I’ve got a standard mix of ETFs, including XIC, XIN, XSP, XBB, and XRB, each with a target percentage of my portfolio and a plan to rebalance when things get out of whack. I plotted the value of my portfolio against the TSX. Guess what? All three lines are almost identical. The correlation isn’t perfect, but close enough over any time period.Jake has a point that the world’s stock markets are highly correlated. The fact that including some fixed-income investments in the mix has made little difference is a coincidence that is won’t continue indefinitely. However, the interconnectedness of our world usually makes different stock markets move together.
So what has my “diversification” and “balancing” bought me (aside from extra transaction fees)? Are markets so tightly interconnected as to make “diversification” impossible/meaningless? When was the last time you saw the S&P go one way but the DOW and/or NASDAQ go the other? Is there any advantage to carving off a chunk of cash and investing in a sector or part of the world? Logic says yes, but the results say no.
I won’t give up on my diversification just yet, but if I was giving advice to a newbie it might be “buy XIC and some bonds and diversify later (much later!).”
The short answer to the value of diversification is the protection it gives from extreme events. Stock markets tend to move together when all is running smoothly, but there is always the possibility of major events that affect one part of the world more than others. I’d hate to have my investments concentrated in one sector or country and have that country experience some severe crisis.
As for the advice to a newbie, I don’t see anything wrong with starting out with just one or two ETFs while the portfolio is small. What is the value in having $2000 diversified among a half-dozen ETFs? There is nothing wrong with buying one ETF with the first $2000 and then buying some other ETF six months later with another $2000 that has been saved. Another direction for small portfolios is low-cost index mutual funds.