Diversification is Your Friend

by | Sep 5, 2011 | The Economy, Weekly Column

“Don’t own stocks if you can’t stand volatility.” That was a central message at a recent investment conference I attended hosted by Dimensional Fund Advisors (DFA). David Booth, CEO and co-founder of DFA, which manages $240 billion, told us, “Volatility is part of the market. The reason you have the chance to earn higher returns in equity markets is because you take higher risk.”

After two market crashes in ten years, one would think even New York cab drivers understand that higher return and higher risk go hand in hand. But, based on calls I’m receiving from the financial reporters doing stories on “What should investors do now?”, the media hasn’t learned that lesson.

Even politicians are searching for ways to legislate volatility out of the markets. Few of them understand that this would be changing the spots on a leopard. If they succeed in removing market volatility, they’ll have a completely different animal. It will be called a certificate of deposit, with low risk and no return.

Booth emphasized, “What will determine your long-term success is what you do when markets are not doing well.” Readers of this column know that, when markets are not doing well, doing nothing is the path to long-term success. Even more important is what you’ve done before markets don’t do well.

Booth isn’t a big believer in the ability of money managers to time the markets or pick a high-performing portfolio of stocks. He said, “Professional money managers don’t do any better than random selection. We have 45 years of empirical evidence of this. Indexing gets you 80 to 90% of the way there.”

But DFA doesn’t believe you do best by owning index funds. Indexes periodically add and remove companies. The companies and the dates of the additions or deletions are well known. Booth explained a person doesn’t need to be a genius to figure out you don’t want to buy or sell a stock on the day it goes in or out of an index. This is especially true with small caps that have thinner markets.

DFA believes in a combination of passive selection of securities and actively managing the trading. Their philosophy appears to have merit, since the performance of their funds consistently beat index mutual funds, which have a totally passive approach.

Booth admits the idea of passively selecting stocks and the belief that markets are mostly efficient is counter-intuitive. While the incentives are huge for individuals to have a competitive edge in business, “it’s not the same with managing money.” He adds that there are a lot of benefits to passive stock selection. Not only does the strategy produce superior returns to 97% of actively managed funds, “There is much less stress in managing money with a buy and hold strategy, and better returns.”

When it comes to investing in stocks, an investor can’t control the direction of the market or the fate of individual companies. Booth concluded that investors need to broadly diversify by owning thousands of companies and then focus on what they can control: expenses, asset class diversification, minimizing taxes, and not selling during market panics.

Eugene Fama, a professor of economics at the University of Chicago, also told us, “Diversification is your buddy,” and emphasized that investors need to own many asset classes. The one thing you can do today is be sure your portfolio owns a good helping, equally split between the US and foreign, of short and intermediate term bonds, inflation adjusted bonds, stocks, real estate investment trusts (REITS), commodities, and alternative investments.

Then, relax for the ups and downs of a long ride.

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