How Investment Diversification Makes You Rich

What is your investment strategy? Do you even have one? Or do you just invest in whatever is hot at the moment, hoping you will crush it and be able to retire in a few weeks? Sadly, this investing strategy is ripe for failure. The only true way to “crush it” in the market is to use investment diversification to your benefit.

You might point out however that you’ve picked a hot stock here or there in the past and did end up crushing it. While that could be true, the reality is there are many more times where you invested in the stock of the day and lost your shirt.

No investor, over the long term, consistently picks the best stocks every single time. The fact that the average investor only earns 2% per year while the stock market earns 8% proves this. So while you might get lucky here and there, the better option is to invest in a well diversified portfolio.

By using this simple strategy, you can earn more money investing and even limit your losses. Sadly, 99% of investors out there ignore this and lose money as a result.

The Fallacy Of Market Timing

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 typically give in to their emotions when they should not be listening to them.

A classic market timer probably became so scared in 2008 that they pulled everything out of the stock market and stayed out until a few years ago. They bought back in and are now worried again because people are talking about the market hitting all time highs.

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. In fact, investment professionals have made this cycle into a chart.

How investment diversification makes you rich

This classic scenario plays itself out over and over again. Next time you are 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 they jump in and out of the market. 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 of the highest-earning days does to your return.

How investment diversification makes you rich

Your return is almost cut in half by missing the 10 best days! Good luck at guessing when those days will happen.

The Power Of Investment Diversification

While everyone does get lucky every now and then from timing the market, it is not a sustainable formula for success. I would even venture to say that most investors have probably lost more than they realize, they just focus on that one investment they crushed the market with. This isn’t a fault of theirs; it is how human beings are wired.

To show you that market timing doesn’t work, I want to play a little game with you. I’d like you to look at the picture below and see if you notice anything.

This isn’t a trick quiz where if you stare long enough an image appears, and it’s not a Tetris map either. Just see if you can spot a pattern.

How investment diversification makes you rich

My guess is that you did not see a pattern. This is good, because there is no pattern to be found. The colored boxes each indicate a benchmark of the stock market from 1997 through 2017, 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.

As you can see, one benchmark does not dominate the top of the chart. Each one is all over the map. 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 1997 international stocks were the worst performers. But come the next 2 years, they were the best performers of the market. Then they plummeted to the bottom for 2 more years, only to rise once again.

how stock diversification makes you rich

U.S. Stocks: While international stocks tend to have more volatility associated with them, large U.S. stocks too are all over the map. Below is a chart of their performance over the past 20 years.

U.S. 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.

Real Estate: One last example to show you. Let’s look at real estate. For those who do not know, the historically typical return for real estate is around 3% a year. When you hear people talking about getting rich in real estate, it typically happens through renting out the property and not through price appreciation.

This is not to say prices don’t rise, but not like they have recently. Looking at the chart below, real estate is a strong performer from 2000 through 2006. Then the bottom fell out in 2007. But in 2009 it came roaring back for a short run, only to fall again.

how stock diversification makes you rich

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. You 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 to see if they can help you lower your risk and stabilize your returns.

#1. 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 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, since they tend to be less volatile than stocks. 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 to save enough money for retirement or reach your financial goals.

And even though there are few negative return years for bonds, it looks like 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 stop it, the “bubble” that has formed in bonds is going to deflate. This could lead to either negative returns or close to zero returns for a period of time.

#2. Stay Out Of The Market

Your next option would be to simply stay out of the market. This too is not a good option. For one thing, you need the return on your money that the stock market provides so 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 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 invest in assets that are way too risky for you and lose everything.

#3. Investment Diversification

The first two options are not a winning strategy, but having a well diversified portfolio is. Investment diversification is a fancy way of saying not to 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 diversified portfolio example would be to split your investable money into two equal parts and invest half in stocks and the other half 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 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 had enough and sold out. Over the next five years, international stocks perform outstandingly.

Let’s look at this in terms of your money. Let’s say you did jump in with $10,000 at the end of 1999 to ride the wave. What happens to your $10,000?