Diversification

The word “diversification” comes up often in finance. Diversify your portfolio. Diversify your risk. Diversify your asset classes.

I am focusing on diversification in this investing article  to show you what a diversification strategy is and how to implement it.

Sometimes a diversification strategy can sound perfectly reasonable when it isn’t.

Having simple “rule of thumb” guidelines will help you diversify your investments.

Diversify your Portfolio

Here is one way to visualize diversification in your portfolio. A bottle of Vitamin D.

Vitamin D is produced in our bodies when we are exposed to sunlight. If you don’t get enough sunlight you can take a Vitamin D supplement, also called the Sunshine Supplement.

If you live in a sunny place, you might question a recommendation from your Doctor to take a Vitamin D supplement. Once given the recommendation, you trot off to the local pharmacy and buy a bottle anyway.

A few weeks later you are in a different pharmacy and you pass the vitamin aisle. “Wasn’t I supposed to buy Vitamin D?”

You buy a second bottle because you forgot about the first bottle.

Did you forget because you are spending too much time in the sun? I digress.

Several months later as you comb through the cupboards you discover 4 bottles of Vitamin D. Every pharmacy or grocery store you went into; you bought another bottle. Same brand every time!

Where can I be going with this analogy?

Let’s assume that instead of four bottles of Vitamin D you have four different financial accounts.

You have a bank savings account, an IRA, an employee pension plan, and a joint account. There might be a few smaller accounts from previous employers. In each account you must make an investment decision. What should I invest in?

Well, you say “I like Vitamin D (I bought four bottles) so why don’t I just buy some Vitamin D stock in every account?”

Then I am diversified because I’m not buying a ton of Vitamin D stock in one account.”

So, you do. You buy Vitamin D stock in four different accounts , at the same time incurring four separate  transactions costs.

Then the Doctor calls and says: “My bad. You don’t need Vitamin D; you live in a very sunny place. You need Vitamin B”

Now what? Do I sell my four positions in Vitamin D stock from every account, incurring more transaction costs?

Before I can sell, the stock price of Vitamin D drops. I now have losses in four accounts. My losses are four times greater than I expected. Owning Vitamin D stock in one account would have been enough.

My Vitamin D – versification strategy has not worked out.

Diversification means buying different vitamins. Having multiple accounts with the same securities in each account is not diversification.

Diversify your risk.

The easiest way to diversify your risk is to limit the amount of money you invest in any one security. A rule of thumb is 5%.

For example:  you have total assets to invest of $100,000.00. A 5% position in one security is equal to $5,000.00. As a starting point you can buy 20 different securities.

A security is a single stock or a single bond.

Owning shares of a stock fund or a bond fund are also securities.

With twenty different securities you will be well diversified.

Keep it simple.

Diversify Asset Classes

Diversifying risk includes diversifying asset classes. Asset classes are stocks, bonds, cash, real estate, private equity or hedge funds and commodities.

You do not need to own every asset class to be well diversified. It is okay to stick to the three basic asset classes.

The first step is to allocate.

How much of my $100,000.00 do I put in stocks, how much in bonds and how much do I keep in cash?

This is the hierarchy of decision making. You start at the top and work your way down.

It’s like checking items off a list.

The second step is to diversify the sectors of the market you invest in.

Here the main point is to know the difference between an asset class and a sector.

Thinking of asset classes and sectors reminds me of Russian Nesting Dolls. You start with one doll. Inside that doll is another doll, then another doll, then another doll. First you choose a sector and then a subsector, and subsectors of subsectors.

It looks like this:

Asset class → Equities

Sector → Healthcare

Healthcare → Subsector: Equipment and Services

Look for Equipment and Health Care Companies to invest in.

If you buy the stock of 10 different companies but all the companies are technology companies, you are not diversified.

If you buy stock in 10 different sectors you are diversified.

Sectors have a funny way of moving together like a herd. The stock price of one technology company goes down, fear grips the sector and other technology companies go down with it. Even if they are great companies.

When fear grips a sector, it can be a great time to buy.

In both the stock market and the bond market there are plenty of sectors to choose from.

• Energy
• Materials
• Industrials
• Consumer Discretionary
• Consumer Staples
• Health Care
• Financials
• Information Technology
• Telecommunication Services
• Utilities
• Real Estate

Recap:

• Diversify your portfolio: Don’t go all Twin Peaks and mirror your investments across accounts.
• Diversify your risk: Minimize the amount of money you will invest in any one security.
• Diversify the sectors you are invested in: Start with a sector you like or are interested in.

This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.