Why Diversify?

When in doubt, spread it out.

Sarah Newcomb 31.12.2019
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Imagine you put all of your savings into the stock of a company that is researching cancer, and then the cure is found…

...by a competitor who owns the patent.

Or, imagine going all-in with your buddy’s new business venture and it folds after a year. Or you decide to put all of your savings into wind power and geothermal ends up taking over the market. Any time you put all of your money in one place, you make yourself entirely dependent on how that one investment performs.

The smart shortcut for this week is this: When in doubt, spread it out. In other words, diversify.

Business cycles and technological change create volatility. When one industry is up, others are down. In lean times, discount retailers do well. In good times, luxury retailers thrive. When the stock market is booming, bonds are less lucrative. When there is a stock slump, bonds are more attractive. This is normal, and it’s why you constantly hear people saying you need to diversify, diversify, diversify.

But what does it mean to diversify, and how do you do it as a novice investor?

Diversifying means having a lot of different investments in your portfolio. That way, when one investment or sector is doing well, that part of your portfolio makes up for the parts that may be lagging. On balance, as the entire economy grows, your portfolio grows with it.

With that in mind, why not just buy a few shares of 100 different companies that span lots of industries? Because it would be too expensive for most people to do that--not to mention that you’d have to pay transaction costs on every single purchase, draining your potential returns. Thankfully, someone thought of this, and created what we know today as a fund.

Funds to the Rescue
A fund is a collection of stocks, bonds, and other assets that have been chosen according to some pre-identified investment strategy. The basic idea is to pool money together from thousands of people into one big pot, and then use that kitty to create one big collection or combination of stocks, bonds, and other assets.

A fund is just one large portfolio, and when you buy a share of a fund, you’re buying a fraction of ownership in the whole thing. So instead of buying individual shares of stock in many companies, you can buy one share of a fund and effectively own a tiny fraction of a share of all the companies that are in the fund’s portfolio. Funds are diversification made easy, and with lower transaction costs. There. Now you know more than most people do about funds (no kidding).

Is a Fund a Product or a Service?
It’s critically important to know the difference between a product and a service. Here, we have both. Someone has to decide which companies/bonds/and others to include in the fund, and someone has to make sure the investment strategy is maintained over time. The creation and management of the fund is a service. A share of the fund is a product. You pay for the product by buying the shares, and you pay for the service by paying fund management fees each year. Pay attention to those fees!

The Fund-Selection Booby Trap
Funds are a great way for beginner investors to diversify without needing to spend a fortune or research hundreds of different companies independently. By buying just a few funds (or, arguably, just one well-diversified fund), you can build a nicely diversified portfolio.

Mutual funds began in the 1920s, and today there are thousands of funds to choose from. There are funds made up of bonds and funds made entirely of real estate stocks. Some try to behave just like the Dow or the S&P 500. You can buy a fund made of only biotech stocks, or one that only buys shares of green companies. There is even a fund that invests in IPOs for the person who wants to roll the dice on newly public companies without having to research and follow each one.  

In fact, there are so many funds that many people get overwhelmed. The point of a fund is to make diversification easy, so, how do we keep fund investment simple?

In his book, Simple Heuristics That Make Us Smart, behavioral scientist Gerd Gigerenzer lays out a smart shortcut for this kind of selection problem. It’s called “take the best” and its dirt simple. First, you decide what’s most important and filter your search based on that. If you still have many options, choose what’s next most important and filter again. In this way you can whittle it down to the best option(s) based on your personal priorities and goals.

Step 1: Decide What Matters Most to You and List Them in Order
Remember, when you buy a financial product, the rule is: caveat emptor. Buyer beware. As a customer you want to decide which fund or funds are right for you based on the attributes that matter most to you and your situation. That might be price, fees, the particular companies that compose the fund, or any number of other things. Here let me make another shameless plug for Morningstar research (hey, I’m proud of our ratings--they are really helpful): If you want a quick way to compare funds, you can look at our Fund Analyst Ratings. We assign Morningstar Medalist ratings (Gold, Silver, Bronze) to funds based on how likely we believe they are to outperform over a full market cycle. The ratings are a short and simple way to compare funds on a broad measure of overall quality.

You can list as many attributes as you like, but I would recommend sticking to three or four. Beyond that and you might be splitting hairs or making things unnecessarily complex.

So, let’s say you decide that what matters most to you are, in order of importance:

A. Because you have a long-term time horizon, you want to focus on stocks.
B. Funds with Gold or Silver Morningstar Analyst Ratings.
C. A mix of companies across many industries.
D. Low fees.

Now you’re ready to start your search.

Step 2: Filter Your Options
Fund screeners are all over the Internet, and we have them on Morningstar.com, of course. Screeners let you filter the list of all available funds based on what you care about. The important thing to remember when using a fund screener is not to get overwhelmed by all the filtering options you don’t understand.

Very sophisticated filters (like those on our site) will have dozens or hundreds of filtering criteria to choose from. Don’t panic. Remember, good is good enough, and if you can find a fund that fits all of your criteria, then its likely good enough.

For Example?
Imagine your employer gives you the choice of five funds for your retirement account. You run them through your filters and find that three of them meet all of your criteria. In that case, you could divide your money across all three, put it all into one, or choose other criteria to narrow it down further.

If all of them fail all of your criteria, then try some different criteria (and consider lobbying your employer for better options).

Summing Up
You can easily build a well-diversified portfolio by investing in one or more funds. Think about what matters most to you. Fees are important, as is time horizon, and beyond that there are lots of ways to customize your portfolio by using fund filters to narrow down your set of options to find those that match your needs and goals.

The bottom line is that by investing in funds, you avoid the risk of losing everything if an individual company fails. Because a fund is made up shares in many companies, the failure of one firm won’t sink the ship.

As one of my finance professors used to say: “The best stock can go to $0.00. The worst fund never will.” So remember: When in doubt, spread it out! 

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Sarah Newcomb

Sarah Newcomb  Sarah Newcomb is a behavioral economist with Morningstar.

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