Diversification: Does Your Portfolio Have It?
By Ron DeLegge, Editor
June 28, 2010
SAN DIEGO (ETFguide.com) – The word “diversification” ranks quite highly among the most commonly uttered words in Wall Street jargon. But to the average person this foreign term doesn’t ring a bell. And despite its relatively simple premise, even financial professionals disagree about the true meaning of diversification.
One simple definition of diversification is “not putting all of your eggs in one basket.” Another definition is to own a variety of assets or investments to reduce risk. Since not all asset classes are 100 percent correlated all the time, a diversified portfolio of investments should theoretically hold up better.
Even though diversification is a good strategy for most investors, let’s clear up a few things about it; diversification won’t necessarily protect your investments from declining in value. In other words, diversification is a hedge against market risk, not a guarantee against it.
The Views of one Billionaire
Billionaire investor Warren Buffett once quipped, “Diversification is a protection against ignorance.” This single statement has caused many people to conclude that obtaining market beating returns by holding a handful of stocks just like Buffett is the surest way to long-term financial success. Usually, after a few years of fanciful thinking, they realize how wrong they were.
Unfortunately, most investors don’t have the same skills and acumen as Buffett in knowing which investments to buy and in what proportion to own them within a portfolio. In fact, many of Buffett’s best investment ideas were private transactions made available only to him. Beyond that, Buffett’s investment portfolio today is quite different than it was when he made his diversification comment. Upon closer analysis, Buffett’s portfolio via Berkshire Hathaway (NYSE: BRK-B) today has a broad mix of businesses in various industry sectors and different countries. Whether or not Buffett acknowledges it, to some extent he’s diversified.
How can you achieve a perfectly diversified portfolio? This can be done by having broad exposure to major asset classes within your investments like international, emerging markets and U.S. stocks, corporate and government bonds, commodities, real estate, and cash. It’s up to you to specifically determine what percentage of your investments should be allocated to each area – don’t leave it up to chance. Also, be sure to avoid over-diversification – a financial problem created when you own too many of the same types of investments.
To obtain a truly diversified portfolio you will need to avoid erroneous views.
For example, many financial professionals have the misinformed view that a 50/50 all stock and bond portfolio translates into a diversified investment mix. This type of deranged thinking is evident from the substandard investment choices given to the 50 million Americans that have 401(k) plans.
At employee meetings, 401(k) participants are told to build and maintain a diversified portfolio, but ironically, the menu of investment choices they’re given won’t allow them to do that! When will the Department of Labor start doing its job by enforcing 401(k) rules that given retirement savers diversified investment choices – not just to stocks and bonds – but to other key asset classes like real estate and commodities?
Another little discussed facet of diversification is currency diversification. By simply diversifying your investment portfolio into foreign index funds or ETFs you gain other benefits beyond equity and bond diversification. Virtually all international and emerging markets stock and bond ETFs offer unhedged currency exposure.
For instance, broadly diversified index funds like the Vanguard FTSE All-World ex-US ETF (NYSEArca: VEU), iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM) and the SPDR MSCI ACWI ex-US ETF (NYSEArca: CWI) offer both equity and currency diversification.
In summary, all well-built portfolios should have low cost market exposure to major asset classes. After all, that’s what diversification is all about.