Stock Scandals Not Scary, If You Diversify

The headlines are enough to give any stock investor pause. Volkswagen’s CEO stepping down over emissions cheating, a crazy biotech startup raising drug prices 5,000%, Caterpillar flummoxed by the global slowdown, and so on.

It’s enough to make you want to sell it all and just sit in cash. Yet you know that’s a mistake, too. How can anyone stomach stock scandals and stay an investor?

Easy enough: diversification.

I am reminded of a friend with a young son. Like any pre-teen, the boy is caught up in brands. Clothing brands, electronics brands, car brands — you name it.

He’s just testing out ideas, searching for an identity. So he asks his dad, “Hey, do we own stock in Nike?” Yes, answers the father. “Adidas?” Yes, the father says, adding, “Before you ask, we own all of the major shoe brands, the sock makers and the store that sells them, too.”

That’s diversification. By owning an index fund, the family has invested in nearly all major companies worldwide. They don’t own very much of any given stock — index funds are weighted to represent the size of each company’s stock “float” relative to the others — but they do own them all.

In exactly the same way, the long-term stock investor is effectively insulated from stock scandals by diversification. If you own a foreign stock index fund, you own Volkswagen. If you own a U.S. blue-chip stock fund, you own Caterpillar.

You probably don’t own that startup pharmaceutical company making headlines last week for all the wrong reasons, but here index funds protect you again. You can own small cap stocks through an index fund, but generally not microcaps and startups. Too risky.

Volkswagen took a hit from the emissions mess it managed to get into. They have nobody to blame but themselves. And the stock will recover.

Moreover, for the long-term index investor a temporary dip in one large stock is no reason to panic. In fact, it’s an opportunity.

Ignore stock scandals

That’s because a stock index fund rebalances internally, repurchasing shares using incoming dividends. All things being equal, some of those shares will be cheaper for a while. Then they will rebound. Volkswagen is not going out of business. Neither is Caterpillar.

Likewise, a portfolio of uncorrelated asset classes allows the long-term investor to put even more money into temporarily cheap assets. If stocks as a group fall hard enough, long enough, cash inflows from other asset classes can be liquidated to buy more.

That’s rebalancing, a powerful strategy for increasing return.

So don’t sweat the crazy headlines you might see about car companies gone rogue or whatever is leading the business news. Unless you have your entire retirement invested in one stock — as some company employees unfortunately do — you simply aren’t exposed to serious risk.

On the contrary, you’re doing just fine, retirement intact.