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The fine art of investment diversification

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With the stock market in a significant state of volatility in 2014, especially with oil trading at historic lows of under $60 a barrel, safeguarding your portfolio via diversification is especially critical right now – if you do it right.

Investment guru Benjamin Graham once said of investing, “If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.”

What Graham refers to is diversification – i.e., spreading your assets around various investments to reduce risk, and strengthen performance.

Diversification simply means dividing your investments up into more than one uniform category. It’s one of the best ways, to help protect your money from the pendulum swings of the economy and the financial markets. By diversifying your investments, you’re reducing the risk that one investment that’s gone sour will poison the rest of your portfolio.

The theory is that the classes move in a manner that penalizes those investors who place all their investments in one basket, as the old Wall Street saw goes. In fact, a sophisticated risk tolerance breakdown will go beyond asset classes (stocks/bonds/cash) and into what type of stocks (large-cap, growth/international) to boost and protect your portfolio.

Additionally, diversification can help boost performance. Studies show that a properly balanced investment portfolio with holdings in different sectors outperforms portfolios that invest in single, specific sectors.

 

A Closer Look at Diversification

To illustrate how powerful the principle of diversification is, consider the following hypothetical scenarios of a diversified mix of investments with various rates of return. This is not a representation of actual performance:

A. A $100,000 investment with a guaranteed fixed annual rate of return of 8% will grow to $684,850 after 25 years.

B. The same $100,000 could be evenly diversified between five separate investments each with a different degree of risk.

The net result would be an accumulation value of $962,800 after 25 years or $277,950 more than the guaranteed investment. Although three of the five investments performed below the guaranteed investment, the diversification into other assets that outperformed the guaranteed investment provided a greater long- term total return.

 
This chart is a hypothetical example for illustrative purposes only. It does not reflect a specific investment, an actual account value or the performance of any investment. The chart represents a single guaranteed investment of $100,000 invested at 8% for 25 years would grow to $684,850 versus diversified investments of $20,000 each in five separate investments each with varying degrees of risk and rates of return which could accumulate to a value of $962,800 after 25 years. The diversified investments are an example of $20,000 that had loss of $0, invested at a rate of 0% would have a rate of return of $20,000, invested at 5% would have a return of $67,730, invested at 10% would have a rate of return of $216,690 and invested at a 15% would have a rate of return of 658,380.
 
 

To get the most out of your diversification strategy, consider these tips:

Balance growth and income – A properly balanced investment portfolio has a good mix of investments that emphasize growth (like many small capitalization, high-technology companies) with income (such as large capitalization companies in traditionally stable sectors, like consumer goods and utilities.

Search for dividends – When you’re choosing your blend of growth and income investments, opt for companies and funds that offer solid dividend potential. Dividends offer steady, reliable income that can beef up your portfolio’s income in weak financial markets.

Protect your investments with bonds – Stocks are mostly about capital appreciation, meaning they help your portfolio grow more highly and quickly, but bring greater risk to the table. Bonds, which are more about capital preservation, help you stabilize your portfolio by reducing risk. Thus, it’s a good idea to add a sturdy fixed-income blend to your investments, with Treasuries, municipal bonds, corporate bonds, and/or bond funds that comprise all three bond investments.
 
Go abroad – Studies show that investment portfolios with a good dose of foreign stocks and funds offer greater asset protection, and can help boost returns, too. In general, if U.S. stocks are underperforming, foreign stocks in select international bourses can offer protection, with historically solid investment performance. As always, check with your financial advisor for the best mix of foreign and domestic stocks and funds.
 
Consider your age – The number of candles on your birthday cake can also impact investment portfolio balance. Ideally, you’ll want your portfolio’s investment mix to match those candles on your cake, and help you fund the right risk tolerance levels for your long-term investment goals. The Investing Age tool can help you determine whether your investing style is aggressive, conservative or right in line with other investors your age.

Diversification: Lowering Risk, and “Smoothing Out” Returns
Perhaps the biggest takeaway on diversification is this: Dividing your investments between the asset classes is proven to lower your investment risk and increase your return.

 

“If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.”

 

Put another way, diversification helps to smooth your returns out over time, so that while you may invest in certain volatile assets, you have others that will be more balanced in their returns. This means you may have lower-than-average market returns in good years, but you won’t lose as much in underperforming years.

That both stabilizes and supports better investment returns, thus helping you stay on track to meet your unique long-term financial goals – all by following Graham’s advice and “picking the right groceries,” using diversification as your investment model.

 


Fixed income investments are subject to interest rate risk, in that their value will decline as interest rates rise.

Investing in foreign securities presents certain unique risks not associated with domestic investments, such as currency fluctuation and political and economic changes.

Diversification does not assure a profit or protect against loss in declining markets and it is possible to lose money when investing in securities.

 

 

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About the Author

Brian O'Connell is a freelance author

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