Diversification Really Does Work

 In our last two entries, we discussed that one important step to avoiding a personal financial crisis is to make sure you have a satisfactory emergency fund.  A second step is to make sure your portfolio is well diversified.

 Whenever we write about investing, we always talk about diversification and how important it is.  Over and over again we tell our readers and our clients that being broadly diversified is critical to their investing success and to protecting their hard-earned savings.  Diversification increases portfolio returns while at the same time lowering risk (as measured by portfolio volatility).

Normally, higher returns come with higher risk.  If someone is claiming they can ensure unusually high returns, it’s almost certain that the investment is highly risky, or possibly even, a scam.  Yet with the proper amount of diversification, one can actually increase returns and at the same time lower risk.

 Diversification doesn’t mean just holding ten or twelve stocks.  Sure, ten or twelve stocks provides more diversification than just two or three stocks.  To be broadly diversified, however, you need to hold a broad array of distinct asset classes whose returns are uncorrelated.  And for even further diversification, within those asset classes, you need to invest in broadly diversified mutual funds, exchange traded funds (ETFs) and index funds.

 We have modeled our investment strategy after the approach presented in Roger Gibson’s book Asset Allocation, 4th Edition.   Consistent with Gibson’s approach, we recommend that our clients’ portfolios include nine different asset classes.  Inluded are cash, short-term, intermediate-term and high-yield domestic bonds, international bonds, large and small domestic stocks, international stocks and real estate equities via domestic and international real estate investment trust (REIT) mutual funds.

The returns of these different asset classes have varying correlations. This means that during normal markets, some asset classes will have positive returns and others negative returns.  Thus, when some assets classes are down in value, others will be up.  This tends to moderate losses and helps to improve overall returns while reducing portfolio volatility.

 In extremely poor markets like we have experienced recently, nearly all asset classes will be down in value.  Nevertheless, some do better than others and a diversified

portfolio overall will perform better than a non-diversified portfolio.  Instead of being down 30% to 40% overall, a diversified portfolio may only be down 15% to 25%.

 If your portfolio is not adequately diversified, we highly recommend you seek competent professional help to make the changes necessary.