Which matters more when investing: Diversification or Asset Allocation?

I've previously shared that while stock market prices will fluctuate wildly in the short term, “the longest it has ever taken an investor to recover an original investment in the stock market (including reinvested dividends) was the five-year, eight-month period from August 2000 through April 2006” (Jeremy Siegel, Stocks for the long run, 2022 Edition). 

In other words, the stock market goes down….but it has never stayed down! This means that permanent loss when owning a diversified portfolio of stock investments is only something we can bring on ourselves by making rash/emotional decisions.  So let’s ask the question again: “Gideon, what about diversifying your investments OUTSIDE/AWAY from the stock market….shouldn’t we be diversifying more of the pot into other assets?” 

NO. 

If our goal as investors is to maximize long term return & gives ourselves the best chance of reaching our financial goals 10, 20, and 30 years from now….than the preponderance of your liquid net worth should be held in mainstream equities. 

Investing in the capital (stock) markets has, historically, been the greatest way to compound your wealth & outpace inflation over time.

Read that sentence again. It is both the historical reality & something that NEEDS to be understood to get where we all want to go. 

And taking my answer even further, if the stock market is a greater means to maximizing long term return as compared to the other asset classes available to us (cash, fixed income, T-bills, real estate, gold etc.), well, then, how does moving money out of equities for the sake of “diversification” make any sense?

Diversification is meant to minimize risk….it’s not meant to minimize return! Here’s the point: you are already plenty diversified because WITHIN your stock market driven portfolio you own a combination of the following types of equities: large cap, small cap, mid cap, growth, value, dividend payers, emerging markets & developed markets. 

Building portfolios in which we own shares of companies in all of those categories is how we stay diversified while giving ourselves the greatest chance for long term investment success. There will be periods where small cap outperforms, or international, or value-oriented stocks etc….that is the point! 

Too often, people mistake asset allocation FOR diversification. It is not. Asset allocation merely refers to the act of investing into different categories of investments (bonds, cash, real estate etc.)….whereas diversification means that you aren’t too concentrated in any one specific investment in a way that can cause you financial problems if something were to go wrong with that one asset. 

It’s analogous to a basketball game. You wouldn’t say you want fast, medium, and slow players on your basketball team in order to be “diversified” across player speeds. Instead, you’d say you want to find as many fast players as you can get….but you’d like fast players that play different positions: point guard, center, shooting guard etc.  

Let’s use a real example: Asset allocation is achieved when you own 50 shares of Amazon stock and $10,000 worth of Amazon bonds…..Yes, you are allocated between asset classes (stocks and bonds) but you are NOT diversified as you are tied in exclusively to Amazon as a company. Diversification is achieved by owning $2,000 of Amazon, $2,000 of Berkshire Hathaway, $2,000 of Google, $2,000 of Johnson and Johnson, $2,000 of Proctor and Gamble, $2,000 of Nike along with shares of 200 other companies.  Yes, you are entirely invested in equities but you are PLENTY diversified. You are simply utilizing the asset class that, historically, has provided the greatest long term return (equities) but you are doing so in a way where you are not concentrated in any one company or approach….if one isn’t doing so well, the other companies will make up for it. (Btw, these are just EXAMPLES and not specific RECOMMENDATIONS as we would never suggest owning a limited/concentrated portfolio of stocks....we are talking about stocks as an asset class through the ownership of low cost index funds)

As always, if you have any questions please reach out to schedule your 15 minute "Right Fit" call here so we can figure out together if there's more you can be doing now in your financial world.