The Importance of Diversification in Achieving Long-Term Goals

That’s what diversification is for. It’s an explicit recognition of ignorance. – Peter Bernstein

My 2007 book, Wise Investing Made Simple: Larry Swedroe’s Tales to Enrich Your Future, contained 27 tales to educate investors about important investment concepts and strategies. This article is in the spirit of those tales. The examples are hypothetical.

In early January 1993, Ryan received a letter informing him that he had just inherited $1million from his grandfather, who had recently passed away. He now had to determine how to invest the funds. He met with a friend who was a finance professor to seek his advice. The professor told him that new academic research had found that, historically, small-value stocks had outperformed the S&P 500 by about 3% a year. The professor explained that the excess return was not a free lunch. Those small-value stocks were a lot riskier, with volatility that was about 35% greater than that of the S&P 500. There were also some multiyear periods over which small-value stocks dramatically underperformed. The professor recommended he read the literature so he could understand the risks. He went on to add that if Ryan could remain disciplined, living through those periods when small-value stocks underperformed without abandoning the strategy, it was likely he would be rewarded.

Ryan liked the idea of trying to outperform the market. He felt he could take the risks of owning those riskier small-value stocks because he had a stable job and no debt. With that in mind, he went to the library and read Eugene Fama and Kenneth French’s 1992 study, The Cross-Section of Expected Stock Returns, which provided the historical evidence on the existence of both a small-stock and a value-stock premium. He was convinced. He called the professor and asked him for advice on implementing the strategy of investing in small stocks.

The professor told him that, fortunately, there was a relatively unknown company that had employed both of the authors of the paper he had read, and they were about to launch a U.S. small-value fund that would invest based on the research. Because the fund would not be engaged in any individual stock selection, nor any market timing, the fund’s expenses would be relatively low. The fund was called the DFA U.S. Small Cap Value Fund (DFSVX).