Maximizing
the Performance of Your Total Portfolio
Diversification does more than just reduce risk. Over time,
an intelligently diversified portfolio will almost always outperform a single holding.
Indeed, even a not-so-intelligently diversified portfolio will probably do the same.
In fact, a case study has shown that even five randomly
selected stocks would add value to an account. If they are chosen at random, they will
probably be in different industries, grow at different rates, and respond differently to
market forces. Long-term, an account containing these five stocks would have a higher
average value than one containing only one of the stocks.
While nobody would advocate such a coin-toss approach to
investing, there is a good case to be made for the passive strategy of investing.
We looked at this in the Investment Vehicles chapter, under index funds. A passive
strategy means that you buy a group of stocks that is diversified and hold on to them.
Your portfolio doesn't need to be "managed" -- that is, with stocks and shares
constantly being bought and sold. One passive investment method is to choose a selection
of stocks that are representative of the overall economy, so that, for example, the
percentage of General Motors stock you buy (your "weighting") would reflect GM's
size compared with other companies in the U.S. economy's corporate sector.
This is the principle behind the indexes and averages that
many mutual funds are linked to. The Dow Jones Industrial Average is based on thirty Blue
Chip stocks traded on the New York Stock Exchange. The Standard & Poor's 500 Index
tracks the 500 largest corporations in the country. An army of mutual funds, called Index
Funds, attempts to track the S&P Index's performance. Other popular indices include
the Wilshire 5000, the various Russell indexes and the Value Line Composite Average. You
can invest in funds that mirror any of these indices, depending on your preferences.
You may still be wondering why the best strategy isn't just
to put all of your money into a winning stock and watch it grow.
To begin with, it is impossible to know what will be a
winning stock in a few years. What's more, it does not make financial sense to tie your
retirement account to the performance of an investment that ends up doing well in the long
run, but fluctuates a lot in the meantime. Minimizing the downside risk through
diversification doesn't just protect the integrity of your investment; it actually
enhances the total performance of your portfolio. To understand how, consider what we'll
call the "up-and-down rule." Simply put, this rule says that a gain and loss of
the same size are not really equal.
Let's say you invest $100 in an individual stock. In the
first year, it gains 40%. In the second year, it loses 40%. See the chart below to find
out what your $100 investment is worth after two years.
| |
Starting Value |
Performance |
End-of-Year Value |
| Year 1 |
$100 |
+40% |
$140 |
| Year 2 |
$140 |
-40% |
$84 |
| |
| Total Portfolio |
$84 |
Are you surprised to find your investment has lost $16? Now
let's see what happens if you diversify your portfolio by adding another stock, and invest
$50 in each (instead of putting the entire $100 in one stock).
| |
Starting Value |
Performance |
End-of-Year Value |
| |
| Stock A |
| Year 1 |
$50 |
+40% |
$70 |
| Year 2 |
$70 |
-40% |
$42 |
| |
| Stock B |
| Year 1 |
$50 |
+10% |
$55 |
| Year 2 |
$55 |
-10% |
$49.50 |
| |
| Total Portfolio |
$91.50 |
Because your diversified your investments among two stocks,
your portfolio is worth $91.50 at the end of the two years. While you've still lost money,
you have $7.50 more than you would have had by investing in just one stock.
So remember: any amount of short-term loss you can shave
off is money you can reinvest toward the long-term buildup of your savings.
|
