Why would I want a diversified portfolio, versus throwing my investments into an index fund?

Question

Index funds are well-known to give the best long-term investment. However, most financial planners recommend having a diversified portfolio, including components such as bonds and foreign markets. I understand that having bonds adds stability to your investment, preventing it from decreasing too much during economic turmoil, though reducing your overall earnings.

When index funds are touted as being the best long-term investment, does this line of thought also factor in foreign markets (which are risky, but have high returns)? Would I be better off including some of these foreign market funds in my portfolio, or do index funds still offer the best long-term growth regardless?

Answer 1

Index funds are well-known to give the best long-term investment.

Not exactly. Indexes give the best long term performance when compared to actively managing investments directly in the underlying stocks. That is, if you compare an S&P500 index to trying to pick stocks that are part of it, you're more likely to succeed with blindly following the index than trying to actively beat it.

That said, no-one promises that investing in S&P500 is better than investing in DJIA, for example. These are two different indexes tracking different stocks and areas.

So when advisers say "diversify" they don't mean it that you should diversify between different stocks that build up the S&P500 index. They mean that you should diversify your investments in different areas. Some in S&P500, some in DJIA, some in international indexes, some in bond indexes, etc.

Still, investing in various indexes will likely yield better results than actively managing the investments trying to beat those indexes, but you should not invest in only one, and that is the meaning of diversification.

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In the comments you asked "why diversify at all?", and that is entirely a different question from your original "what diversification is?".

You diversify to reduce the risk of loss from one side, and widen the net for gains from another.

The thing is that any single investment can eventually fail, regardless of how it performed before. You can see that the S&P500 index lost 50% of its value twice within ten years, whereas before it was doubling itself every several years. Many people who were only invested in that index (or what's underlying to it) lost a lot of money.

But consider you've diversified, and in the last 20 years you've invested in a blend of indexes that include the S&P500, but also other investments like S&P BSE SENSEX mentioned by Victor below. You would reduce your risk of loss on the American market by increasing your gains on the Indian market. Add to the mix soaring Chinese Real Estate market during the time of the collapse of the US real-estate, gains on the dollar losing its value by investing in other currencies (Canadian dollar, for example), etc.

There are many risks, and by diversifying you mitigate them, and also have a chance to create other potential gains.

Now, another question is why invest in indexes. That has been answered before on this site. It is my opinion that some methods of investing are just gambling by trying to catch the wave and they will almost always fail, and rarely will individual stock picking beat the market. Of course, after the fact its easy to be smart and pick the winning stocks. But the problem is to be able to predict those charts ahead of time.

Answer 2

Diversification is extremely important and the one true "Free Lunch" of investing, meaning it can provide both greater returns and less risk than a portfolio that is not diversified. The reason people say otherwise is because they are talking about "true" portfolio diversification, which cannot be achieved by simply spreading money across stocks.

To truly diversify a portfolio it must be diversified across multiple, unrelated "Return Drivers." I describe this throughout my best-selling book and am pleased to provide complimentary links to the following two chapters, where I discuss the lack of diversification from spreading money solely across stocks (including correlation tables), as well as the benefits of true portfolio diversification:

• Jackass Investing - Myth #8: Trading is Gambling – Investing is Safer

• Jackass Investing - Myth #20: There is No Free Lunch

Answer 3

I can think of a few reasons. I'm not sure if they're good reasons, so I'll leave that for voters/commenters to provide judgement.

• index funds (ETFs) charge fees which can range from roughly 0.04% - 1% p.a. If you're planning to buy & hold over long periods, these fees could become relevant compared to owning stocks which has no ongoing cost as far as I'm aware. At the same time, don't forget to take into account the one-off costs such as brokerage fees and the buy/sell spread which are usually lower for the same volume investment in ETFs.
• you may want to pick (or avoid) specific companies for non-financial reasons. There are some ETFs which filter stocks from an index according to ecological, social and/or governance (ESG) values, but their evaluation of some companies may not match yours. Or their priorities might not match yours. If you have strong values and want your portfolio to closely match those values, you're probably going to have to invest in individual stocks.

Answer 4

Index funds are well-known to give the best long-term investment.

Are they? Maybe not all the time! If you had invested in an index fund tracking the S&P500 at the start of 2000 you would still be behind in terms of capital appreciation when taking inflation into considerations. Your only returns in 13.5 years would have been any dividends you may have received. See the monthly chart of the S&P500 below.

Diversification can be good for your overall returns, but diversification simply for diversification sake is as you said, a way of reducing your overall returns in order of smoothing out your equity curve.

After looking up indexes for various countries the only one that had made decent returns over a 13.5 year period was the Indian BSE 30 index, almost 400% over 13.5 years, although it also has gone nowhere since the end of 2007 (5.5 years). See monthly chart below.

So investing internationally (especially in developing countries when developed nations are stagnating) can improve your returns, but I would learn about the various international markets first before plunging straight in.

Regarding investing in an Index fund vs direct investment in a select group of shares, I did a search on the US markets with the following criteria on the 3rd January 2000:

If the resulting top 10 from the search were bought on 3rd January 2000 and held up until the close of the market on the 19th June 2013, the results would be as per the table below:

The result, almost 250% return in 13.5 years compared to almost no return if you had invested into the whole S&P 500 Index.

Note, this table lists only the top ten from the search without screening through the charts, and no risk management was applied (if risk management was applied the 4 losses of 40%+ would have been limited to a maximum of 20%, but possibly much smaller losses or even for gains, as they might have gone into positive territory before coming back down - as I have not looked at any of the charts I cannot confirm this).

This is one simple example how selecting good shares can result in much better returns than investing into a whole Index, as you are not pulled down by the bad stocks.