Catch a Gideon

Diversification - Ch 12 Bogleheads Series

November 17th, 2006 by digerati

This is Chapter 12 in the Bogleheads series here at Catch a Gideon. We are going through each chapter in the book and letting you know what we learned from reading it. You should buy the Bogleheads Guide to Investing. It has more examples and more depth than I’m giving here, and is overall an excellent investment book.

Diversification is protection against ignorance.  - Warren Buffet

We’ve all heard the expression “don’t put all your eggs in one basket” and that definitely applies to investing.  We’ve already covered asset allocation in ch 8 of the Bogleheads Series.  Diversification applies to holding multiple uncorrelated securities of a single type.  We’ll discuss stocks here, though the ideas extend to any sort of investment.

There are two benefits to diversifying: reducing risk and possibly increasing returns.

Diversifying is easy.  One method is to purchase mutual funds.  We can choose funds that covers multiple segments (technology and health for instance) or funds that range in investment style (core stocks, value stocks, and growth stocks).

Correlation Coefficient Principal

A correlation coefficient is a measure of how related two investments are.  If investment A always goes up when investment B goes up, they are highly correlated.  If A is up and B is down (alway) they are negatively correlated.  The strength of these correlations can be measured on a scale from -1.0 to +1.0.  A score of 0 indicates that two investments are not at all related (A may go up or down when B goes up).  Generally an average score closer to 0 would indicate a diverse portfolio.  A portfolio with a score of .52 would be more diverse than one with a score of .78.

Many investors think that owning a variety of stocks or funds guarantees diversification.  Nothing is further from the truth.  The problem is that many funds overlap in their holdings and market segments.   An investor needs to be sure to choose funds wisely to avoid highly correlated funds (assuming diversification is the goal).

Another option is to buy a “fund of funds.”  Vanguard offers this option as Vanguard’s Target Retirement funds.  These funds are managed to diversify their holdings so that you can just buy a single fund and not worry about managing it again in the future.

If you haven’t bought the book (The Bogleheads Guide to Investing) you should do it NOW.  The book has more detail than these summaries and is a good and easy read about investing.

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