Cooking up a Diversified Portfolio

A diversified portfolio owns securities from various markets – the bond market, the real estate market, and the stock market. Additionally, a diversified portfolio benefits from geographic diversification. This means that it typically owns both U.S. and foreign securities. By contrast, a “focused” portfolio owns only a few securities – often within just one market. For example, some investors hold only a few U.S. stocks, often those of companies operating close to where they live. A San Francisco resident might own a “high-tech” portfolio with a heavy emphasis on Silicon Valley companies; a Huston resident might own oil companies; a Seattle resident might hold aircraft manufacturing, coffee retail firms, and perhaps some Microsoft stock. Most independent research concludes that a focused – i.e., undiversified – portfolio can make or lose money very quickly. This is because various market sectors or regional economies tend to oscillate, over time, between good performance and bad performance.

However, a well-diversified portfolio is something more than owning lots of “stuff.” The building blocks of diversified portfolios are asset classes. An asset class is a group of securities that share common economic and geographic characteristics. For example, the asset class of large company U.S. stocks is represented by the companies in the S&P 500 Stock Index. Each asset class is a mini-universe that includes many securities. How many asset classes are there? Financial asset portfolios usually are built using eight to sixteen asset class building blocks. Each building block has exposure to hundreds of companies. Buying all of them would take a lot of time and money. Fortunately, pooled investments such as mutual funds make it easy to do.

But wait – why spread your risk/reward exposures over kingdom come? Wouldn’t it be better to own only the asset classes that are expected to do well and avoid the others? Shouldn’t an investor be selective about what goes into the portfolio?

Unfortunately, it is extremely difficult to predict how asset classes will perform over the near term. One way to illustrate the value of diversification is the use of a “periodic table” of investment returns. Let’s look at a periodic table of ten asset-classes over the twenty-eight year period 1989 through 2016.

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As the table shows, the relative performance of asset classes can shift dramatically from one year to the next. It is difficult to discern any exploitable patterns in the historical returns. Winners seem not to persist. But a strict contrarian approach – investing in the previous year’s losers – doesn’t work out very well either.

Investors can choose whether they will try to predict the winning asset classes for the forthcoming year – a prediction they’d have to keep making again and again, year after year – or instead maintain a constant exposure to many asset classes, to avoid the possibility of extreme performance results.

We can see the difference between the two strategies by looking at what would happen if we used them in mixing ingredients for a cake. If you want to bake a cake, it is an obvious mistake to use only the ingredients that taste good on their own. Think of what would happen if you added lots of milk, sugar and vanilla to the mixing bowl, but left out the flour, baking powder and eggs! If you follow this type of “ingredients selection policy,” you will end up with an inedible mess. The same principle applies to the composition of an investment portfolio from various asset classes.

Bottom line: Diversification is a key to financial safety. Having multiple risk/reward exposures in your portfolio keeps you from getting financially whipsawed.

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