The Case for a Diversified Investment Allocation

Every so often someone will ask me what I would recommend they invest in. There’s a lot of ways this question is phrased, and it’s not always so direct. I.e.,

“Hey, I’d love to pick your brain on investing over lunch some time.”

I hate letting people down, but this is one area where I feel like I need to set some boundaries.

For starters, I would never tell anyone exactly what ticker symbols they should invest in and how much in each. There’s simply nothing good that can come from it. Even if my recommendation blows the roof off over the next year, it could be a terrible laggard the year after. Or maybe it craps the bed right away. Either way, I’m the jerk.

Secondly, for me to even give a recommendation is to pretend that I know what will perform well. I don’t. Nobody does (tip: if someone pretends like they do, they are not to be trusted). That’s why investing in equities carries risk. If everyone knew where the good returns were going to come from, it would drive down those returns because everyone would pile in to those investments and drive up prices.

diversified investment allocationI will say this – I stay away from individual stocks because they do not offer diversification (and you can easily rack up hefty trading fees) and are high risk as such. Diversification is key for amateur investors. So where to get it?

Some folks recommend a diet of the S&P 500 index, through the purchase of a passively managed index fund or ETF. Heck, even one of the greatest investors of all time, Warren Buffett, did just that with his advice to amateur investors in the 2014 Berkshire Hathaway letter to shareholders,

The goal of the nonprofessional should not be to pick winners — neither he nor his “helpers” can do that — but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.

The S&P 500 is the 500 largest publicly traded companies in the U.S. Because it consists of 500 companies in a wide cross-section of sectors, it is itself diversified. Furthermore, even though these are U.S. companies, 44% of the revenue of the S&P 500 comes from overseas (FYI, Vanguard’s international equity exposure was recently increased to 40% in its Target Retirement and Life Strategy funds). So you’re getting significant exposure to the global economy with the S&P 500.

If you are only going to pick one investment, you can surely do a whole lot worse than a low-cost S&P 500 index fund or ETF (note: Vanguard has a few good ones). However, you can get even more diversified than that…

Enter the Callan Periodic Table of Investment Returns

callan periodic tableThe image to the right is a small section of the Callan Peri Callan Periodic Table of Investment Returns (click the link for the full chart).

What you’ll see is the performance of the largest indexes over the last 20 years, with each column showcasing the the top performing index to the bottom performing index for that year, as well as their returns. As you can see, no index consistently is at the top or bottom of this chart, year after year. And there are no easily distinguishable patterns.

By selecting from a number indices, you increase the diversification in your investment portfolio. Diversification won’t necessarily lead to better returns, but it can help you smooth the ride and avoid putting everything in to one index, only to see it under-perform the others for an extended period and decimate your nest egg.

If you’re looking to avoid that scenario with a very diversified allocation, you could do a lot worse than a mix of the following indices, at your discretion:

  • U.S. large cap (i.e. S&P 500)
  • U.S. small cap (i.e. Russell 2000)
  • International (i.e. MSCI EAFE)
  • Bonds
  • Real Estate (MSCI US REIT)

And no, I’m not going to give you percentages. ;-)

If that’s too much for you, you can do a lot worse than sticking with the S&P 500.

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