Investing Principle 4: Diversification Is Key

by Mark W. Riepe, CFA, Senior Vice President, Schwab Center for Financial Research
June 17, 2008

The fifth article in an 11-part series on Schwab's investing principles.

Whenever you invest, you take on a certain amount of risk. However, successful investors only take on the level of risk that they need to, and no more. Diversification is an excellent tool that you can use to control excessive risk-taking. In fact, according to Schwab’s Investing Principle No. 4, diversification is the second most important factor in reaching goals.

Put your eggs in more than one basket
One example of proper diversification is to make sure that the fate of your portfolio doesn’t rely too heavily on what happens to a single stock or bond that you may hold.

If you invest in individual stocks, just think of the damage to your financial future if you had held mostly Bear Stearns stock. If you think the collapse of Bear Stearns is an isolated instance or a fluke, it isn’t. Because there are so many things that can go wrong with a particular company, we believe it just doesn’t make sense to have more than, let’s say, 10% of your portfolio in any one stock.

Think of the airline stocks done in by a bad business model, or fraud taking down companies like Enron and WorldCom.
Obsolescence wreaked havoc with various technology companies as well as old stalwarts like some film and camera manufacturers.
Asbestos litigation has been the bane of many old-line industrial firms.
High labor costs are creating well-publicized problems for many firms in the automotive sector.

In retrospect, the problems these firms faced seem obvious. Unfortunately, only hindsight is 20/20. Each of these companies had thousands—if not millions—of shareholders who thought the stocks of these companies were worth holding before troubles mounted. It can be harder than you think to see a train wreck coming.

3 important steps	10 proven principles
Create a plan	1. Having an investment plan that is realistic and actionable is crucial to meeting goals. 2. Understand your plan, follow it and adjust it when things change in your life.
Put it into action	3. Saving and spending rates have the greatest impact on success. 4. Diversification is the second-most important factor in reaching goals. 5. Select the asset allocation that’s right for you and stick with it. 6. Choosing professionally managed investments can be a better way to invest. 7. Acting now generally beats waiting.
Stay on track	8. Periodic checkups keep a portfolio healthy. 9. Progress toward goals is more important than short-term performance. 10. Use the right benchmarks to evaluate performance.

A rising tide lifts all boats? Not always
Another way of thinking about diversification is to consider that even when the overall market is rising, there’s no guarantee the stocks you own will rise along with it. For example, in 2006, the S&P 500 Index rose 16%. That kind of performance is well above average. However, during that same year, 120 of the 500 stocks in the index declined in price. This wasn’t an isolated occurrence. In 1999, the S&P 500 Index rose 21%. In that year, 256 companies—over half of the index—were down for the year.

There’s nothing wrong with investing in individual stocks, but my advice is to take some risk off the table by spreading your bets around. I think you’ll be better for it.

If you’re employed by a firm whose stock is publicly traded, don’t compound the problem by loading up on the stock of your employer. After all, your career is already invested in the company. Making an even larger bet on the firm by investing your portfolio in it just isn’t prudent.

Diversification reduces many types of risk
Up to this point, we’ve discussed individual stocks. The same principles apply to individual bonds issued by corporations. It’s all too common for investors in individual bonds to load up on the highest-yielding bonds that are rated investment grade. I understand the attraction, but credit ratings aren’t static. Just because a firm is rated investment grade today doesn’t mean it will stay that way—and when bonds get downgraded, their prices begin to suffer. Eventually, the bond issuer may have difficulty making their interest payments, let alone any repayments of principal.

Schwab has found that if you’re creating a portfolio of individual bonds, you can eliminate three-quarters of the risk associated with companies defaulting on their bonds by investing in at least 10 different issuers.

Spreading your portfolio out across different companies is a good start, because it reduces the risk of problems with one company having an undue impact on your portfolio. But it isn’t enough. There are many other sources of risk that can be reduced through diversification.

Think back to the late 1990s and the many investors whose portfolios were heavy with technology stocks. They may have had many names in their portfolios, but because those names were in the same industry or sector, they weren’t as diversified as they should have been, —creating excessive risk compared to spreading one's investments across different industries and sectors.

The stock market often flows in cycles, where so-called growth stocks will dominate in some periods and value stocks will dominate in others. Because it’s difficult to call the turning points, we suggest you have both growth and value stocks in your portfolio.

If you’re an income-oriented investor, these lessons apply to you as well. Income investors will often invest in stocks that pay high dividends in their desire to get those juicy dividend payments. There’s nothing wrong with that, of course. However, things get problematic when the equity portfolio becomes composed entirely of REITs and bank stocks, which tend to pay the higher dividends. When this happens, the extra risk the income investor is taking on will cause problems during periods like last year, when real estate markets and the credit crunch created chaos in the real estate and financial sectors.

The final aspect of diversification is asset allocation: spreading out one’s portfolio across various asset classes. We’ll talk about this next the next installment of our series on Schwab’s Investing Principles.

For now, do yourself a favor and make use of some of our tools on Schwab.com that are designed to assess whether your portfolio is adequately diversified. Specific examples include our Portfolio Checkup Tool and our Quarterly Portfolio Profile (you can find links to these tools in the box on the right). Take action if the tools point out any problems.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The types of investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Examples provided are for informational purposes only and not intended to be reflective of results you should expect to attain.

The types of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Examples provided are for informational purposes only and not intended to be reflective of results you should expect to attain.

Diversification strategies do not assure a profit and do not protect against losses in declining markets. Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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1. A Blueprint for Success

2. Stick With Your Plan

3. The Top Success Factor

4. Diversification Is Key

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