I just wrote this article on February 23rd, 2012 for my Golden Valley Patch Blog.
The definition of diversification in managing your investments has always been best described as not “having all your eggs in one basket.”
The very reason that mutual funds dominate the investment option menu of most Minnesota company 401(k) plans is because of the diversification concept. It is thought to be more safe for an individual company retirement plan participant to own a “basket” of stocks and bonds through a mutual fund than it is to own those same stocks and bonds individually.
If you own a an individual stock or bond, you will always have much more price risk and stock market risk than if you own a broad range of stocks and bonds; the definition of a mutual fund.
In the vast majority of company 401(k) retirement plans, diversification means a buy-and-hold investment strategy that remains 100% invested in high cost mutual funds.
The theory of diversification is designed to expose your company 401(k) account to several different types of mutual funds in order to have exposure to the best investment performance over a period of time.
In addition, diversification intends for you to stay invested in different styles of mutual funds in the hope that the historical investment performance of a broad holding of mutual funds will somehow better preserve your company retirement plan principal during the next stock market crash.
I have been providing investment advice to individual company retirement plan participants for over 28 years. Common sense plays as much a part of long-term investment success as any textbook definition of diversification does.
Historical investment performance clearly shows that in the majority of previous stock cycles most 401(k) mutual funds badly underperform the widely-followed stock market benchmarks.
Why would you keep the majority of your company retirement plan account invested in poor-performing mutual funds, with the hope that “someday”, those mutual funds would begin to perform better?
Does the old adage of “a stopped clock is right twice a day” sound familiar?
If diversification would have improved the long-term investment performance of just one of my clients to any significant degree during the recent stock market volatility, I would be the first one to write about it here.
It has not.
In realty, the odds for long-term investment success remaining diversified in a handful of mutual funds in your company retirement plan are extremely low.
Individual company retirement plan participants continue to read and hear (most times for the mutual fund companies that populate their company retirement plan menu) that buy-and-hold diversification is the only way to remain invested in their company 401(k) retirement plan account.
The investment strategy that works much better is to identify the two or three best performing mutual funds in your company retirement plan menu, and stick with them until their investment performance declines.
When one of the mutual funds you currently own begins to underperform the broad market averages, you should then “diversify” into a better mutual fund option.
When the stock market begins to rise, there are always one or two mutual funds in your company retirement plan menu that rise in price at a faster rate. When the stock market begins to fall, these same mutual funds usually fall in price at a slower rate.
These are the kind of mutual funds that you want to “diversify” into in your 401(k) company retirement plan account. These are also the kind of mutual funds that you can safely buy-and-hold.
This is as much diversification that any individual company retirement plan participant ever needs.
Ric Lager
Lager & Company, Inc.
