When I was a kid, one of my favorite cartoon characters was Yogi Bear. Yogi and I share a passion for food. If you remember his antics, you recall that Yogi was always trying to find ways to steal picnic baskets. Here was a guy looking for the proverbial “free lunch.” Now we all know there is no such thing. Yet, as I get ready to write about diversification of investment portfolios, Yogi somehow comes to mind. Diversifying your investments is in some ways analogous to a free lunch. With a well-diversified portfolio, one or even several bad investments won’t ruin you. Your portfolio will have fewer wild swings in value that make you queasy. And, you will experience more steady progress toward your investment goals.
Picture Yogi with a choice between two baskets. One of them holds tasty sandwiches, some potato salad and a piece of cake. The other has but a few well picked over chicken bones. How does he increase his chances of getting full one and decrease the chances of going hungry?
There are many ways to invest, and there is risk that we, like Yogi, end up with the chicken bones. Most of us want a plentiful retirement basket. The best way to increase our chances of that outcome is diversification. No one can tell with any degree of certainty what classes of investments are going to do well next year. So, we diversify. We want to make sure we have large and small company stocks, international stocks, different types of bonds, real estate, cash and so on. Without the keen nose of a bear, we need to rely on other selection skills in choosing the best investments.
The Four-Course Meal
A way of picturing our diversification is called asset allocation. I like to use the metaphor of a four-course meal to describe the allocation. The four courses are Cash, Bonds (or fixed income), Stocks (or equities), and Real Estate/Alternatives. The percentages we have in each of these categories describe the meal. The picture of your diversification (often represented as a pie chart, Yogi’s favorite) is important. It determines how much your investments are likely to grow over time and the amount of risk you are taking to achieve those returns.
What is proper diversification? It is vital to select investments that do not move in tandem with one another. Financial vehicles with similar risk characteristics tend to move together. Take stocks for instance. If US stocks go up one percent on a given day, the chances are they also went up in Europe that day. The stocks in both markets have similar risk profiles. Putting them together in a portfolio will only have modest diversification benefits. If we now add US government bonds to the portfolio, and stocks go down on a given day, the value of the bonds might actually go up. The investments are not moving in the same direction. An investment category is a good diversifier if it does not move in tandem with other investments in your portfolio.
The main benefit of diversifying in this way is that it provides a cushion against wild swings in the value of your portfolio as a whole. Since no one knows in advance which investment categories will outperform each year, by diversifying you increase your chances of being in some categories that are appreciating. While you may not experience many years where your portfolio rises by 25 percent, the diversified portfolio will rarely decline 25 percent. Less volatility means steadier progress toward investment and retirement goals.
Be Sure to Diversify Each Course
One final point bears mentioning. In order to be well diversified it is essential to vary the investments in each of the four main categories of your allocation. Many people do not realize that options to diversify within the bond and stock categories exist today that were not readily available just five years ago. If you’re like Yogi, and are “smarter than the average bear,” you will review your portfolio with a critical eye to assessing diversification. Achieving reduced volatility in your portfolio with steady progress toward your investment goals is the closest you can get to a free lunch.