Did you review your portfolio this year?
Before coming into this business, I thought I was diversified by having my investments in a Vanguard S&P500 index mutual fund. I figured. Hey, I’m across 500 stocks, that’s diversification. In reality, all my holdings were in one asset class, large-cap domestic stocks. Real diversification includes many categories of investments including but not limited to small stocks, large stocks, international stocks and bonds.
As far as asset-class winners and losers, the last time large stocks gave the highest return was in 1998. Since then, bonds and international stocks performed better. So why diversify? Winners rotate; you don’t want to miss out on the best performing asset classes.
To reduce the volatility of returns in a portfolio, combine assets that tend to have low correlation to one another.
For example, a rock group needs musicians with different attributes and talents – the group must be diversified. Building a group with four guitar players is not a great idea, as much as we like guitar players. A singer is needed, as well as a drummer. Because they have different attributes and talents, the correlation between guitar player and drummer is low – and low correlation is what you’re after.
Low correlation equals diversification. Economics professor Harry Markowitz summarizes the basic premise underlying diversification and portfolio asset allocation in one sentence: “To reduce risk, it is necessary to avoid a portfolio whose securities are all highly correlated with each other.”
A preferred asset allocation should be based on your investment goals, risk tolerance, age and your time horizon. A portfolio of all stocks or all bonds may not be appropriate for you. A balance of many asset classes is ideal.