Economists: Diversification Rocks

In 1964, my best friend’s much older brother had his bar mitzvah and went to his parents with an idea: he wanted to invest the significant wad of cash he had just been handed by scores of family members and friends in IBM stock. His parents, well-off, upper-middle class business owners, scoffed at this idea and put his money in a savings bond. I don’t need to tell you how this story ended.

Mr. and Mrs. L’s decision to reject the stock scheme likely would have been praised by the economists who now populate the IGM forum. The experts were recently asked whether they think equity investors are better off choosing a well-diversified, low-cost index fund than by picking a few stocks. Nearly 90 percent of the Forum voted in favor of the diversified fund.

“Almost everyone should be investing in this way and ignoring tips from friends and experts on particular stocks,” noted Anil K Kashyap of Chicago Booth. Because, as Jonathan Levin of Stanford explained, “Most people are unlikely to replicate Warren Buffett’s performance.”

Because diversification is so highly valued by this panel of elite academics, some responses ranged from “Duh” to “The annual test to see if panelists are awake.” But there were other considerations to discuss.

For example, Nancy Stokey of the University of Chicago pointed out that investors could save a few dollars on transaction costs by doing the diversification and periodic rebalancing themselves, but dismissed this notion as not being worth the time or money. Also, Aaron Edlin from the University of California at Berkeley, agreed that the typical investor is certainly better of buying a low-cost indexed fund, but does think that there is money to be made from stocks without inside information.

Still, the general consensus was stated best by UC Berkeley economist Carl Shapiro: “Diversification rocks.”