Diversified Investment with Examples
Six Assets You Should Own Now
A diversified investment is a portfolio of various assets that earns the highest return for the least risk. A typical diversified portfolio has a mixture of stocks, fixed income, and commodities. Diversification works because these assets react differently to the same economic event.
In a diversified portfolio, the assets don't correlate with each other. When the value of one rises, the value of the other falls. It lowers overall risk because, no matter what the economy does, some asset classes will benefit. That offsets losses in the other assets. Risk is also reduced because it's rare that the entire portfolio would be wiped out by any single event. A diversified portfolio is your best defense against a financial crisis.
Example of How Diversification Works
Stocks do well when the economy grows. Investors want the highest returns, so they bid up the price of stocks. They are willing to accept a greater risk of a downturn because they are optimistic about the future.
Bonds and other fixed income securities do well when the economy slows. Investors are more interested in protecting their holdings in a downturn. They are willing to accept lower returns for that reduction of risk.
The prices of commodities vary with supply and demand. Commodities include wheat, oil, and gold. For example, wheat prices would rise if there is a drought that limits supply. Oil prices would fall if there is additional supply. As a result, commodities don't follow the phases of the business cycle as closely as stocks and bonds.
Include These Six Asset Classes to Diversify Your Portfolio
A diversified portfolio should contain securities from the following six asset classes:
U.S. fixed income. The safest are U.S. Treasurys and savings bonds. These are guaranteed by the federal government. Municipal bonds are also very safe. You can also buy short-term bond funds and money market funds that invest in these safe securities. Corporate bonds provide a higher return with greater risk. The highest returns and risk come with junk bonds.
Foreign stocks. These include companies from both developed and emerging markets. You can achieve greater diversification if you invest overseas. International investments can generate a higher return because emerging markets countries are growing faster. But they are riskier investments because these countries have fewer central bank safeguards in place, can be susceptible to political changes, and are less transparent.
Foreign investments also hedge against a declining dollar. U.S. companies do well when the dollar is weak because it boosts exports. Foreign companies do well when the dollar is strong. That makes their exports into the United States cheaper than when the dollar is weak.
Foreign fixed income. These include both corporate and government issues. They provide protection from a dollar decline. They are safer than foreign stocks.
Commodities. This includes natural resources such as gold, oil, and real estate. Gold should be a part of any diversified investment because it's the best hedge against a stock market crash. Research shows that gold prices rise dramatically for 15 days after the crash. This is why people invest in gold. Gold can be a good defense against inflation. It is also uncorrelated to assets such as stocks and bonds.
You should include the equity in your home in your diversification strategy.
If your equity goes up, you can sell other real estate investments, such as REITs or real estate investment trusts, in your portfolio. You might also consider selling your home, taking some profits, and moving into a smaller house. This will prevent you from being house-rich but cash-poor. In other words, you won't have all your investment eggs in your home basket.
Most investment advisors don't count the equity in your home as a real estate investment. They assume you will continue to live there for the rest of your life. In other words, they consider it to be a consumable product, like a car or a refrigerator, not an investment. That encourages many homeowners to borrow against the equity in their homes to buy other consumer goods. When housing prices decline, they owed more than the house was worth.
As a result, many people lost their homes during the financial crisis. Some walked away from their homes while others declared bankruptcy.
Diversification and Asset Allocation
How much should you own of each asset class? There is no one-size-fits-all best diversified investment.
Investors use asset allocation to determine the exact mix of stocks, bonds, and commodities. It depends on your comfort with different risk levels, your goals, and where you are in life. For example, stocks are riskier than bonds. If you need the money in the next few years, you should hold more bonds than someone who could wait 10 years. So, the percentage of each type of asset class depends on your personal goals. They should be developed with a financial planner.
You should also rebalance depending on the current phase of the business cycle. In the early stage of a recovery, small businesses do the best. They are the first to recognize opportunity and can react more quickly than big corporations. Large-cap stocks do well in the latter part of a recovery. They have more funds to out-market the smaller companies.
Beware of asset bubbles. That's when the price of any asset class rises rapidly. It's being bid up by speculators. It is not supported by underlying real values. Regular rebalancing will protect you from asset bubbles. You should sell any asset that's grown so much it takes up too much of your portfolio. If you follow this discipline, you won't get hit too hard when the bubble bursts.
In a well-diversified portfolio, the most valuable assets don't correlate with other assets. Since the financial crisis, stocks and commodities have been correlated at a coefficient of 0.6. So have U.S. stocks and developed international markets at 0.93. If you have U.S. stocks, there are no diversification benefits to having developed markets in your portfolio. They move the same way stocks do.
According to Vanguard research, the only asset that isn't correlated with stocks is U.S. Treasurys with a negative correlation coefficient of -0.3. But that doesn't mean you should only hold U.S. stocks and U.S. Treasurys. It would protect you from risk, but it won't give you the best return. Vanguard found that a diversified portfolio that contained all the six asset classes mentioned above provides the best return with only slightly greater risk.
When a Mutual Fund Is a Diversified Investment
A mutual fund or index fund provides more diversification than an individual security. They track a bundle of stocks, bonds, or commodities. A mutual or index fund would be a diversified investment if it contained all six asset classes. To meet your needs, it would also have to balance those assets according to your goals. Then, it would adjust depending on the stage of the business cycle.
The Bottom Line
You will receive the highest return for the lowest risk with a diversified portfolio. For the most diversification, include a mixture of stocks, fixed income, and commodities. Diversification works because the assets don't correlate with each other.
A diversified portfolio is your best defense against a financial crisis. To find out if you're protected, consult with a financial planner. He or she will determine your asset allocation based on your personal financial goals.