I have met with several individual Minnesota company 401(k) retirement plan participants in the last two weeks. I ran into the diversification monster in each meeting.
Diversification has been widely sold to individual investors. Investment advisors and financial planners preach it constantly. Diversification is advertised as the best way to insulate stock and bond market investments from unnecessary risks.
Diversification does nothing to improve investment returns. This football analogy will help me illustrate how poorly diversification serves individual stock and bond market investors.
What professional football team would you bet your own money on to win the Super Bowl next February?
I doubt many knowledgeable football fans would bet on teams like Detroit, Kansas City, or Jacksonville. Each of these teams was among the worst in the NFL last season.
Instead, diehard fans would bet their hard earned money on teams like Denver, New England, or Seattle. These teams were among the best in the NFL last season. Each of these teams is among the best NFL teams so far this season.
The same investment management concept can be applied to choosing the mutual funds in your individual company 401(k) retirement plan account.
Small and mid cap mutual funds have been the best to own for the last several years. Why would you have sold the best mutual funds available in your company 401(k) retirement plan menu in the past?
Diversification is the only reason. Individual investors have been told to own small parts of all kinds of mutual funds in a company 401(k) retirement plan account.
Interest rates are moving up from all-time low levels. Bond mutual funds decline in value when interest rates rise. Why on earth would you continue to own bond mutual funds when the value of those bond mutual funds is falling?
Diversification again is to blame. Individual investors have been told to own both stock and bond mutual funds in a company 401(k) retirement plan account at all times.
There is a clear disconnect between common investment management sense and diversification. In theory diversification is great. But that theory does not often apply to real life investment management decisions.
If you take all the risks associated with stock market mutual funds; own the best mutual funds available to you. If you continue to own bond mutual funds when interest rates are rising, don’t be surprised when you lose money.
Diversification can actually hurt your long-term investment returns. Nothing works better than good old common investment sense. You need to protect your individual company 401(k) retirement plan account when the stock market falls and interest rates rise.
Ric Lager
Lager & Company, Inc.
