Diversification starts with predictability. Before we even start building an investment portfolio for a client, we need to have some form of predictability. We need to be able to analyze each stock or bond category in order to mix them together in ways that are meaningful for you. This can only be done well if we pick stock and bond categories which actually have a long enough track record for us to look at.
This performance history of each stock or bond category allows us to predict each category’s average rate of return, which is crucial in diversifying properly. Let look at an example of two potential investments:
1st-year return: 9%
2nd-year return: 10%
3rd-year return: 11%
This equals an average return over 3 years of 10%
1st-year return: 20%
2nd-year return: 10%
3rd-year return: 0%
This also equals an average return over 3 years of 10%
Both stocks earn an average return of 10%; however, stock “A” had a tighter band of volatility, and for most people, it is the better stock to own. But if you don’t know the volatility around the average return, there’s no way you could have chosen wisely between these two investments. The same holds true for stock and bond categories. We have to know the average rate of return and the volatility that occurs around that return. After that, you need one more thing: you need to know how each category relates to each of the other categories.
There are some categories, let’s take value and growth stocks for example, which tend to move in opposite directions with one another. They may have the same average rate of return over the long run, but more importantly, because there are significant periods when they tend to move opposite one another, they provide greater opportunity to diminish risk. If one category tends to go down when another goes up, they both provide the same average return. So, when you combine them together, you get the same return and the volatility of each offsets the others. This reduces overall risk and is the heart of diversification.
We’ve used stocks in our example thus far, but the concept extends to bonds, as well. In fact, the concept extends across all the investment categories.
Figure out the average return, the volatility and how categories relate to one another, and you can then mix them together in different ways to attain different returns and risk profiles.
Because of this, a well-diversified portfolio will most likely have a mix of some amount of each of the following investment categories:
– Large Cap Growth Stocks
– Large Cap Value Stocks
– Small Cap Stocks
– International Stocks
– Real Estate
– Long Term Bonds
– Short Terms Bonds
– Money Market CDs.
We’ve covered a very complex topic very quickly, but these really are the basics of diversification. Identify the correct investment categories, and you can mix them in ways which either target a certain average annual return, or which corral volatility or achieve a combination of both.
There is a lot of science and math behind this, so we don’t recommend the average investor attempt to mix investments themselves. An objective financial advisor will have the tools to wade through all that math and analysis and help you determine which diversification strategy will satisfy your needs.
Don’t worry; we won’t just tell you what to do. It’s ultimately your decision as to which mix is right for you, but a good advisor will simplify this process and help you understand the tradeoffs so you can make the best decision and ultimately achieve your goals and dreams.