Asset diversification is one of the most cliché things in the world of investing. Even people who don’t know the first thing about investing have most likely heard of diversification. If you’ve ever watched any of the financial shows on MSN, FOX Business, or Bloomberg Television, you’ve probably heard some of the talking heads ramble on saying, “You’ve got to diversify your investment portfolio!” Well, if everyone’s talking about it, there’s probably a good reason. So what is diversification? Join me as we take a closer look at the sound reasons for diversifying our portfolios… in financially simple terms.
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Simply put, diversification is holding investments that will react differently to the same market or economic event. Believe it or not, a downturn in the market isn’t always a bad thing, at least not to every type of investment position. Some positions hold strong in the face of a market crisis, while others suffer greatly, which is why it’s so important to have a diversified and varied portfolio. As I stated in my last article, diversification is not putting all of your eggs into the same basket.
Kent Insley of Tiedmann Advisors in New York City says, “It’s very rare that any two or three assets with very different sources of risk and return, like government bonds, gold, and equities, would experience declines of this magnitude at the same time.” What he’s speaking of is diversification. When we diversify our investments, we are minimizing the risk of loss to our overall portfolio. But it does so much more than that.
If our portfolios are properly balanced, having holdings from a number of different investment positions, it opens us up to greater opportunities for return. You see, when we invest in a wide variety of positions, we are attempting to position assets where at least one of our assets will be on the rise, regardless of whatever is happening in the political and financial climate.
Diversification helps to dampen loss. Just as Kent Insley said, it is highly unlikely that all of your holdings would be on the decline at the same time so long as they are in very different positions. During times of market decline, investors could have rebalances within diversification.
For example, when the U.S. market tanked a few years back, many investors panicked. They quit buying stocks because they were fearful of what was going on in the market. However, that should have been like the K-Mart blue light special for them. It was a great opportunity to snatch up a bundle of equities at a deep discount. Had they responded to the situation rather than react to their emotions, many investors would have realized that the market — like so many other things in life — is cyclical. It always rebounds, eventually.
Nobel Laureate, Harry Markowitz, once described diversification as “the only free lunch in investing.” He went on to explain that by diversifying, an investor gets a benefit — reduced risk — without losing returns. I don’t know about you, but I like free lunch, especially PIZZA! I also like being able to receive the benefit of reducing my risk without simultaneously reducing my potential returns. If I can have my pizza and keep my money, why wouldn’t I take advantage of that?
Well, many would argue that in today’s interconnected world, diversification is no longer needed. I may come back to this in a later series just because this is such a nuanced argument. However, for today’s purposes, I will keep it simple. Anthony Davidow, Vice President of Charles Schwab, says, “The best response to the new more interconnected world then is not to erase modern portfolio theory from the chalkboard altogether, but to acknowledge that asset allocation strategies can be dynamic – both in choosing which asset classes to include and in making tactical adjustments to reflect short or long-term changes in the market or macroeconomic environment.”
What this means is that we don’t necessarily have to do away with Modern Portfolio Theory but that we should also see the value in choosing our assets based on the rhythms of each asset type within the market.
Depending on who you’re talking to, there are between seven and twenty asset classes. In many instances, I would agree that there are up to twenty. For our current discussion, I have chosen to simply go with the seven most popular asset classes available to us.
As the name implies, these are common stocks that appear on the U.S. market. These stocks are found on the NASDAQ or the New York Stock Exchange, and they represent American businesses.
Cash and cash equivalents are incredible assets to have, but you have to be careful to not rely too heavily on them, as they are subject to inflation.
This class of assets essentially allows you to play the role of the bank. You basically loan the bond issuer — usually, the U.S. Government or a corporation — a set amount of money, and they pay it back with a fixed amount of interest upon maturity.
Commodities are goods that are readily tradable and sellable in exchange for currency or other goods. These can literally be anything that someone is willing to pay a price for. For example, I am wearing what I like to call my “tablecloth shirt” today. Someone made it, and I was willing to pay for it.
It’s easiest to think of global market assets as the opposite of U.S. equities. They are stocks that are traded in international markets and exchanges.
I love real estate as an asset class. It is a hard asset, meaning that it is tangible or physical property, unlike stocks and bonds. I have owned many pieces of real estate throughout my career.
Just as global markets are to U.S. equities, global fixed income is to bonds and fixed income. It is the same principle just applied to the global or international market.
IN-DEPTH READING: Asset Types and How They Apply To You
Now that we’ve outlined seven popular asset classes, it’s important to understand how to further diversify such a diverse group of assets. Just as diversifying is good for your overall portfolio, diversifying your diversification is good for your individual asset classes. As an added benefit, investing in this way provides further benefit to your overall portfolio.
Within the market, there are a variety of equities. You want to have some of each type in your portfolio. The major types include large, mid, and small-cap companies, and they can be categorized as growth or value stocks. They each have a different risk/return ratio and will yield returns at faster or slower rates depending on their individual type.
Basically, we have either U.S. currency, foreign currency, or crypto-currency. I am of the belief that these should be in separate classes, but for now, this is how they are grouped.
Like the rest of the asset classes, bonds and fixed income come in a variety of flavors, ranging from general obligation bonds to municipality or even U.S. Treasury bonds. Each one responds differently to various market phenomena.
The sky is really the limit with this one. If you choose to put 80% of your investments in tablecloth shirts and the rest in oranges and uranium, well… that’s on you, but the point is there are a lot of different commodities that you can diversify your investments through.
Just like the U.S. market, the global market deals in large, mid, and small-cap companies that offer growth and value stocks in each. They offer the same types of risk/reward ratios, and they can add tremendous diversification to your portfolio.
As much as I love the real estate class of assets, I love its diversity even more. Yeah, you’re probably thinking, “Residential and commercial, big whoop!” However, it goes far beyond that. There’s residential and commercial, sure, but there is also mining, timber, farm, land, and even burial. Yes, burial real estate is a thing. How do you think we get cemeteries?
Once again, this is very similar to the domestic version of the fixed income class. The different varieties offer varying levels of risk and reward as well as different reactions to fluctuations within the global market. Basic flavors include government and general obligation bonds.
When we find ourselves in an extended Bull Market, it can be tempting to become lackadaisical or even greedy with our investments. We might start thinking more about the position that we haven’t put a lot of our money into instead of simply being patient with our portfolio. In doing so, we can very easily go from a diversification strategy to a market timing strategy, which is rarely beneficial.
Life is hard, life is good, and life can be frustrating. Money doesn’t have to be. Let’s continue to make our lives at least financially simple. Just remember that our best safeguard against market cycling is a well-diversified and long-term focused portfolio.
Get more articles like these by visiting our Investment articles in the Personal Finance for the Business Owner series.