5 Myths About Stock Diversification

Diversification is often described as the only free lunch in investing—reducing a portfolio's risk without reducing expected return. This idea of spreading money across different kinds of investments is so accepted and so straightforward that it is a fundamental principle that even the most unsophisticated investors know about it.

But while many individual investors think they understand diversification, they often fall prey to certain myths that keep them from fully partaking in this free lunch.

First, let's look at how diversification reduces risk.

Investors commonly assess the risk of a portfolio by the volatility of its returns, which is usually measured by standard deviation, or how widely prices range from the average price. The standard deviation of portfolio returns declines with each stock (or investment) added.

There is, however, a better way to understand diversification: It ensures that your money is never concentrated in the worst-performing assets, thus saving you from being a bottom investor.

To illustrate, compare a portfolio of one stock to a better-diversified portfolio, composed of two stocks, A and B. During any given year, one stock will return 22% and the other minus 6%, but you don't know which stock will turn in the positive performance and which the negative. A portfolio composed only of A or only of B would yield either 22%, making you a top investor, or minus 6%, making you a bottom investor. But a diversified portfolio of A and B, say in 50-50 proportions, would make you a mediocre investor, with a return of 8%.

Diversification blocks you from being a top investor. But by eliminating the risk that you will ever be a bottom investor, it provides a safer way to make your money grow over time.

Here, then, is a look at some diversification myths and how they can hurt investors:

Myth 1: Diversifying a portfolio beyond 12 to 18 stocks offers no benefits.

Many investors, including investment experts, note that you can obtain more than 90% of the benefits of diversification by owning just 12 to 18 stocks.

That statement is true, but the implication that there is no benefit to extending diversification beyond 12 to 18 stocks is a myth. More diversification always pays off—as long as the benefits of adding an investment exceed the costs of making the addition.

To illustrate, imagine that I place 19 gold coins in front of you and say that you can take as many as you like. Now suppose you have taken 18 of the coins, amounting to more than 94% of the 19 coins. Would you stop, or take the 19th? As you contemplate your choice you ask yourself what is the marginal benefit of taking the 19th coin? Say it is $1,000, the coin's worth. What is the marginal cost of taking that coin? Virtually nothing, just a flick of your fingers. The choice is simple. Get the 19th coin.

So while the marginal benefits of increasing diversification from 18 stocks to 19 stocks may be small, the marginal costs of increasing diversification from 18 stocks to 19 are essentially zero when investing in an index fund or ETF containing thousands of stocks, way more than 19, and charging a 0.04% annual fee.

To be sure, the cost of diversification is enormous if you diversify on your own into thousands of stocks or other investments with high expenses. Efficient diversification is accomplished by low-cost index funds or ETFs.

Myth 2: Owning a handful of stocks you know is safer than a portfolio of thousands of stocks you don't know.

"Invest in what you know." How many times have we heard that?

Too many, it seems.

A recent study from researchers at the University of Colorado found that many investors are convinced that a smaller portfolio composed of companies they know and understand is much less risky than a diversified portfolio of thousands of companies they don't know. When investors have too many stocks to research and monitor, they are likely to miss something important and lose their competitive edge—or so the thinking goes.

In reality, most of the returns of the market over time are generated by a very small number of stocks. A2018 study published in the Journal of Financial Economics found that the best-performing 4% of stocks each year collectively account for the total gain of the stock market since 1926.

If you choose to own only a fraction of the more than 3,500 publicly traded stocks in the U.S., what are your odds of picking exactly the right ones? They are very small, probably similar to picking a winning lottery ticket.

If you decide to invest in virtually all of the publicly listed stocks in the U.S. through a total stock-market index fund, however, the odds that you will hold tomorrow's biggest winners are essentially 100%.

Therefore, portfolios of 12, 18 or even hundreds of stocks are likely to lag behind a diversified index fund containing almost all stocks over time because the undiversified portfolio is likely to miss the "super stocks" that will be driving most of the market's future returns.

Myth 3: Owning an index fund provides you with diversification.

An S&P 500 index fund is more diversified than a portfolio composed of a handful of stocks. But an S&P 500 fund isn't nearly as diversified as a total stock-market index fund.

That's because the S&P 500 index comprises mostly large-capitalization companies, or those with relatively large total value of all their shares. In any year, the return of an index fund of large-cap stocks is likely to be different than the return of an index fund composed of small-cap stocks. And the returns of both are likely to differ from that of a total stock-market index fund, which includes both large- and small-cap companies.

The same concept holds true for index funds focused on value stocks, growth stocks, high-dividend stocks and so on. Their returns will reflect one slice of the market and could differ substantially from that of the stock market as a whole.

Those interested in building a diverse portfolio might start with three index funds: a total U.S. stock fund, a total international stock fund and a total bond fund. From there, investors can fine-tune, based on their individual needs and goals.

Myth 4: U.S. and international stocks are closely correlated, so there is no diversification benefit in owning both.

In general, when two investments are closely correlated, the difference in their returns is usually smaller and the diversification benefits of owning both lower. But correlation isn't the only factor investors should consider. The volatility of the two investments' returns also is important. When volatility (as measured by standard deviation) is high, the average difference between returns can be high, which increases the diversification benefits of owning the investments.

Looking at Vanguard index funds again, it is clear that U.S. and international stocks are closely correlated. From 2000 to 2019, the correlation between the returns of Vanguard's total U.S. stock fund and its total international stock fund was 89%, not far from the 100% perfect correlation.

But a look at their returns shows benefits of diversifying between U.S. and international stocks were great.

For example, whereas the return of the total U.S. stock fund in 2006 was 15.6%, the return of the total international fund that year was much higher at 26.6%. And whereas the return of the total U.S. stock fund in 2019 was 30.8%, the return of the total international fund that year was much lower, 21.5%. The difference in returns—11 percentage points in 2006 in favor of international stocks, and 9.3 percentage points in 2019 in favor of U.S. stocks—points to significant diversification benefits in owning both types of stocks.

The story of the returns of U.S. corporate bonds and U.S. government bonds complement the story. The correlation between the returns of the two kinds of bonds from 2000 to 2019 also was 89%, identical to the correlation between the returns of U.S. stocks and international stocks, but the volatility of the returns of bonds is lower than that of stocks. That resulted in smaller differences between the returns of two kinds of bonds than between the two kinds of stocks, and lower benefits of diversification between bonds.

Myth 5: Market timing is necessary, in addition to diversification.

Many investors lost faith in diversification during the financial crisis of 2008, when both U.S. and international stocks were decimated. Vanguard's U.S. total stock-market index fund plunged 37% in 2008, while its international stock-market index fund fell 44.1%. The difference in performance was 7.1 percentage points, indicating substantial diversification benefits, but these benefits elicited few cheers. In contrast, an index fund of long-term bonds, combining U.S. corporate and government bonds, gained 8.8% that year.

That led some investment pros to suggest that in addition to diversification, money managers should engage in so-called tactical methods, too. They were referring to tactical asset allocation, or timing the market. These pros imply that competent money managers would have sold stocks and bought bonds at the end of 2007, avoiding the 2008 crash, and reverted back to stocks in time for 2009, when the U.S. total stock-market index fund gained 28.8% and the total international stock-market index fund gained 36.7%.

But market timing is easier said than done. Amateur investors trying to time the market tend to buy and sell at all the wrong times and end up underperforming their buy-and-hold peers.

Diversification protects us from being bottom investors, as we abandon hope of being top investors. Successful market timing can make us top investors, but it is likely to be unsuccessful, turning us into bottom investors.

That said, the two approaches can coexist. You can own a total stock-market index fund and then, in a different account, also make bets on a handful of stocks you believe will earn extraordinary returns. But investing in just a dozen or so stocks and expecting extraordinary returns is just too risky for most investors.

Dr. Statman is the Glenn Klimek professor of finance at Santa Clara University's business school and author of "Behavioral Finance: The Second Generation" (available free at cfainstitute.org). He can be reached at reports@wsj.com.