Like a great car, diversification is something that almost everybody wants but seems hard to get if you do not have a lot of money to spend. Luckily for investors, there are more options now than ever before for adding diversity to a portfolio. Better still, these options are not all that expensive. (For more, see The Importance Of Diversification.)
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Mutual Funds - Old, But Useful
An actively-managed mutual fund is still an excellent way to diversify a portfolio. By allocating even just one "slot" of a portfolio to a mutual fund, an investor can draw on the accumulated benefit of potentially thousands of stocks, as well as the skill of the management team making the selections. Although some funds still charge loads, many do not and it is not hard to find funds that are likewise efficient with respect to expenses and taxes.
Mutual funds are not just about adding diversity in numbers, though. They also allow an investor to diversify across investment styles. An investor with a natural affinity for value investing may find it useful to own a quality growth-oriented fund (and vice versa for growth investors) as a counter-balance to their own natural inclinations. There are periods when growth shines and other periods when value works best, but it is unlikely that a normal investor will be able to change with the times. Rather than attempting to be a good growth investor and a good value investor - something precious few people ever manage - it is much simpler and cheaper to buy a fund in an opposing style.
Funds also permit investors to diversify across asset classes. The argument over whether investors should always have some allocation to fixed income is a topic for another article, but those who believe the answer is "yes" often find that funds are a good option. Given the sizable cost of individual bonds, a well-diversified portfolio of government, corporate and foreign bonds is all but impossible for a small investor. A single fund, though, can give that investor most of those benefits at a much more reasonable price.
ETFs - When Autopilot Is Good Enough
Though some investors will regard the active management of a mutual fund as a virtue, others will point to the mountain of evidence that suggests most funds underperform their targeted averages. For them, exchange-traded funds (ETFs) may be the answer.
Although there are some actively-managed ETFs, the majority are passive vehicles designed to track a specific index like the S&P 500 or MSCI World Index. Within the realm of ETFs, investors can find options that mimic an entire country's stock market (or even a global index), or a specific industry or commodity. In short, it is a huge menu of options for investors and the costs are generally low.
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Hard Assets and Property - Harder Than It Looks
Hard assets are also another option for achieving diversification. Unfortunately, this process can be harder than it looks. Owning the actual hard goods (bullion, coins, real estate, etc.) is expensive, time-consuming and can require a fair bit of specialized knowledge. Consequently, it is generally the case that coins are better for coin collectors and gold bars are better off left to the true gold bugs.
While futures contracts are an option for some investors, they too are expensive to hold in a small portfolio. Luckily, investors can fall back on mutual funds and ETFs to fill this gap. There are numerous securities out there that offer exposure to gold, real estate and other hard assets. Yes, technically these would represent allocations to equities and not hard assets, but given that the price is closely linked to the underlying assets, it is close enough for the individual investor's needs.
Diversifying Across Space and Time
It was worth repeating that diversification can have multiple meanings. Geographical diversification, for instance, has been shown to boost returns and lower overall risk over time. While global equity markets are linked, they do not move in lock-step and a global (or region/country-specific) fund or ETF can boost the diversification of a portfolio.
Dollar-cost averaging can be thought of as a means of diversifying across time. History has clearly shown that there are good times to invest and bad times to invest, but it is devilishly tricky to know which one "now" is. If investors accept that they cannot reliably time the markets, it makes sense to consistently invest over a period of time - guaranteeing that the investor will be buying relatively more shares when the markets are low and fewer when the markets are high. (For more, see Chosing Between Dollar-Cost And Value Averaging.)
The Bottom Line
Ultimately, the best way for an individual investor to diversify a small portfolio of stocks and funds is to buy more stocks and funds. By allocating a few slots in the portfolio to other assets classes (bonds, hard assets, real estate, etc.), other styles (growth, distressed, etc.), and other regions, investors can achieve an impressive level of diversification without stretching their capital too far. However, remember not to diversify just for diversity's sake - give the same level of careful attention and due diligence to any asset that you are considering as an investment. (For more tips, see Diversification Beyond Stocks.)
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