Diversification and Why It’s Crucial to Your Portfolio

Ever played a game of roulette? When the ball rolls, there’s a wheel’s worth of results that transpire. If you’ve chosen the winning number, you rake in the chips. Now imagine if you played the same game of roulette, but you bet small amounts of money on every single number. In this scenario, there’s no way you won’t win.

In a very basic sense, this principle underlies the investment strategy of diversification, which we adhere to at Betterment. Except in the stock market, unlike in Vegas, the house doesn’t always win. In roulette, only one number can win with each spin, so you’re going to be betting on a lot of losers in order to guarantee that you have a winner. But when you diversify your investment portfolio, while not all the stocks in it are going to end up increasing in value, there won’t be just one winner, either. So, if you diversify your assets as much as possible among the stocks that have at least the potential to succeed, you’re putting yourself in the situation with the least risk and the highest potential reward. The SEC explains this idea using a familiar idiom:

It is often said that the greater the risk, the greater the potential reward in investing, but taking on unnecessary risk is often avoidable. Investors best protect themselves against risk by spreading their money among various investments, hoping that if one investment loses money, the other investments will more than make up for those losses. This strategy, called “diversification,” can be neatly summed up as, “Don’t put all your eggs in one basket.” [emphasis ours] Investors also protect themselves from the risk of investing all their money at the wrong time (think 1929) by following a consistent pattern of adding new money to their investments over long periods of time.*

How to Diversify Effectively: Mixing Riskier and Safer Assets

Of course, diversification must be executed with a careful eye to which stocks to include. At Betterment we do the selection for you, and the basic principles of the value of diversification as well as how to execute it are explained by what economists refer to as “Modern Portfolio Theory.” What we end up with, in our Stock Market portfolio, is a basket that broadly represents the US stock market – and this is the “high risk, high return portfolio” that we recommend to our customers.  We could take the diversification even further than US stocks, by including international investments and real estate, but for the moment, we’ve kept this portfolio simple, because you get some foreign and RE exposure via US stocks, and anyway those asset classes are relatively highly correlated.

Not every investor wants a high risk, high return portfolio.  Some want a low risk, more short-term investment.  And for that, we offer Treasury Bonds, which do carry the risk of a changing price, but don’t carry the risk of default (because the US government backs them). By combining the stock portfolio with the less risky basket of government bonds, we can create a balance that’s right for any customer, from low risk to high return. This is a balance that has been heralded by economists. As London Business School professor Raman Uppal writes: “…every investor’s portfolio can be constructed by investing in only two portfolios: the riskless asset and the portfolio T, consisting only of risky assets.”*

Don’t Try This at Home: The Pitfalls of Behavioral Bias

Now, you might be wondering: once I know what needs to go into a well-constructed portfolio, why shouldn’t I just go out and buy up a bunch of stocks and bonds myself? Well, there’s an important part of the investing puzzle–the basis of one of the key criticisms of the purest incarnation of the Modern Portfolio Theory–which is behavioral bias. We’ve gone into more detail on this in our post about Why You Can’t Beat the Markets, but the general idea is that if you try to allocate and reallocate your funds yourself, you are highly likely to fall into human error traps that your brain sets for you. In fact, a study from DALBAR shows that over the past 20 years, mutual fund investors underperformed the S&P by 5%. That’s a scary figure. It means that people who thought they were choosing diversified investments in the form of mutual funds did worse than if they’d just bought up S&P stocks and held them. The reason for this is that when left to their own devices, people make investing decisions that work against them due to behavioral bias. That’s why the Betterment set-and-forget approach works: once you put your money in with us and choose the level of risk you’re comfortable with, we reallocate automatically for you. So, you aren’t in danger of making reallocations that appear to make sense in the immediate term but in fact will reduce your earnings long-term.

* See page 5.  This type of “dollar-cost-averaging” is enabled via Betterment’s Automatic Savings Plan.

*See page 12