Diversification Is A Prudent Decision

Tips on Which Assets to Diversify and How

By Paul Jarvis, CFP®

AreaVoices Financial Planning Blog

 

Diversification is a prudent decision; it is an effective, inexpensive, and easy-to-implement strategy in an investor’s toolbox to help reduce the risk of loss, without completely sacrificing return. The concept of diversification is readily grasped in a bit of homespun wisdom: when your mother advised “not to put all your eggs in one basket,” she was telling you to diversify.

But let’s unpack this wisdom for a moment. If you put all your egg-dollars in a blue chip stock, your wealth will inevitably fluctuate with the health of the U.S. economy, changing tax laws, and the vagaries of the stock market. However, you also incur the risks specific to the particular company – such as a slowing Chinese economy that spoils the country’s appetite for their product, or a lawsuit brought by U.S. government against the company over its privacy policies. Now you have some extra demons to keep you awake at night.

You can counteract a company risk, by investing in companies in other industries, such as food or pharmaceuticals, or in other countries:  in other words, companies that “zig” when your main holding “zags.” Furthermore, because  a company specific risk can be diversified away, you won’t get extra return by keeping it.

But the “why” of diversification says nothing about the “how” and “what.” Here the questions get harder.

How diversified should I be?

It used to be that you could diversify by holding three basic asset classes: stocks, bonds, and cash. But trends over the past 40 years introduced additional options. With globalization and the creation of marketable securities for illiquid and directly-held assets, it is possible—and potentially advisable—to consider expanding one’s investment repertoire. Now investors may invest in foreign countries, commodities, mortgages, and real estate, with a click on their hand-held devices.  Furthermore, recent studies suggest that value stocks offer different risk and return profile from growth stocks, and likewise with large-company stocks versus small. As a result, diversification possibilities have become more diverse. Now there are ETFs, in addition to mutual funds, which open up yet another possibility for investors intent on covering the investment field.

Is it possible to do too much diversifying?

Yes, particularly when investors uncritically believe that more is better than less. It’s well known that 401(k) participants often diversify according to the 1/n rule, where “n” is the number of investment options in the plan.  For example, if a plan sponsor offers four US stock funds, participants are likely to contribute 25 percent to each.  With ten options, they divide their money into tenths.

It is possible that sufficient diversification of a U.S. stock portfolio may be achieved with approximately 10 to 13 stocks.  Many CFP® professionals would agree that holding a broad U.S. stock index, a broad international stock index, a U.S. and a foreign bond index, and a high quality money market fund may provide adequate diversification.  A commodity fund might be added to the mix, as might a real estate fund, as the investment amounts grow larger.

What other risks can be diversified?

Beyond asset classes, other areas in an individual’s financial life may all potentially benefit from diversification:

  • Human Capital: the skills, education, training, and professional experiences that an individual offers to the workplace.  In today’s fast-changing knowledge economy, having a wide array of these resources is becoming more essential to higher paying, more secure jobs. With just one skill, or experience in just one industry, comes a greater risk of lay-off, burn-out, and stagnant wages.
  • Type of Investment Accounts:  Think Tax Location Management – Many people invest solely in their homes and tax-deferred retirement accounts, both of which can be illiquid, difficult to tap, or carry significant tax costs. Diversifying some investment capital into taxable accounts, where withdrawals can be made without ordinary income taxes or early withdrawal penalties, can provide tax savings and cash flow flexibility in retirement.
  • Acquisition Cost: For large investments, it makes sense to diversify the prices at which the investment is purchased, rather taking the risk of buying an entire position which then goes on to plummet in price.  Dollar cost averaging is a commonly known method for this type of price diversification which lowers the average cost per share of the acquired position. It involves continuous investments in securities regardless of fluctuating price levels of such securities and the investor should consider his or her financial ability to continue purchases through periods of low levels.

As a final point, there is no one diversification strategy that fits all. Personal circumstances matter.  An individual expecting a sizeable Social Security or pension benefit may not require the same allocation to bond holdings as would a retiree depending solely on his portfolio to provide income.  An executive working for a major oil company does not necessarily need to diversify into a commodity fund. This is where holistic financial planning provided by a CFP® professional who focuses on individual needs and goals comes in.  Pair financial planning and diversification, and you get two solid things working together.  Not to mention a good nights’ sleep.

Diversification does not ensure a profit or protect against a loss. ETFs will fluctuate with changes in market conditions and are not suitable for all investors. In many cases, ETFs have lower expense ratios than comparable index funds. However, since ETFs trade like stocks, they are subject to brokerage fees and trading spreads. Therefore, ETFs are not effective for dollar cost averaging small amounts over time, and likewise any strategy using ETFs must account for these additional costs. ETFs do not necessarily trade at the net asset values of their underlying holdings, meaning an ETF could potentially trade above or below the value of the underlying portfolio. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.

 

ABOUT Paul Jarvis

Paul Jarvis is a CFP Board Ambassador and leads United Capital’s office in Fargo. See more at http://financialplanning.areavoices.com.