When I was working on my MBA I became interested in a technology company that was changing the way the computer industry stored data. This was 1990 – long before the dot-com craze and this company actually manufactured something – and they were very good at it and profitable. Being on a budget, I bought 100 shares in the $20 price range and kept an eye on it. Over the next ten years my 100 shares became 800 shares (due to stock splits) and the price went from $20 to ~$110 per share. Then one day in 2001 the dot-com bubble burst and the price of my stock crashed with it. This wasn’t some profitless dot-com company like Pets.com or WebVan – but then again neither was Cisco or Qualcomm and their stock prices were pummeled too. It was simple guilt by association and anything related to technology was suddenly poison. By October of 2002 my favorite stock was worth about $5 a share. I was devastated. But not nearly as devastated as a colleague who’s “significant other had placed a large portion of their retirement savings in this stock. This intelligent, well educated, hard working individual had fallen victim of hype and forgotten the most important rule about investing: Diversification.
What is diversification?
The concept is simple. We spread out our investments in such a way that when the value of one investment or group of investments falls, the impact on our overall portfolio is minimized. Sure in 1997 it probably seemed like a great idea to put all your money in technology stocks – but those that did were essentially wiped out in 2001. The folks that had a diversified portfolio lost money for sure, but they had investments in energy stocks and consumer goods and banking stocks – and these stocks weren’t as badly affected and recovered sooner. Diversification essentially minimizes risk. In fact, a well-diversified portfolio would include international stocks as well. An economic downturn in the US may not affect China at all. And to reduce risk even further, we probably would want to include some investment instrument whose price is inversely correlated with stocks: Bonds.
Bonds vs. stocks
In general, when stock prices fall, bond process tend to rise – and visa versa. It’s by no means a perfect inverse correlation – but it often does work out this way. Why? Well investors chose between safe, low return bonds and risky (historically) high return stocks. When stocks prices are rising, investors take money out of bonds and invest more in stocks. Thus prices of stocks go up even further and bonds prices go down. When interest rates are high relative to the return offered by stocks (e.g. a bear market), investors sell some stocks and buy bonds. Stock prices go down and bonds become more expensive. Thus, we have a somewhat negative correlation.
How much diversification is enough?
In the past people have argued that diversification could be achieved with as few as 15 or 30 stocks. Dr William Bernstein addressed this misconception quite nicely here. Dr Bernstein is former neurologist who is now considered one of the foremost experts in the field of modern portfolio theory. It’s an interesting read – but for those that want the short answer – “the only way to minimize the risks of stock ownership is by owning the whole market.” How can you possibly own the “whole market”? Really the answer is quite simple: no-load, low cost, index mutual funds. But which ones and how much to invest in each? And what about how much to put into stocks and how much in bonds? We cover all that in other posts!