Let's talk Diversity!

First, I would like to say thank you for such an eclectic reception so far.  Regardless of the sentiment I just want to send my appreciation to everyone who has read and taken the time to send me your thoughts.   Everyday my goal is to try to make this site more reader friendly and useful for you.   Today the plan is to get you familiar with or refresh the idea of diversification and its role in how you approach your investments.  I think at this point we are still early in the second quarter and it's always a good idea to give your assets a one-over.

I know that diversification is another one of those heavily talked about topics but it’s important to lay a foundation in the beginning.   So to be diversified in any type of portfolio literally means to be varied and today we are talking about the major staples of a portfolio.  Typically when people talk about diversification they are talking about dividing assets into three general asset classes.  First are equities which represent an ownership interest or stake in a company like a common stock.   Next are debts or bonds.  These are, essentially, promises made by either the government or institutions to pay back a principal upon maturity and usually come with interest or coupon payments along the way.  Lastly is cash, the most liquid and conservative of the three.  

The general idea is to find out what your goals are, how long until you reach each goal, and what your overall attitude is towards taking risks.  After you get all that information your portfolio(s) should be constructed so that you try to capture as much appreciation (return) as possible given how comfortable you are with the risk and the time the money will be in play.  Believe it or not there are actually spectrums within each asset class that run the risk gammit.  You could have a brand new small cap IPO from a company no one has ever heard of -very risky- all the way up to your IBM's and Googles's -not so risky.  That's why it's important to do some soul searching and your homework here.  As an investor and to avoid making irrational decisions you need to be clear on what your tolerances are and the time until the money is needed.  I've seen so many people pull money out of the market in haste because they thought they were comfortable with the level of risk.  As soon as the markets fluctuated they liquidated, missed out on rebounds, and fell very short of their goals.  Don't let that happen to you!!

Before we go any further I want to take a brief moment to talk about correlation which is crucial in the diversification conversation.  Correlation has to do with how your investments behave individually and then comparatively with the rest of the portfolio.  Just because you have five different large cap growth mutual funds in your 401k doesn’t mean you’re diversified.  If for the rest of this year large cap growth funds perform the worst of the mutual fund universe then, all five of those mutual funds will perform terrible together and hamper your chance for capital appreciation this year. The reason is they have a high correlation to and move in-step with one another.  This is important when you are deciding how to arrange your portfolio; you want to reduce your non-systematic risk (risk you can diversify away) as much as possible.  

The idea is to keep a balance between sectors, industries, market capitalizations, and asset classes so that if one part of your portfolio flounders then hopefully another will be soaring to prevent loss and smooth out a growing growth rate over time.  On the other hand if everything is doing great like in the late 1990’s then having assets spread out across the board keeps you from missing out on a solid bull run.  Deciding how to invest depends on your goals, time horizon and risk tolerances.  So when evaluating your options make sure you take the broad asset risk scale and the risk scales for each of the classes into consideration. 

After those three broad asset classes you can begin to look at how investments are packaged.   If you are new to investing and financial planning the most efficient way to take a fixed amount of dollars and spread them as far as possible would be mutual funds and exchange traded funds (ETF’s).   Each of these act as their own enclosed portfolios filled with underlying assets (instant diversification) that will have a goal for the funds invested.  There are mutual funds and ETF’s designed for capital appreciation and those that are more focused on spitting out an income.  Keep in mind though; are they more aggressive actively-managed funds or made up entirely U.S. Treasuries which are about as conservative as you can get. 

Take a look at your own statements and try your best to avoid the large cap scenario I outlined above.  Take what you’re goals are and asses your risk to help point you in a more balanced direction.  If you’re in it for the long run keeping all your eggs out of one basket gives your chicks a better chance at hatching if a farmer drops a basket along the way. If you are still thirsting for more take a look at The Perfect Portfolio: A Revolutionary Approach to Personal Investing.  Hevner does a pretty good job at helping investors choose asset classes and teaches a way to build a safe and productive portfolio, especially if you don't have all day to do investment research. 

Cheers!