Chances are you’ve heard one of heard the following:
Immediately after you hear these statements (or something close to it), you are then told to purchase some combination of small, medium, and large cap stocks (or bundles of these stocks in a mutual fund).
You may even hear something about adding bonds. Or that the percentage of stocks to bonds is based on your age.
Typically, these are the broad options given to you by your first financial advisor.
But don't be fooled; you are not getting diversified investments.
Investments, by themselves, are not "diversified". Even if you buy one mutual fund that experts consider "diversified", you still only own one type of asset.
Diversification is measured using your total portfolio, or all the different types of investments you hold in your accounts.
Asset allocation is the process of selecting the asset classes you need to be diversified. It is an action that you take buy purchasing different types of investment instruments.
The end goal is to a bunch of different investments that are based on a bunch of different asset classes.
The expectation is that by holding a bunch of different assets, no one single asset can sink your portfolio - you make money when the market goes up, when it goes down, and when it goes sideways.
Owning small, medium, and large cap stocks just gives you a diversified set of stocks.
You may be asking yourself, "OK, where’s the problem then?"
Think of it this way: A dinner plate may have 10 different types of vegetables, all with different of colors and textures. But overall, you still have a plate full of vegetables.
All the vegetables probably taste differently too. Again, it is still a plate full of only vegetables.
In order to have a healthy body (diversified investment portfolio), you'll need other food groups (asset classes) along with exercise (process-based investing techniques and decisions).
Stocks are one asset class, called equities. In William O'Neils book "How to Make Money In Stocks", he describes the historical phenomenon that 3 out of every 4 stocks follow the "market" trend.
This means that 75% of stocks will move in the same direction as the overall market indexes that you see on the news every evening.
When the stock market goes down, a majority of the stock prices within the market also fall, regardless of whether they are small, mid, or large cap.
The good news is that when the stock market goes down, there are other asset classes that tend to go up.
So a large number of different stocks may seem diversified, but it is still just a collection of stocks. The point of diversified investments is to have money in asset classes that move up and down at different times.
Safe Investing Tip:
If all your investments are going up in price, then your investments ARE NOT diversified.
Diversification is measured using a ratio called "beta". Beta represents the correlation between two assets.
Beta is affected by several factors, including:
A beta of 1.0 means 1 to 1 correlation. For instance, if the S&P 500 goes up 1%, you would expect an investment in an S&P 500 index fund to also rise 1%.
If you were investing in a leveraged fund, then the beta value would probably be two or three. A value of two or three means that a 1% increase in the S&P 500 will result in a 2-3% increase in your investment.
In order to know if you're diversified, you need to know the beta of your investments. Below is a great graphic from Rydex that lists the beta for different assets class from 2004 to 2011, when each class is correlated to the S&P 500 stock index (click the image to enlarge in a new tab).
The chart shows perfect correlation between the S&P 500 and itself...as you would expect. But do you notice anything else?
Look at how many asset classes move with the S&P 500. 7 of the 14 asset classes in that graph are highly correlated to the S&P500. This means that when the S&P 500 rises and falls, any investments in those 7 asset classes are likely to follow suit.
Diversification spreads your money across different asset classes using asset allocation (selecting the different asset classes) and position sizing (calculating how much money to put into each asset class).
The graphic above shows how each asset class relates to a benchmark (in this case the S&P 500), which is useful information for selecting investments.
The key thing you need to remember is that your portfolio will have several different asset classes in it. And when it comes to making diversified investments, you need to focus on the combined returns from all the asset classes.
The combined returns (verses a benchmark like the S&P) will tell you whether you're truly diversified.
By having your money in a variety of asset classes, you limit the risk that a loss in one asset class wipes you out. This is because there are very few times that ALL asset classes move in the same direction, at the same time.
For example, if we enter a bear market in equities, then everything based on stocks will probably fall in price. If your portfolio was split between stocks, bonds, and gold (representing 3 asset classes), your losses would not be as high compared to a portfolio that only contained stocks (representing 1 asset class).
Safe Investing Tip:
Asset classes CAN move in the same direction under certain circumstances! The financial crisis in 2008 is a great example.