Bob Rall* says diversification reduces risk in a portfolio by allocating investment dollars across asset classes, countries and industries.
Photo: Rebekah Howell
Diversifying is one of the most basic rules when investing.
It’s the “don’t put all of your eggs in one basket” strategy.
The basic thought process behind diversifying your investments is if you spread your investments around, you’ll reduce the risk of losing money because when one of your holdings moves lower, another is likely to be moving higher.
For example, bonds usually move higher when stocks move lower, and vice versa.
We know we are supposed to diversify, but a lot of investors don’t do it very well.
Many account owners think their portfolios are diversified when they aren’t.
Here are some of the most common diversification mistakes investors make.
Common diversification mistakes
One of the most common diversification mistakes is when someone owns several mutual funds and thinks that the number of funds they hold makes them diversified.
Say they hold an S&P 500 fund, a large-cap growth fund, a large-cap value fund and a dividend growth fund.
They may think these four different funds provide good diversification, but they don’t.
If you looked at the stocks held in each of those funds, you would find they are all invested in the same asset class: large US companies.
Another common mistake is when investors own an S&P 500 fund and a bond index fund and think they have a good mix of stocks and bonds.
This example is better than the first one, but the mix is still not providing good diversification benefits.
The S&P 500 fund provides exposure to the 500 largest companies in the US, but none of the 2,500 or so other publicly traded US companies.
There’s also no exposure to international stocks or bonds.
How to properly diversify your portfolio
Invest globally
When building a portfolio, it’s important to look beyond the borders.
“Home country bias” refers to the tendency of investors to focus on the investments within their own country.
For example, US companies make up about 50 per cent of the total market capitalisation in the world, yet the average US investor has about 70 per cent of their portfolio in US holdings.
A recent study in Sweden showed investors in that country put their money almost exclusively into investments from Sweden, even though their country makes up about 1 per cent of the world’s capitalisation.
Invest across asset classes
When building an investment portfolio, focus on diversifying across the various asset classes.
The first step is to determine what percentage should go into the two largest, broad-based asset classes — stocks and bonds.
A conservative investor might have 30–40 per cent of their money in stocks; a more aggressive investor might have 60–80 per cent.
The balance in each situation would be allocated to the bond side of the portfolio.
Determine your geographical allocation
The next step would be to allocate geographically.
Put 50–60 per cent of the stock allocation into US stocks, representing the US capitalisation mentioned earlier.
Next, allocate between 25 and 30 per cent of the stock into international developed countries in Europe, Australia, Asia and the Far East.
Invest the remaining stock allocation into emerging markets, which gives exposure to companies in China, India and other developing countries.
Follow a similar approach with the bond side of the portfolio, with more exposure to the US, which makes up about 60 per cent of the world bond market.
Finally, diversify within the geographical asset class.
Spread your investment dollars across companies of different sizes.
Make sure you have exposure to large, medium and small companies in domestic, international and emerging markets.
Diversifying helps save you money
Diversification reduces risk in a portfolio by allocating investment dollars across asset classes, countries and industries.
The goal is to maximise returns by lessening the chance a major market event would have a devastating effect on an entire portfolio.
That’s why it’s so important to get it right.
* Bob Rall is CEO and founder of Rall Capital Management.
This article first appeared at www.investopedia.com.
