A cliché that’s sometimes used to explain diversified investing is “Don’t put all your eggs into one basket.” That’s true enough, but it’s only part of the picture.
To be a diversified investor, you must put your money into different asset classes—the investment equivalent of several different types of containers. You don’t just put your eggs into different baskets; you divide them among bowls, buckets, boxes, and egg cartons.
You achieve the greatest reduction of portfolio risk by dividing your money among various asset classes.
True diversification means owning different classes of assets. Some of those classes include:
- U.S. Stocks (large-cap, mid-cap, and small-cap)
- International Stocks Bonds (government, corporate, high yield, mortgage)
- International Bonds Absolute Return Funds (arbitrage, long/short, event)
- Natural Resource (gas, oil, metals, commodities)
- Cash (money market, certificates of deposit)
- Real Estate (REITS, directly held investments)
If you don’t have at least four of these asset classes in your portfolio, you have no asset class diversification. The biggest benefit comes from five asset classes or more. Also, you need to allocate a significant portion of your portfolio to each asset class, usually five percent or greater. Only then can you begin to claim with any accuracy that your investments are diversified.
The whole point of asset class diversification is that, as economic conditions change, some asset classes earn more and others earn less. If you have a good mix, you might lose money in the short term in one asset class that is doing poorly, but at the same time you’ll be gaining on another asset class that is doing well.
One of the frightening aspects of the current economic situation is that, at least in the short term, this balancing of the seesaw doesn’t seem to be happening. Virtually everything has been going down.
In this environment, it’s tempting for both do-it-yourself investors and investment advisors to abandon everything they have learned about diversification. The problem is, no one knows what to do instead. Attempting to time the markets in today’s economic conditions is an even riskier strategy that it would ordinarily be.
Because I’ve been doing financial planning for so long, by now diversifying a client’s portfolio is second nature. I have learned over the years that it is essential for successful long-range investing.
While I prefer to set firm asset allocation targets, other advisors satisfy their need to “time” the market while maintaining some protections by establishing a minimum and maximum allocation for each asset. For example, if your asset allocation strategy called for a 10% allocation to real estate investment trusts (REITS), you would set a range of 5% to 15%. This would mean you would never reduce your allocation to REITS lower than 5% or increase it to more than 15%.
Establishing a range is one way to avoid getting caught up in a market bubble and selling out or loading up on an asset class at precisely the wrong time. This is known as tactical asset allocation.
Many investors whose advisors insisted on fixed or tactical asset allocation models were kicking and screaming in late 1999 that they were missing out on the party when all the other kids on the block were making fortunes in tech stocks. Those same investors subsequently were grateful they missed that particular party.
Will the same thing happen now? Who can say for sure? Right now, plodding along with asset allocation isn’t a lot of fun. But I believe, in the long run, it will prove once again to be the best strategy. Those who think otherwise are likely to end up with egg on their faces.
