Alex Tabarrok and Tyler Cowen–two professors at George Mason University–created Marginal Revolution University, a website where top economists provide free courses and lessons on economics. In the video above, taken from a course called Principles of Economics: Macroeconomics, Tabarrok makes the case for diversification. If you’re investing, he maintains, you must Diversify! Diversify! Diversify! The key idea here is this: “Diversification allows you to reduce your risk by spreading your investment across many different assets. The great thing about diversification — it’s a free lunch. It reduces your risk without reducing your return.”
Tabarrok goes on to note: You don’t want to put all of your money in one stock. (Look at what happened to everyone who had their money in the Enron basket.) You want to spread things out, putting your eggs in many baskets. That’s why he suggests investing in low-cost index funds–like the S&P 500 or the Wilshire 5000–that spread your money across 500-5000 companies. As he notes, companies like Vanguard offer these funds at a low cost.
The professor then adds: You “don’t want to limit your diversification to stocks from your home country. That’s called home market bias. It’s quite easy to diversify internationally by buying an international index fund or by buying more big multinational companies.” Vanguard also offers low-cost international stock funds.
Still further, other experts routinely advise investors to diversify their money across different asset classes. Beyond the stock market, investors can put money into bonds, real estate, cash, commodities and other alternative investments–with the idea being that when some asset classes go down, other asset classes won’t suffer the same fate and thereby stabilize an investor’s overall portfolio.
Above John Bogle, the founder of Vanguard, acknowledges that, when it comes to asset allocation, there are no easy answers. It’s highly individual. In his case, he suggests that the 60-40 portfolio (that is, 60% stocks/40% bonds) is “probably the best option.” However, being a more conservative investor, he had his money in 50/50 portfolio. (It’s worth noting that the 60-40 portfolio performed poorly in 2022, when interest rates moved rapidly higher. Since then, the portfolio has mounted a “respectable comeback,” and some experts expect it to perform better in future years.) In the meantime, you can find other investors who recommend more nuanced asset allocation strategies. Take for example Ray Dalio, who developed (circa 2016) an All Weather Portfolio, which “involves a mix of 30 percent stocks, 40 percent long-term U.S. bonds, 15 percent intermediate U.S. bonds, 7.5 percent gold and 7.5 percent other commodities.” He notes that it needs to be rebalanced annually.
The point here isn’t to recommend a specific asset allocation/diversification. Rather it’s to get you thinking about the diversification strategy that makes sense for you. And, above all, it’s to get you to think twice about putting your eggs in that one basket.
