Let’s examine the facts and fiction about portfolio diversification.
Fiction: A 60/40 stock and bond portfolio (Nasdaq:VBMVX) is fully diversified.
Fact: Only investment portfolios with market exposure to all the major asset classes – not just stocks and bonds (NYSEARCA:BND) – but real estate, commodities, and cash too are fully diversified. That means a 60/40 stock and bond investment mix is a really good start toward diversifying, but still incomplete.
Fiction: Portfolio diversification is a hedge for ignorance.
Fact: Anybody with the misinformed view that diversification is for losers needs to familiarize themselves with Yale University’s endowment.
Yale’s endowment returned 11% per annum over the 10 years ending June 30, 2014, surpassing broad market results for domestic stocks, which returned 8.4% annually, and for domestic bonds, which returned 4.9% annually. Even more impressive is how Yale’s endowment generated returns of 13.9% over the past two decades compared to the estimated 9.2% average return of college and university endowments. How did Yale do it? By diversifying investment risk – not concentrating it – across a variety of different assets like commodities (NYSEARCA:DBC), real estate (NYSEARCA:VNQI), and private equity (NYSEARCA:PSP).
Fiction: Diversification prevents losses.
Fact: The purpose of diversification is to spread investment risk across a variety of different asset classes in order to reduce risk. While this should help to cushion your investments against the impact of a market crash, it won’t completely eliminate the possibility of market losses.
Fiction: Securities diversification is all that matters.
Fact: A well-rounded investment plan incorporates more than just securities diversification, but also currency diversification and making sure your assets are diversified across various financial institutions.
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