Diversification is one of the most important safeguards for amateur investors, but many don’t understand how to do it effectively.
Diversification is not a simple matter of taking several positions within a market. You could be invested in a hundred different stocks, but if each stock’s performance is positively correlated with the overall market, then you’re not truly diversified. If the market drops, all your stocks will drop with it.
The point of diversification is to shelter you from deep losses due to unexpected market behavior. If all your investments react the same way to a change in market conditions, then your diversification is failing you.
So how do you choose investments that are truly diverse? You need to look at how your investments rate in four criteria: cost, liquidity, safety, and rate of return. If assets are different in these four categories, then chances are, they will each react differently to various market conditions.
Let’s break down each one of these criteria, using examples of real estate and stocks to show what true diversification looks like.
Cost is pretty self-explanatory: How much money does an investment require?
You have a limited set of funds with which to invest. If all your investments are high cost, chances are, you’re not going to have very many positions. You don’t need to invest in a hundred different assets, but neither do you want to invest in only two or three. In order to build an adequate number of positions within your portfolio, look for both higher-cost and lower-cost investments.
Let’s consider real estate. Are houses costly? Absolutely. For many people, a house is the largest purchase they will ever make.
Stocks on the other hand are less costlys, although it’s still fairly costly to invest at a level high enough to provide strong returns.
So far, it’s looking like investing in both real estate and stocks would be true diversification.
Now let’s look at liquidity.
Liquidity is how quickly an investment can be converted into cash without affecting its price—essentially, liquidity is how easy it is to buy and sell the asset.
Liquidity is important because the point of investing is to make money that you will eventually spend. Especially as you near retirement, when you will begin to draw on your investments for living expenses, you want to pay attention to liquidity. If all your assets are non-liquid, your investments aren’t going to do you much good!
Let’s return to our real estate and stocks example. Real estate is not a very liquid asset. Typically, it’s difficult or impossible to sell a house within a week or two. Anyone who does this will likely receive much less than market value. Stocks, however, are much more liquid.
On to the next criterion: safety.
Safety is a measure of an investment’s risk level.
In determining safety, consider both the amount of money you could lose and the probability of that loss. If the amount of money at stake is high, you will likely only tolerate a very small probability of loss, whereas if the amount of money at stake is relatively low, you may tolerate a higher probability of loss.
The housing crash notwithstanding, real estate usually offers a reliable income. Stocks are far more risky than real estate. They can drop in value with no warning.
We have one more criterion to consider: rate of return.
Rate of Return
Rate of return is the profit on an investment. When considering rate of return, think in terms of one year or longer. Also consider any relevant fees and expenses.
For real estate, in the United States, the national average is 4 percent growth in house prices per year. Stocks have the potential to deliver a higher rate of return than that.
So in all four criteria, real estate and stocks are different, giving a strong indication that investing in both would provide diversification.
Diversification in Action
What does diversification look like in practice? A typical client of mine wants to spread their risk across a range of sectors. They build a diverse portfolio of stocks, with some positively correlated and others negatively correlated to the market (meaning that when the market goes up or down, some stocks will move with the market, and some stocks will move in the opposite direction). The client may also own a business and some real estate. They keep cash and capital in distinct markets with a percentage of their investments in lower-risk areas such as bonds.
There’s a good mix of assets in terms of cost, liquidity, safety, and rate of return. Should we encounter a recession, their business may suffer somewhat. On the other hand, the value of their real estate may remain strong. Some of their stocks will drop in value, whereas others—if they’re properly correlated—will hold steady or even grow.
By choosing your investments wisely, considering these four criteria, you will be well on your way to achieving a diversified portfolio that will protect you from deep losses.