding the roller coaster of real estate or international stock returns that I just mentioned would be too much. They wouldn’t be able to sleep at night with that much volatility. So what are you left with? Here are your options:
- Pick a different sector/benchmark
- Stay out of the market
- Investment diversification
Let’s look at each one of these individually.
Pick a Different Sector/Benchmark
If you are looking for a different sector or benchmark to invest in that is less volatile but still provides you with your needed rate of return, you are unfortunately out of luck. As you can see from the chart, all of the benchmark returns vary widely from one year to the next.
Some might try to argue the case for bonds. While it is nice to see only two years with negative returns, in most cases, bonds aren’t going to offer you the return you need over the course of 40 years in order to save enough money for retirement.
And even though there are few negative return years for bonds, we are entering a new period for bonds. The Federal Reserve has been pumping money into the economy, keeping interest rates artificially low. As they slow down this stimulus and eventually stop it, the “bubble” that has formed in bonds is going to deflate, meaning either negative returns or close to zero returns.
Stay Out Of The Market
Your next option would be to simply stay out of the market. This too is not an option. For one thing, you need the return on your money that the stock market provides so that you can afford retirement. If you just put your money under a mattress, you are losing out to inflation each year, meaning you need to save more and more money just to get by.
Another reason this won’t work is because even if you are successful at staying out of the market for a period of time, one day you will realize that you have nowhere near enough money to retire. Trying to make up for lost time, you will put everything into the stock market at either the exact wrong time or you will invest in assets that are way too risky for you and lose everything.
The first two options are not a winning strategy, but investment diversification is. Investment diversification is a fancy way of saying don’t put all of your eggs in one basket. The more diverse the areas of the market you invest in, the better off you will be. A classic example of investment diversification would be to split the money you have to invest into two equal parts and invest one part (50%) in stocks and the other part (50%) in bonds. You can see the power of this idea in this post.
The reason investment diversification works is because you are hedging your losses. Not all sectors of the stock market are going to increase every year. Look again at the chart again and 1998 in particular as an example. International stocks (the orange boxes) did quite well. Same thing in 1999. In fact, most investors would jump into international stocks at some point in late 1999 to ride the wave.
Then 2000 happens, a loss of 14%. You think it will get better in 2001, but it doesn’t, another loss, this time of 21%. Some investors will jump ship and cut their losses, while others will try one more year. 2002 results in another 16% loss. By now you’ve have enough and sell out. Over the next five years, international stocks perform outstandingly.
At the end of the day, you don’t know what is going to happen in the market. If during this same period you had invested 50% in international stocks and the other 50% in US bonds, you would have hedged your losses. Some might argue that you are robbing yourself of higher returns by following this strategy. This is true only in the case that you pick the winners every single year. As it stands now, I know of no investor, not even Warren Buffett, who picks a winning stock every single year without fail.
Your best bet for success in the stock market is to invest a portion of your money into each of the sectors equally (aka investment diversification). By investing in this way, you are guaranteed to pick the winners every year. You will also be picking the losers too, but this is actually not a bad thing.
How would this investment diversification strategy look and what would your return be? I’m glad you asked. See the chart below – and click to enlarge it.
This chart takes this investment diversification strategy into account. Here, 1/7th of your money is invested in each of the sectors listed. This chart shows that an equally weighted portfolio (investment diversification strategy) – the white boxes in the chart – runs in the middle of the pack, which is to be expected. The portfolio has healthy returns and doesn’t require you to pick the winner each year. As noted above, you will be guaranteed to pick the winner each year since you will own a piece of each sector in the market. Here is how this portfolio looks charted out, as I did with the examples earlier (click to enlarge):
You might look at the equally weighted portfolio and see that the annual returns vary a great deal. While this is true, the idea is that by investing in this type of portfolio you are limiting your losses. Note that I said you are limiting your losses, not removing losses altogether. You will lose money over the short term – that is inevitable. You need to keep your focus on the long-term because the long-term trend of the stock market is up.
Final Thoughts on Investment Diversification
If you read the magazines dedicated to investing or even watch the 24 hour investment news channels, you will quickly become overwhelmed with your investing options. Investing isn’t complicated and neither is investment diversification. It’s actually very simple: invest in a diversified portfolio, with low cost investments and stay invested for the long-term. We’ve covered the importance of investment diversification in this post and I’ve spoken about fund expenses in my outrageous fees post.
As for the long-term, that is self-explanatory. You need to stay invested for the long-term. That doesn’t mean sell out when the market drops or your mechanic tells you about a hot new stock. You stay invested in lazy portfolios through the ups and the downs and over time, you will be in a good place financially. Just think of your investments like a raft in the water and just ride it out. With investment diversification, the waves will be much smaller than they would be if you keep jumping in and out of the water, trying to time the waves.
So what is the easiest way for you to become diversified? Below I will share several resources to help you along the way.
First, you could create a spreadsheet, list your holdings down the first column and the asset classes across the top from left to right. Then, figure out each asset category for your investments and allocate the balance to the corresponding cell in the spreadsheet. Sounds like a lot of work, and it will take you some time. Luckily, I am here to help! If you click here, you can download a free asset allocation spreadsheet template that I created. It’s pretty straight-forward, but if you want a quick tutorial, you can check out this video I made on how to fill it out.
If on the other hand you want a less manual option, you can use Morningstar’s X-Ray Tool (here is the link as it is hard to find on the site.) You will need to enter in your holdings ticker symbols and the amount of the investment. From there, Morningstar does the rest for you.
A third option is less labor intensive. Just head over to Personal Capital and create a free account. Once you link your investment accounts, they will show you just how diversified you are. The ultimate benefit with this option is that your information is always up to date. No more updating the spreadsheet from above, nor entering in the ticker symbols and values with Morningstar either. Set everything up once and you are done. There are other benefits to Personal Capital as well, including saving money on fund fees that make the service invaluable. I run through all of them in this post here.
Once you understand your asset allocation, you can begin to make any needed changes, if you aren’t diversified enough. An additional resource is my ebook, 7 Investing Steps That Will Make You Wealthy, which you can use as a guide for helping you along the way.
Now, if you would rather not worry about diversifying your investments, then look into a firm like Betterment. From the very start, you are completely diversified. In fact, in 10 minutes you can open an account, choose your goal and set up an automatic transfer of money to be invested. Betterment will take care of the rest. How awesome is that? In addition to automating your investing and being diversified, Betterment rebalances and tax-loss harvests for you. (If you don’t know what this is right now it’s OK, just know it helps you in the long run.) I have an account with them and getting started really is that easy. I call them the lazy man’s way to invest.
Lastly, you can also look at the Horizon Fund options at Motif Investing as well. Their Horizon option is very similar to Betterment, the only difference is that there is no management fee, making it 100% free to invest (aside from the underlying ETF fees that you pay regardless no matter where you invest).
So there are your options for becoming more diversified and lowering (but not eliminating) your risk when it comes to investing. It is well worth your time to make sure you are diversified because without proper diversification, you are exposing yourself to greater losses than necessary.