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Diversifying Your Investments: Tips on Creating a Customized Formula

Starting from the assumption that diversifying your investments is a good idea, the first step in doing so is understanding what constitutes an "egg" for basket-storage purposes. Sometimes people think of a stock in a particular company as the equivalent of an egg, and therefore it's better to have lots of stocks than just a select few.

While that does represent a form of diversification, it's important to begin with a broader perspective — that of "asset allocation." That means dividing all the securities you can invest in, into asset classes, then deciding the proportion of your portfolio that should be invested in the various asset classes.

The Basics

The most basic asset class categorization consists of only three components: stocks, bonds, and "cash" (that is, short-term liquid securities that aren't volatile, such as money market funds).

An additional asset class that gained attention following the 2008 financial crisis was "alternative" investments, such as real estate (equity, not mortgages), gold, other precious metals, agricultural commodities and more exotic investments. "Alts," as they're also called, came into focus then because during that period both stocks and bonds took a dive, while gold zoomed up.

One of the fundamental principles of asset allocation is to hold "non-correlated" assets. That means, in theory at least, these assets move in opposite directions in response to the same conditions. That way, if one component of your portfolio is losing value or just not performing very well, another part will be gaining value. Stocks and bonds usually are non-correlated assets.

You don't want a zero-sum game, of course. You want your entire portfolio to increase in value over time. But when your portfolio has a healthy balance of non-correlated assets, you'll likely be in for a smoother ride.

Asset Subclasses

Alts aren't for everyone. So, setting them aside, the next topic is sub-asset classes. For example, the broad category of stocks can be subdivided into growth and value stocks, domestic (that is, U.S.) and international, small cap (capitalization), mid-cap and large cap. You can also think of stocks of companies within different industries as sub-asset classes.

Within the bond universe, subcategories can be established according to such factors as:

  • Credit quality (often measured by a bond's rating, such as AAA, BB, and so on),
  • Issuer, as in, whether the bond is issued by a corporation, a national government (U.S. or foreign), or special public-sector entity, for example, a school district, or
  • Maturity date, that is, how long until the bond "matures," and the face value of the bond is repaid.

A final sub-asset class distinction that spans stock and bonds pertains to stock and bond funds, whether mutual funds or exchange-traded funds. It's "passive" vs. "active." Passive means the portfolio is created to mimic the performance of a particular index, such as the S&P 500. Active means the fund managers are actively buying and selling securities in an effort to outperform the market segment they are operating in.

Now comes the fun part: Creating your personalized asset allocation recipe to meet your diversification needs. A basic criterion that financial planners use to guide their clients on this issue is your age. The younger you are, the higher the recommended allocation of stocks, which are generally "riskier" than bonds over relatively short periods of time. While more volatile than most bonds, stocks historically have outperformed other asset classes over longer periods of time.

Time to Recover

If the stocks in your portfolio plunge in value when you're 35 years old, and you don't plan to access them for at least another 30 years, you've got plenty of time to recover. That wouldn't be true at age 60, of course. So, if age alone were the basis for your asset allocation-based diversification strategy, you'd gradually reduce the proportion of the stock component of your portfolio over time.

Another variable for diversification is your "risk tolerance." If you start losing sleep every time the stock market takes a dip, and promptly start liquidating your stock portfolio, you have a low risk tolerance.

To keep from selling low and buying high (and improving your sleep), a proper diversification strategy for you would be to adjust downward the stock allocation from that which would be appropriate for someone with a higher risk tolerance (and age is still a factor). But, that could mean you'd need to add more to your portfolio every year than might otherwise be necessary. That's because risk and reward tend to move in the same direction; the lower the risk, the lower the return.

Allocations within the asset subcategories is beyond the scope of this article.

Target Date Funds

Here's one way you can get a starting point for determining an appropriate asset allocation. "Target-date funds" (TDFs) attempt to automate the whole asset-allocation diversification strategy for you. The three largest TDF asset managers handle 64% of total TDF assets. If you average their asset allocations for three different target dates, here's what you get:

  • 2040 funds (that is, intended for people who expect to retire in around 2040): 86% stocks, 12% bonds, 2% cash.
  • 2030 funds: 76% stocks, 26% bonds, 2% cash.
  • 2020 funds: 56% stocks, 38% bonds, 6% cash.

 

In conclusion...

You can't create a diversification strategy by throwing darts or flipping a coin. But the stakes — your future financial security — are high. It's worth the effort. Also, creating your own diversification formula needs to incorporate factors that might distinguish you from the "average" investor. Guidance from a professional advisor might come in handy.