Have you ever dreamed about going back in time? What would you do if you could? Other than telling Rick to guard Grant Hill to prevent the pass to Christian Laettner during the 1992 NCAA tournament, I would buy Apple stock. Why Apple? Because in the history of the markets since 1926, Apple has generated more profit for investors than any other American company – $1 Trillion. Hendrik Bessembinder, a name built for Pig Latin if I ever saw it, is a professor of Finance at Arizona State who has studied stock return data and concluded that most stocks aren’t good investments at all – many don’t even beat the paltry returns of one-month Treasury bills. What?
In fact, only 4% of all publicly traded companies have accounted for 100% of the net wealth earned by investors in the stock market since 1926. That means 96% of stocks are losers. Dr. Bessembinder defines net wealth as total stock returns in excess of 1-Month Treasury bills, which averaged 3.38%, so the total actual returns of Apple and these 4% are even higher than indicated.
So, all we have to do is figure out which stock will do the best over the next 20-30 years and we will be set! Or, of course, travel back in time and pick Apple – which may actually be easier to do. Dr. Bessembinder said, “In a market where most of the big gains are attributable to a few big winners that are hard to identify in advance, it makes a lot of sense to diversify to avoid the danger of omitting the big winners from your portfolio.”
Consider this: If a non-diversified portfolio has $500,000, all in U.S. stocks, and the market declines by 20%, the portfolio will decline approximately $100,000 to $400,000. If you are within a few years of retirement, that can be quite frightening. Now, in order for your investment assets to grow back to their pre-downturn amount, the stock market must gain 25% to reach their original value of $500,000. Even scarier.
But, if your portfolio is properly diversified, it shouldn’t match the ups and downs of just the U.S. stock market and it shouldn’t decline as much when the market declines.
Here is how to ensure you own the big winners over the next 20 years and are properly diversified: First, pick funds that contain a large number of stocks rather than purchasing individual stocks themselves. Second, pick funds that are attempting to generate returns by using different strategies. For instance:
• Growth Funds seek to purchase stocks of companies that they believe have the potential to increase sales and earnings;
• Value Funds seek to purchase stocks of companies where the current stock price doesn’t reflect the company’s value;
• Small Cap Funds invest in companies with small market capitalizations;
• Mid-Cap Funds invest in, you guessed it, mid-sized companies;
• Large Cap Funds invest in, of course, larger companies.
Furthermore, to truly diversify a portfolio one must also invest in asset classes that aren’t closely correlated with the stock market. In other words, they zig when the market zags, and vice versa. Asset classes such as:
• Long Term Income assets that are designed to generate income, not necessarily appreciate in value;
• Real Estate funds that invest primarily in the stocks of real estate companies and seek growth through both capital appreciation and current income and are often a good hedge against inflation;
• International funds that invest in non-U.S. companies and seek returns through the growth of those companies.
As always, your financial plan should guide your actions and your portfolio should be constructed so it supports your long-term goals. Diversifying properly will help you achieve those goals faster and with fewer ups and downs.