“Diversify across securities, across asset classes, across markets—and across time.” – Charley Ellis
It’s been said that true diversification means always hating some of your investments. As a result, you never hate your portfolio.
Most people are familiar with the concept of diversification, which can be broadly described as "not putting all your eggs in one basket." Most people know that it’s a good thing to have, but how does one build a diversified portfolio? There is more than one way to diversify after all.
Here are six forms of diversification that you should include in your portfolio.
1. Individual Company Diversification
It’s easier now than ever before to get a diversified allocation of stocks through a bevy of different index funds. This wasn’t always the case. In the 1950s, Nobel laureate Harry Markowitz demonstrated a portfolio’s risk dropped considerably as additional stocks were added to the portfolio—even if the individual stocks were all of equal risk. More recently, research by Longboard Asset Management revealed that from 1983 to 2006 nearly two in five stocks actually lost money (39%), almost one in five lost at least 75% of their value (18.5%) and two in three underperformed the Russell 3000 index. Furthermore, the best 25% of all stocks over this period accounted for nearly all the gains.
2. Industry Diversification
Just like getting a mix of individual companies is an important way to diversify your portfolio, having a balance across the multiple industries in the economy is important too. It’s especially important to remember to diversify away from the industry with which you are most familiar. For example, just like with the home-country bias, people also tend to overweight their home industry. According to "JP Morgan’s Guide to the Markets for December 31, 2015," those living in the West tend to overweight technology as many are familiar with the tech companies based there or are directly working in the industry. The Northeast favors financials, the Midwest, industrials, and the South, energy.
The point is, just like with individual company stocks, it’s not healthy to overweight an industry that you are also counting on for your paycheck or regional economic health. (For related reading, see: Shifting Focus to Sector Allocation.)
3. Asset Class Diversification
Different assets (stocks, bonds, cash, real estate, commodities) are going to perform differently in various economic environments. For example, during an economic recovery stocks will likely perform well while in a recession bonds provide protection. Commodities, TIPS or cash can protect against the forces of inflation while during a deflationary environment long-term bonds are often the best investment.
4. Strategy Diversification
Within asset classes there are different strategies to get the exposure—many of these different strategies (also called factors, risk factors, smart beta, etc.) have been shown in the academic research to deliver superior returns over time versus a market-cap weighted index. But this outperformance doesn't happen every year, and there can be long periods of underperformance. For most, the best approach is a mix of these factors (value, small-cap, momentum, high quality, etc.) with the realization that you won't have 100% allocated to the hot strategy, but that you also won't be 100% committed to a strategy that's lagging. (For related reading, see: Diversify Your Strategies, Not Your Assets.)
5. Geographic Diversification
Again, most investors have a home-country bias, preferring the stocks of companies based in their home country. However, the research also shows a benefit to diversifying internationally. For an example, think about the performance of the Japanese stock market since its 1989 peak. As author Jonathan Clements wrote last month:
What if the U.S. turns out to be the next Japan? It strikes me as improbable. But in the late 1980s, when Japan’s economy was the envy of the world, the subsequent bear market would also have been considered wildly improbable.
My contention: If you’re going to invest heavily in stocks, you should consider allocating as much as 40% to foreign shares, so you aren’t betting too heavily on a single country’s stock market. I don’t know whether that will help or hurt returns. But it will reduce risk—and potentially save you from financial disaster.
Just like with asset classes or strategies, no one economic region is going to consistently outperform. Best to have a mix.
6. Time Diversification
Also called dollar-cost averaging, if you’re still contributing to your investment accounts, it can reduce the impact of poor investment behavior (a lack of discipline) or unlucky timing. While the research shows that around 70% of the time investing a lump sum is better than investing it over time, dollar-cost averaging or any rules-based, disciplined approach can lead to better investor behavior and therefore better investment results. As author Ben Carlson wrote, “Dollar cost averaging takes the responsibility of poor timing decisions out of your hands. It’s not the perfect solution, but it helps you move from short-term guessing to long-term planning.”
So, there you have it—six ways to diversify your portfolio. What do you think? Is your portfolio fully diversified?
(For more from this author, see: Increase Retirement Wealth With the Right Withdrawal Order.)