Investing: Why You Should Diversify

In previous videos, we've hopefully convinced you what you should not do. Don't try to beat the market by picking stocks. And definitely, don't pay someone big money to help you pick stocks.

Now let's turn to a rule that tells you what you should do. Investment Rule #3: Diversify! Diversify! Diversify! And, choose funds with low fees. Diversification allows you to reduce your risk by spreading your investment across many different assets. The great thing about diversification -- it's a free lunch. It reduces your risk without reducing your return. Don't put all your eggs in one basket. I'm sure you've heard that saying before. Yet when Enron -- one of the most successful and seemingly safe energy giants -- when it collapsed, its employees had about 60% of their retirement savings in Enron's stock. Many employees who once had been millionaires -- they retired with next to nothing.

So, let's be clear: it may sound loyal, but investing in the stock of your employer -- it's never a good idea. Two reasons: First, you should never have a substantial fraction of your wealth in a single asset, whether it's your employer’s stock or not. Second, investing in your own employer really does put all your eggs in one basket. If the company goes down, you lose your job and your retirement savings at the same time. Terrible idea!

Moreover, modern financial markets make it easy to diversify. Our favorite investment is index funds -- low fee funds that simply mimic a large market basket, like the S&P 500 or the Wilshire 5000. But don't limit your diversification to stocks from your home country. That's called home market bias. It's quite easy to diversify internationally by buying an international index fund or by buying more big multinational companies.

Once again, diversification is a free lunch. By diversifying, you can lower your risk without reducing your return. Since stock picking doesn't work, you shouldn't pay someone to pick stocks for you. We've said that already. And we've said that our favorite investment device is a low-cost index fund. But, even among index funds, some have higher fees than others. So, look for funds with low fees. Vanguard often has lots of good choices of low-fee index funds.

But in any case, make sure you check. Fees might not seem like a big deal, but they're one of those things that adds up over time. If you invest $10,000 today, for example, and you hold it in a mutual fund that charges 1% fees annually, then in 25 years, you'll have about $57,000, assuming a market return of 8%. Fifty-seven thousand -- that's not bad. But if you invest the same $10,000 dollars in an index fund that charges 0.2% in fees, a very reasonable number, then in 25 years, you'll retire with just over $70,000 dollars. Do you really want to give up nearly $13,000 -- for nothing?

The bottom line is that when it comes to investing, simple is the way to go. If your employer offers a 401(k) plan, sign up. Invest a constant fraction of your paycheck regularly and put the money in a low-cost index fund. I know there's a few sophisticated folks out there who -- maybe they're not yet convinced. Maybe your friend advised you to buy stocks in December to catch the January effect. Or they told you that stock prices fall on Mondays. Maybe you've heard that people aren't perfectly rational and that the market is filled with anomalies that efficient markets theory has trouble explaining.

Next up, we're going to dive into the findings of behavioral finance to see whether we can profit from irrational behavior and market anomalies.