The following guest post is from Tony at Intangible Investor. If you are interested in submitting a guest post, please see our guest posting guidelines.

 

Sir John Templeton's Definition of DiversificationProbably the most propounded view online is that you should diversify your portfolio. Rather than just rehashing what everyone else is saying, I’d like to put a spin on the idea of diversification based upon the ideas of a great investor called Sir John Templeton (for those of you who don’t know, he just passed away a few weeks ago). Many people misunderstand Templeton’s idea of diversification, so I would like to clear that up.

 

A Little Background….

Sir John Templeton was an American (of British descent) stock investor who pioneered the idea of diversification. Here’s how the story goes:

Templeton lived in the 1930s during the Great Depression. When he realized in early 1939 that the world was heading towards WWII, he knew that this was the opportunity of a lifetime. He had the vision that WWII would bring great benefits to American companies and drag the economy out of the Depression. Thus, it would be an extremely wise decision to invest in American stocks before WWII started.

But John faced a dilemma – he didn’t know which companies would fare well and which companies wouldn’t during the war. He knew that some companies would go bankrupt due to the war (primarily the companies whose products were rationed by the U.S. government), but he didn’t know specifically which ones they were. So, he became one of the first to apply the idea of diversification. Since he knew the general market direction but didn’t know which stocks would follow the general market direction, he bought 104 stocks on the New York Stock Exchange (keep in mind that at this time, index-wide ETF’s did not exist). His idea? That while some companies would go bankrupt, others would survive and make him enough profits to more than cover his losses. The rest is history – American stocks soared, and Templeton’s career in the financial markets was made.

 

Where’s the misunderstanding?

The average person uses diversification because he or she does not know what the general market direction will be. Thus, he or she “spreads his or her eggs among multiple baskets”, believing that the baskets won’t all get hit at the same time. HOWEVER, this is not true! Markets nowadays have become more and more correlated than ever – stocks (regardless of whether it’s Coca-Cola, IBM, Microsoft, etc) tend to rise and fall together. (The reason being, the big movers of stocks are the big traders and hedge funds who apply 1 investment model to all the markets, but that’s besides the point).

On the other hand, Sir John Templeton, the pioneer of diversification, used diversification for a totally different purpose. He knew that the general direction of the whole stock market was going up (due to his fundamental view of the market), but what he didn’t know was which individual stock would fare well from the war’s consequences. If he had lived today, Templeton could simply have expressed his stock market prediction by buying an index-wide ETF instead of “diversifying” among many different stocks. But since he didn’t have ETF’s back then, he simply bought most of the stocks on the exchange – in other words, he almost created an index-wide ETF himself.

In short, what the pioneers used diversification for and what it’s used for in the modern day are two very different things. My advice? If you’re going to diversify, you might as well use an index-wide ETF or at least an industry-wide ETF (e.g. the SPDR S&P 500 ETF Trust). Note* I have no affiliation with the SPDR S&P 500 ETF Trust. I am merely using it as an example.

 

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Tony is a financial blogger who analyzes the most basic fundamentals of a company using a market concept – the 5 P’s. Check out his financial blog at Intangible Investor.