Help
There are some well-established, uncontroversial ideas in personal finance that I don’t understand. Maybe I’m not smart enough, I’m not thinking about the ideas in the right way, or I stumbled across something.
The well-established, uncontroversial idea in my crosshairs is an application of diversification. Everyone is encouraged to spread their assets between many different classes including stocks, bonds, real estate, and commodities. The reason for this is two-fold: (1) it’s easier to cash out part of your portfolio and (2) it lowers risk.
While there is some truth to this, I doubt the extent of the benefit provided to investors and propose that most long-term investors would be better off reducing diversification across asset classes in their long-term investments and instead allocating extra to historically higher earning asset classes (i.e. equities).
First, diversification adds the benefit of not having to cash out the underpriced part of your portfolio. However, people often cash out, not the most undervalued asset, but the asset with the worst recent returns. Also, people are encouraged to put their bond/cash portion of their portfolio in their retirement accounts for tax reasons. To the extent someone does this, the benefit is reduced.
Second, diversifying lowers the return and standard deviation of the overall portfolio but, it is argued, the reduction in standard deviation provides a bigger benefit than the reduction in return. However, if you look at returns over any long period, stocks have outperformed bonds in any period, even periods including the Great Depression. While there is less volatility in the short run, if the historically good and bad case long-term scenarios for stocks both outperform those of bonds, why would long-term investors hold bonds? While the future may not play out exactly like the past, it is the best indication of the future we have.
Investors should look at the return and standard deviation of the asset over the intended holding period. If you let an investment ride, who cares how much an investment fluctuates in a year? It has no relevance. What matters are the probable ranges of your net worth many years out.
