People understand diversification in principle. It is as simple as “don’t put all your eggs in one basket.” In practice, however, lowering investment risk is a bit more complex.
For instance, some want to believe that owning a stock mutual fund is diversification, at least in comparison to owning the stocks of just four or five companies. And that is true.
They also want to believe that owning a portion of their investments in bonds as a counterbalance to stock holdings is diversification. And that also is true.
Some go so far as to count their home or business investments as “real world” assets that they can control, diversifying them beyond investing in the public capital markets. True, true, true.
And not in the least bit diversified.
Yes, owning a stock mutual fund reduces your single-company concentration risk. Owning a broad index fund that tracks hundreds of companies, however, does this even better and at rock-bottom cost.
Still, owning more stocks — even hundreds of them in an index fund — means only that you have spread out your company risk. If the stock market declines in value, your entire portfolio takes the ride down.
So, investors often add bonds, usually as a ratio based on age minus some number (the debate about which age and which number is endless). A mix of stocks and bonds is approaching something like real diversification.
That is because as stocks fall in value, bonds often (but not always) rise, and vice versa. Prudently rebalancing — selling off a portion of one investment type and buying another when the ratio is out of whack — lowers overall investment risk.
True, global diversification, however, looks very different. It is not just stocks but big U.S. stocks for solidity, small-cap stocks for growth and foreign stocks both large and small.
It is bonds, but a mix of government and corporate issues of varying lengths and risks. And it is global real estate, too, as well as commodities.
Truly lowering retirement investment risk
In short, your portfolio should look like the whole world, not a narrow slice of it. That is how big university endowments do it. It is how large corporate pension funds and state retirement plans do it.
The impact of owning a diversified portfolio approach is huge. The New York Times recently published research that showed how over 10 years a truly globally diversified portfolio returned 8.3% per year, compared to just 1.4% per year from the seemingly diversified S&P 500.
As for your home equity and businesses, well, those are great investments, but they are not liquid enough to help you. It is great to build up long-term value in such opportunities, but tapping into those assets down the road can be difficult.
Rather, one should seek to own a broad selection of inexpensive index funds representing the biggest slices of the investment world, then rebalance those holdings with discipline at the lowest possible cost.
That approach, over time, is how great retirements are built — patiently, brick-by-brick.