Who: This is post is for people who are looking to find out about diversification of their investments. If you want to find out what diversifying your portfolio means, and how to do it, this post is for you.
What: This post discusses various types of portfolio diversification. This will not be a mathematically heavy post, but will instead focus on types of diversification that some investors don’t think about all that often.

Why Diversify?

Simply speaking (since this is not a mathematical discussion), diversification allows you to not have your portfolio rely on the performance of just one factor. If your goal was to not lose all your money, you would prefer to bet $1 on 10 flips of a coin, as opposed to $10 on just one flip of a coin. The fact that people cannot predict where the market is going to move is a reason why diversification is an excellent choice for any portfolio. If you can’t predict what will happen, you want to give yourself a lot of chances at a right pick, don’t you?

If you’re interested in diversification and modern portfolio theory, the stay tuned for a future post where I will discuss these concepts in much more detail. But for now, I am going to discuss ways to diversify your portfolio (and assume that you believe me when I say diversification is good). There will be some no-brainers in this list as well as some diversification platforms that investors don’t often consider.

Stocks, Bonds, Cash

The top level of diversification is simple. One must decide between stocks, bonds, and cash-like investments. It is usually better to have a mix of these types of assets as stocks tend to be much more volatile than bonds and bonds tend to be more volatile than cash. I will skip an in depth discussion on this type of diversification because 1) Most people already know about it, and 2) It’s already covered in Investing 102.

Market Capitalization (Small, Mid, Large)

It is important to remember that certain economic conditions favor smaller companies and others favor larger companies. For example, higher interest rates may put more pressure on smaller companies that are working on moving towards profitability and still have a high debt while large companies without much debt will be less affected (but affected nonetheless) by this change. For you complainers out there, yes, I know that large companies often carry big debt too, but this is just an example! Additionally, there are distinct characteristics that large companies have (many resources) that small companies do not, and vice versa (small companies react much more quickly to change, on average).

Another large factor that makes me advocate diversification across market capitalizations is the ever-changing face of legislation! New laws are passed all the time and many of them affect businesses in various ways. With legislation enforced to prevent monopolies, large companies might be adversely affected while small companies can benefit.

Value, Blend, Growth

This is another common type of diversification platform that you see. Value stocks are ones that people perceive to be solid stocks trading at an excellent (below true value) price. In general, these stocks have great fundamental numbers, and a low P/E ratio. The other side of the spectrum are growth stocks which usually have high P/E ratios and are expected to grow rapidly in the future. There are obvious benefits to both of these types of equities and just as with large and small companies, different economic and legal conditions can have different effects on these types of stocks.

Don’t forget to check to see that your portfolio is diversified across these equity types!

Across Industry

This is where we start to get into types of diversification that people forget about. Paradoxically, this is also an area in which it seems more likely that diversification would be helpful. There are many different industries in which companies can operate. Some companies are very specific, others operate in a few industries, and others operate in dozens of industries. Make sure that you are not too concentrated in a single industry, even if you do think that industry will do well.

This is particularly important when analyzing mutual funds. You want to make sure you know what sectors and industries your mutual fund holds stocks in. It is a common mistake to forget about this type of mistake because you are purchasing “instant diversification” in mutual funds. Often, a mutual fund will be concentrated in one area (for example, lots of mutual funds have a bias towards the financial services sector).

Pay attention to your mutual fund allocations by industry!

International/Domestic and Currencies

If you have been following the macroeconomics of the world, you have undoubtedly heard about the rapid growth of foreign markets over the past few years and about the declining value of the dollar. In general, foreign market volatility is higher than domestic volatility but the fact that there is not a 100% correlation between the two means that having a combination of these securities in your portfolio will actually decrease your risk. Also, regardless of where you *think* the dollar is going in the coming years, remember that diversifying your portfolio over different currencies will protect you against the major decline of any currency, which is always a possibility (as we have seen with the dollar over the past few years).

So get into those emerging markets, get some Canadian stocks, dabble in Asia, take a look around Europe, and dive into Australia. Add some Euros, Yen, and Francs to your wallet while you’re at it. I am not saying these areas will appreciate or depreciate in value, but I am saying that incorporating them into your portfolio will get you more diversified.

Real Estate is an Industry

Many investors forget that Real Estate is an asset class. Many also believe that they don’t own much real estate in their portfolio, when in actuality the majority of their portfolio is actually real estate. Huh? Remember that HOME EQUITY is in essence, a very un-diversified investment in real estate. When the real estate market declines, you can expect that the value of your home equity will decline and vice versa. How much real estate you have in your portfolio is completely up to you, but don’t forget that your home equity is a part of the portfolio when calculating. Wouldn’t it be scary to see 85% of your portfolio in ANY asset class?

Conclusion - Diversity is Your Friend

I hope this post has helped some of you look at diversification in different ways. Diversification is an excellent way to control your risk without taking any major drawbacks. Many people make the claim that diversification erodes returns, which is a legitimate argument only to the extent that you believe that you can make market-beating assessments consistently (a tall order). If you do not diversify, then you are purposely picking stock or sectors that you think will outperform the market over a given period of time. IF you are RIGHT, then you will beat the market. If you are WRONG, then you will NOT beat the market and have a chance of losing a LOT. Diversification mitigates the downside risk and still allows you to get excellent returns.

Diversification is your friend. Don’t forget your friend when creating your portfolio.

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