Diversification Doesn't Matter

 Toucalit Benton
The idea of a diversified holding of stocks is often said to save many investors from losing large amounts of money. However, the concept of diversification often is misunderstood in its most basic context. Diversification only matters when an investor is spread among completely different asset classes such as real estate (real property and not in the form of primary residence), business ownership, gold and silver (bullion), and stocks. All other notions of diversification are often just that…notions.

For do-it-yourself investors who wish to buy stocks, the mantra has been to diversify your risk. I guess this means, the more stocks you hold the less you’ll lose. Along these lines, diversification is supposed to reduce downside movements while participating in upside action. The fewer stocks you have the more you’ll lose. The more stocks you have the less you’ll lose. Unfortunately real life suggests that the more stocks a person holds the greater the risk of loss. How is this possible? I have my suspicions as to the reasons. However, I would like to provide the evidence for my claim that diversification isn’t all that its cracked up to be.

Many people who follow the stock market know that the Dow Jones Industrials Average is the most widely quoted index. However, most people “know” that the best index to follow for a broader understanding of how the entire stock market performed rely upon the Standard and Poor’s 500 (S&P 500) index. After all, the S&P 500 contains 500 diversified companies in many different industries. This is contrasted by the Dow Jones Industrials, which only contains 30 companies.

However, did you know that the top 43 companies in the S&P 500 comprise 50% of the movement of the index? The top 131 companies comprise 75% of the movement of the index. By the time you get to company number 258, you have reached 90% of the movement of the entire S&P 500 index. This means that the remaining 242 companies in the index only contribute 10% to the movement of the index. It’s as if those companies on the bottom half don’t even exist.

How is it possible that the S&P is so strongly influenced by the top 258 companies? The answer is that the S&P 500 is considered a market value weighted index. This means that, “…movements in price of companies whose total market valuation (share price times the number of outstanding shares) is larger will have a greater effect on the index than companies whose market valuation is smaller.” Basically, larger companies have more influence on the index. For this reason, most people who invest in an S&P 500 index fund or ETF are really investing in companies that have the largest valuation rather than a “well diversified” portfolio.

It wouldn’t be enough to simply say that the S&P 500 index isn’t as diversified as most people think. We need better evidence to show that the concept of diversification can’t stand on its own. Using the Morningstar.com database of various domestic indices, I compared the 1-year, 3-year, and 5-year performances to see if there are any distinguishing characteristics. Because this has been a declining market of the last 2 years we should see the indices with fewer stocks with the greatest losses. If there were any gains then the least diversified index should have the highest percentage gains.

Unfortunately, the reality is quite sobering. When comparing Morningstar’s 37 domestic indices in the 1-year category:
  • Ranked #1 was the healthcare index with a –20.55% loss with 178 companies
  • Dow 30 was ranked #17 with a loss of -35.05%
  • Russell 2000 (2000 companies) was ranked #20 with a loss of -35.27%
  • S&P 500 was ranked #23 with a loss of -36.47%

In the 3-year comparison:

  • Ranked #1 was the energy index with a 11.92% gain with 121 companies
  • Dow 30 was ranked #8 with a loss of -9.3%
  • S&P 500 was ranked #21 with a loss of -12.31%
  • Russell 2000 was ranked #29 with a loss of -15.44%

In the 5-year comparison:

  • Ranked #1 was the energy index with a 11.92% gain with 121 companies
  • Dow 30 was ranked #14 with a loss of -2.66%
  • S&P 500 was ranked #23 with a loss of -3.61%
  • Russell 2000 was ranked #27 with a loss of –3.78%

It seems as if the more diversified the index, the worse it performed. The only time the Dow 30 came at the bottom of the list was when we compared the 1-week, YTD, 4-week and 13-week ranges. Remember, a truly diversified index is supposed to overperform other indices on the downside (go down less) and underperform on the upside (go up less). If you’re investing for the “long haul” then the data tells us that you shouldn’t be invested in the S&P 500 or any other index that is “truly diversified.”

Another way to test this assumption of diversification on your own is to eyeball the different periods of time using the interactive comparison chart at Yahoo!Finance.com. First, pick the S&P 500 or any other “diversified” index and compare it to the Dow Jones Industrial Average. Then select the timeframe that you’d like to compare (5 years or more is best). Once the timeframe has been selected you can slide the timeframe backwards to any period you want. You’ll see that the Dow frequently overperforms on the upside and overperforms on the downside from 1980 onward. Prior to 1980, The Dow and S&P go back and forth in either underperforming of overperforming. The point being, diversification really doesn’t matter when it comes to spreading your risk. Touc.


Conclusion: Although diversification is considered the best way to avoid risk, if you lost 50% in 2008 then diversifying isn't as good as we think.
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Domain: Electronics
Category: Business
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