Diversification Is the Only Free Lunch
“Diversification is the only free lunch” in investing, says the quote attributed to Nobel Prize laureate Harry Markowitz. I like to put it this way to my clients: If you’re using only stocks and bonds to build a portfolio, you’re utilizing a small fraction of the available investment universe. As shown on the following pie charts, US domestic equities and bonds are a fraction of the investable universe. United States Equities and Fixed Income represent only a portion of the global market for stocks and bonds as shown in the pie chart below. In addition, there are numerous other asset classes like real estate and real assets as well.
This chart shows that US stocks and bonds—what the bulk of US investors choose—are a very small part of the investable universe, and you can see that many other opportunities exist that you may not have considered before. If you were playing cards, you would be playing with a partial deck. Is this where you are, currently?
Now, let’s imagine that you’re playing that same game, but you’re holding all the cards in the deck, not just a few. This is what happens when you are dealing with the full investment opportunity set that includes all the asset classes.
The key to diversification is using more assets. The less correlated those assets, the better. Ray Dalio, of Bridgewater Hedge Fund, referred to diversification as the “Holy Grail of Investing” in his book, Principles.
HOW MANY BOATS ARE YOU TRUSTING TO DELIVER YOUR MONEY?
Most people ride the ups and downs of the market, moving things around as needed in one boat and generally trying to stay abreast of the constantly changing circumstances of business and the financial markets—usually US stocks and possibly to a lesser extent US bonds. However, if the stock market hits an iceberg, and investors are just moving items around in the same boat with their stock funds, ETFs, and individual stocks around, those assets are essentially all in the same boat and all go down together.
If the boat (the stock market), goes down, the investments all go down. Big institutions, foundations, and generational wealth are not keeping all their money in one boat. They have already split up their assets into multiple boats that are navigating different courses to the destination. If you do the same, and one of those boats is delayed or damaged, you still have reasonable results. That is the wisdom of diversifying assets. You will have some of your money in other boats.
Wiser diversification with more asset classes is simply a better way to build a portfolio than staying only in US stocks and bonds. Diversifying assets include infrastructure, agricultural land, reinsurance, alternative lending, timberland, VRP harvesting, and private real estate. All of these reduce risk through diversification. Please note these investments are not low risk as stand-alone investments. Their risk reduction properties come from the power of low correlation in diversification. As stand-alone investments, these additional asset classes do not lower risk and are not appropriate as a dominant part of a portfolio. Diversification is the key.
You should evaluate with your financial advisor what method for diversification and reducing risk is best for you. For more information on diversification, you can download a couple of free chapters of my book, Wiser Investing: Diversify Your Portfolio Beyond Stocks and Bonds.
The information is for informational purposes only. The opinions expressed or implied are exclusively those of the writer and are not to be attributed to, or presumed to be endorsed by, the author’s employer or any company with which the author is affiliated and are subject to change without notice.
The information has been derived from sources believed to be reliable, but its accuracy and completeness are not guaranteed. Investing in stocks, bonds, and other assets present various forms of risk to investors and could result in losses; positive returns are not guaranteed. Diversification only reduces the risk of capital loss but does not eliminate this risk. Measures of expected return and/or expected risk are not forecasts of returns or risks but are only statistical definitions for modeling purposes based upon financial and statistical analyses. Past performance is no indication of future results, and all investments or assets could lose value in the future due to a variety of financial factors. Due to volatility exhibited in various markets including, but not limited to, stocks, bonds and other forms of investable assets, these markets may not perform in a similar manner in the future. Among risks which can affect value, financial assets are also exposed to potential inflation and liquidity risks. Expected returns, expected risk, and long-term targeted returns are not forecasted returns or risks, but are only statistical definitions for modeling purposes. Investors may experience different results in any chosen investment strategy or portfolio depending on the time and placement of capital into any assets associated thereto. Diversified strategies are constructed to diversify from an all-bond portfolio, directed toward investment among assets that may largely, though not necessarily completely, be non-bond alternatives. Investors are cautioned that they should carefully consider fully diversifying their total personal investment allocations to incorporate a variety of investment assets which also may include stocks, stock mutual funds and ETFs, international assets, bonds and fixed income instruments (where appropriate), and other non-stock/bond investments (e.g., without limitation, Real Estate and other assets). Nothing should be considered a recommendation nor a solicitation to buy or an offer to sell shares of any security or service in any jurisdiction where the offer or solicitation would be unlawful under the securities laws of such jurisdiction.