Diversification of a Portfolio Done Right

by Neal Frankle, CFP ®

Proper diversification of a portfolio can easily trip you up. At the basic level, this is applying the concept of not putting all your (financial) eggs in one basket. Pretty easy. But to really get this right, you have to dig a bit deeper.  You have to understand what diversification really is and the risks and rewards of this approach.

I know that you are probably reading this because you want to learn how to diversify your financial assets (stocks, bonds and cash). That’s fine. We’ll get there. But in order to do a good job of diversifying your liquid assets, you first have to think about your entire net worth. Why? Because of risk. Let me illustrate by way of example. Your financial picture is made up of the following elements:

  • Stocks
  • Bonds, CDs and Fixed Annuities
  • Savings and Checking Accounts
  • Real Estate
  • Commodities
  • Business Interests
  • All Sources of Income
  • All Debts

Let’s say most of your net worth is tied up in a very risky business. If you keep that risk in mind, you probably want to take less risk with your other investments. If you ignore your business risk and take on lots of investment risk too, you’ll probably end up with a very fragile financial situation. Yikers! Let’s look at a different example.

Assume you have more income than you could possibly spend coming in from rental income and pensions. If that is your situation, you are in a very low risk situation. In that case, you can probably afford to take on a little more risk with your other investments (if you want to).

Let’s look at one more case. Let’s say you have a great deal of high-interest debt. In that case, you would keep most of your investments very liquid to pay off that debt. That means you wouldn’t take much risk at all with your money.

Does this make sense?

The first order of business you must address is to get a handle on how much risk you can afford to take with the money in question. The means you must keep your entire financial picture in mind. OK. Let’s move on.

The next consideration is to think through what you want from your financial assets and when you want it. Let’s say you have $10,000. If this is short-term money that you need to spend within a few years, keep it safe by using a high interest bank account. But if you want to invest this money to achieve long-term goals, (including providing long-term income that starts now) you can use long-term investing strategies. This is the point at which you can focus on diversifying your portfolio to reduce risk.

Diversifying your financial assets to reduce risk -Use Long-Term Investments for Long-Term Goals

Some people – a lot of people – will tell you that you should put “x” percent of your long-term money in cash, “y” % in bonds and “z” % of your money in stocks in order to maximize growth and minimize risk. They are half right.

Allocating assets to bonds and cash will reduce your short-term risk and volatility. But such a move can’t possibly increase your returns. That’s because cash is a short-term investment that has almost no return after taxes and inflation. And bonds almost never outperform stocks over 10 years – the last decade excluded.

Portfolio Diversification Done Right

Once you’ve identified how much risk you can take, what you are going to use your money for and when, you can easily diversify your assets. As I’ve said before, if you have long-term money, the best investments to consider are growth stocks and funds and real estate.

Your next step is to select your specific investments based on the investment strategy you use. If you are a buy and hold investor, decide how much money you want to allocate to the different asset classes and keep that percentage fixed. Use asset allocation to rebalance your portfolio every 6 months or year. Simple.

If you want to use a market sensitive strategy like I do, rely on your methodology to select the investments and rebalance as prescribed.

If real estate is right for you, use some of your money to buy property.

If you have a 10-year horizon (or longer), I suggest that an optimal diversification strategy would be to put half the money in real estate and the other half in long-term growth funds. But this depends on your personal situation.

If you have long-term money but you simply don’t have the stomach to keep all those assets in equity funds or real estate, no problem. Water your portfolio down with bonds and cash. This is not a way to maximize your return. It’s a way to provide the best return with minimal discomfort. There is nothing wrong with this approach but it is absolutely not the way to get the best return for your long-term money.

Bottom line. Convention wisdom tells you to diversify your portfolio by holding cash, bonds and equity. This might be great to reduce your anxiety. It won’t however help you achieve your long-term goals as much as using long-term investments to achieve long-term goals.

How do you diversify your portfolio? What has worked best for you?

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