Proper diversification can make or break your financial plan. Negative events can affect one asset or asset class while that same event can propel a different asset to new heights. It is in your best interest to make sure your assets are properly diversified to keep your investments safe from the inevitable negative events that occur.
What Is Diversification?
Diversification is the process of allocating your investments among different assets and asset classes to reduce risk. Essentially, it is the age old adage “Don’t keep all your eggs in one basket.”
By utilizing diversification, you can reduce your risk due to different assets and asset classes acting differently in the same market. A simple example is stocks and bonds. Bond prices tend to increase when the stock market goes down. Why? Investors want to protect their money during a market downturn. Therefore, they will seek out the safety of bonds during turbulent times. If you have a portfolio of stocks and bonds, your bond portion will increase, helping to offset the decrease in stock prices.
Diversification Techniques
When thinking of diversification, the first level is to diversify within an asset class. For example, instead of investing all of your money in a single tech company’s stock, you will invest amounts in 10 different tech companies. This will give you solid risk against the downfall of one of those companies. This will not, however, stop any risk in the tech industry as a whole. If something were to happen that knocks the industry off its high perch, your investments would all go with it.
Continuing with the example above, instead of investing only in tech companies, you choose 10 companies from a variety of different industries. This will help soften the blow if one industry were to under-perform. But what if the entire market experiences a downturn? This approach will still lead to your investments taking a significant hit.
So then we come to asset class diversification. This is where you invest in a multitude of areas, such as stocks, bonds, real estate, precious metals, cryptocurrencies, etc. What you are trying to do is make it so the gains in one asset class will help offset the losses in another. In essence, you are trying to “smooth the ride.”
How I Diversify
While reading Tony Robbins’ “Money: Master the Game“, one section spoke to me enough to change my entire investing strategy. In it, Ray Dalio, the hedge fund manager who founded investment giant Bridgewater in 1975, discusses diversification among four investment quadrants.
To understand the four quadrants, you must understand first that, per Ray Dalio, there are only 4 things that will change the price of assets:
- Inflation
- Deflation
- Rising Economic Growth
- Falling Economic Growth
Now, put these 4 scenarios into the 4 quadrants:
| Growth | Inflation | |
| Rising | Rising Economic Growth | Inflation |
| Falling | Falling Economic Growth | Deflation |
When you look at it this way, what Ray Dalio said next is simple. You want to make sure you are diversified in assets that perform differently in the four different markets that are outlined above.
| Growth | Inflation | |
| Rising | Stocks Corporate Bonds Commodities | Commodities Inflation Linked Bonds |
| Falling | Inflation Linked Bonds | Treasury Bonds Stocks |
A Risk Based Portfolio
The above describes what is known as a Risk Based Portfolio. This is designed to smooth out the ride by not having too many eggs in one basket to avoid the large, volatile motions that the stock market can have. If you would like to learn more about Ray Dalio’s All Seasons approach, I implore you to give Tony Robbins’ book a read through. It is a mammoth 600+ page book but will teach you everything you need to know to be successful in your investing endeavors.
The rules you want to follow when investing are simple. Warren Buffet, The Mutual of Omaha, has said it best. “Rule 1 is to never lose money. Rule 2 is to never forget Rule 1.” This is what the Risk Based Portfolio is all about. Doing everything you can to minimize any investment losses. While you will still have down years, they are almost impossible to avoid, you do have the ability to keep those losses to a minimum. Sign me up for that any day!
Reallocation of Investments
A key principle of a diversification strategy is to reallocate your investments back to the original allocation after a set period of time, typically once a year. The main reason to reallocate is to keep the level of risk of your portfolio at the desired amount. A lot can change in a year. Your investment balances can vary wildly from year to year, increasing or decreasing and causing significant differences from your original allocation.
Let’s say that one year, stocks increase 10% while bonds are flat. Now, your stocks are at a much higher percentage of your portfolio than bonds are. If you want to stick to a certain allocation, you will need to sell some of your stocks and buy more bonds to get back to the allocation desired. This is the simple process of reallocation.
The Almighty Index Fund
Does all of this sound like hard work? Do you wonder if you have the investment know-how to really implement a diversified strategy? The good news is, due to the index fund, it has never been easier to be diversified among so many asset classes! My investment allocation is formed using only 4 index funds and 1 Exchange Traded Fund (ETF), following the All Seasons Approach by Ray Dalio that was discussed above. This has brought me a return of over 10% since the pandemic started and the bottom fell out from the market in March. I would call that a success!
The Story on Diversification
Diversification is really all about Risk vs. Reward. It is common knowledge that stocks have the most upside when it comes to returns. It is also common knowledge that stocks have the highest amount of risk associated with them. You diversify with different asset classes in order to minimize this risk. Bonds are less risky than stocks, and typically move in opposite directions. This will help offset some losses of stocks, smoothing out your investment journey.
Hold Steady
No investment strategy will be a success without mentioning one final point. The ability to hold steady in uncertain times. I mentioned above about how our investment portfolio has gained 10% since the pandemic started in March. These gains came after the portfolio dropped over 7% to start the pandemic. So while it is all sunshine and rainbows now, there was a point where a significant amount of money was lost. Well not truly lost. Always remember, you haven’t lost any money until you sell your asset. Until then, it is all just on paper. If you have 100 shares of an index fund, no matter what happens to the price on a given day, you will still come out with 100 shares. As long as you don’t sell of course.
When evaluating the market, you will see that most of the largest gains in history followed days of historic losses. The people that sold during the losses to try to save some money miss out on the gains on the way back up. Don’t be those people. Hold on to your asset allocation. Do not throw your hands up and sell in a panic market. If history has taught us anything, the market will come roaring back to life. It may take time. It took many years for the markets to bounce back from the Great Depression. But it still made its way back. The Great Recession was over 18 months after it started. That may feel like a lifetime when you are in the midst of it, but it is really only a small blip on the radar of your investment timeline.