It used to be that investment diversification was a pretty simple exercise. Choose a mix of stocks and bonds – or better yet, stock and bond mutual funds, and then slowly shift the mix towards bonds as you get older.
However, the world has changed and many financial planners would agree that this outdated definition of diversification should be thrown out the window. Here are five of the most obvious reasons why:
1) Stock movements tend to be highly correlated, and when there is a major crash (as we all experienced in 2008/2009) even the stocks of high quality companies can get hit and in some cases hit really, really hard.
2) Investors tend to react emotionally and often sell during big downturns – magnifying the effect and further damaging the potential returns of their portfolios.
3) Owning stock mutual funds doesn’t help much because fund managers tend to buy more stocks than they actually like – reducing overall returns and exposing their funds to broader market forces. (Why they do this is probably a great topic for a future article.)
4) Buying international stocks used to provide a degree of safety, but our global economy has become much more tightly linked over the past decade, reducing the diversification potential of these stocks.
5) Owning bonds or bond mutual funds can help, but these are subject to market forces as well and often investors or fund managers don’t hold their bonds to maturity – again exposing their portfolios to market risk.
So – what’s the savvy investor to do? One option is to consider so-called “Alternative Investments”. These can include a variety of choices from precious metals to oil & gas master limited partnerships to real estate. There are investment funds which specialize in each of these – we like real estate funds in particular as a great way to truly diversify a portfolio, as their performance tends to have a low correlation with the stock market and the returns tend to have low volatility. By choosing the right fund or funds, it’s actually possible to increase your overall portfolio returns while simultaneously decreasing overall portfolio risk. Now that’s diversification!