Today’s posting is on the topic of diversification. Diversification is one of those buzzwords that gets tossed around, but fewer people understand specifically what it means and how it should affect your wealth building processes.
What is diversification?
Basically, it means spreading your money over several types of investments. Its a risk management technique. The main idea is that the particular mix of investments you choose minimizes the total risk to your wealth, while simultaneously maximizing the return that your portfolio yields.
Where does it come from?
The idea that buying a bunch of stocks can reduce your risk and maximize your return dates to work done by nobel prize winning economist Harry Markowitz in the 1950s (clicky for more). Markowtiz came up with modern portfolio theory (MPT) which mathematically showed that you could make more money and reduce your risk if you diversified across types of stocks. The idea was the direct forerunner to the modern concept of “diversification” and has now become a core idea in personal finance.
What does it mean for you?
For most people, diversified investing is an excellent idea. Practically, it means several things:
1) Buying funds that hold a variety of investments. According to MPT you can’t get adequate diversification unless you’ve got a lot of different kinds of investments. So, this means you should be purchasing funds that have a wide basis of investments. For example, you might consider a mutual fund that has stocks in the pharmaceutical industry and the energy sectors.
2) Buying more than just stocks. Most personal finance people talk about diversification in the context of stocks, but its a mistake to focus only on stocks. For example, you might want to be in commodities, real estate and bonds in addition. Why? MPT says that your return will increase if you don’t have your eggs in one basket.
Here are a list of areas you might consider in addition to common stocks in the US.
1) International stocks
2) Different types of stocks
– large companies vs. small companies
– Income vs. growth
4) Real estate
6) Cash equivalents
– Money market funds
– Certificates of deposit
The main point here is if you are serious about wealth building, you should consider buying a wide variety of assets. MTP indicates that you’ll make more money with less risk. This doesn’t mean just stocks, it means you should think about buying real estate, either directly or indirectly and, possibly also starting your own business.
If all this seems like a lot of work, don’t worry. There are several good mutual fund companies such as the Vanguard Group that sell products covering a wide variety of asset classes at a very low prices.
Are there any drawbacks to diversification?
Yes. One major problem with diversification is that you’ll never achieve phenomenal returns. If your money is spread out into different asset classes, you’ll likely never hit a home run on any one particular thing. While hitting the investing jackpot rarely occurs, it can and does happen. Some individuals such as Ken Heeber and Warren Buffet, seem remarkably good at picking winners.