Diversify and Start Young

If it hasn't been written yet, I'm sure someday someone will write the book on the fundamental principles of life.  Granted, we have a lot to argue about and to debate, but there are principles that I believe most people would agree are beyond dispute.  The investment section of the book would undoubtedly include the principles of diversification and the value of time in the investment process.

To illustrate, I once again go to the BlackRock "Asset Returns Table" - this time to page 2.   Here is shown the 20-year results of investing $100,000 in various asset classes and in a diversified portfolio.  Before looking at the results, reflect on the thought that most workers will spend 40 years in the work force.

Diversification and Time

Source: BlackRock

CLICK IMAGE TO ENLARGE   The diversified portfolio is "composed of 35% of the Barclays Capital US Aggregate Bond Index, 10% of the MSCI EAFE Index, 10% of the Russell 2000 Index, 22.5% of the Russell 1000 Growth Index and 22.5% of the Russell 1000 Value Index."  This  portfolio is easily replicated with low-cost, index funds.  The results are straightforward.  At the realized return of 7.7%, money quadruples in 20 years (rule of 72).  Over 40 years, it increases by 16 times!  You can run all kinds of savings scenarios; but the bottom line is that workers who have a regular contribution to their 401k, starting at least by their mid-20s, will have a good-sized nest egg when they reach their 60s, by investing in a diversified portfolio.

Hopefully it goes without saying that they need to ask about company matches and take a look at the choices available in the company 401k plan.  ALL 401K PLANS ARE NOT CREATED EQUAL!

Understanding these basic principles and applying them will result in a person typically being fairly wealthy by the time they reach their 60s.  These are fundamental principles.

But what will keep emotions in check?  Look closely at the chart, and you can easily identify the 2008 period where portfolios fell off a cliff.  Look closely at the black line which traces the diversified portfolio and observe the important fact that it is a lot less volatile than the asset classes it is compared against.  This, of course, is the second half of the investment equation:  risk.  By being less volatile, the diversified portfolio is one where most investors can sleep at night.

Those of a mathematical bent will note that the table shows standard deviation, the basic risk measure for investments.  The take-away is that the diversified portfolio return is reasonably close to the annualized return on the best-performing asset classes over the period at a significantly lower standard deviation - i.e. volatility.

So the fundamental principles are as straightforward as they possibly could be: s ave young, save often, and diversify.  You don't need to pick stocks; you don't need to do a lot of analysis; you don't even need to take a course in investments.

The Rule of 72 - A Great Tool for the DIYer

The "Rule of 72" is used to easily estimate the time it takes for a magnitude to double at a given growth rate. It should be in the tool box of every "Do-It-Yourself" investor.
This is  how it works. Suppose you get 8%/year on $2,000? How long will it take to grow to $4,000? The answer is 72/8 = 9 years.
You can check this by solving for x:

$4,000 =  $2,000 * (1.08)^x

 divide both sides by 2,000 and take logs of both sides:

log 2  = x log1.08 or x = log2/log1.08 = .301/.0334 = 9.01 years

Another problem:

Suppose the return is 9%/year. How many years to double? Answer: 8 years.

Suppose GDP grows at 4%/year. How many years will it take for the nation's output to double? Do this in your head. We know it takes 9 years at 8% so at 4% it will take twice as long, i.e. 18 years.

If you are interested in pursuing this further you may be interested in the following video. Professor Barlett uses 70 as the numerator which is a bit rougher of an approximation. The video is also worthwhile because it stresses "critical thinking", a topic du jour on college campuses.