One of my favorite topics to discuss about investing is diversification. Reason being the concept of diversification is interpreted differently by all walks of investors. We’ve all heard the adage “Don’t put all your eggs in one basket.” This makes perfect sense in theory, but it’s been my experience that most investors, without knowing it, do have all their proverbial eggs in one basket.
For example, I once met with a prospective client whose portfolio was comprised of ten individual stocks – Apple, General Electric, Chevron, AT&T and Pfizer to name a few. The prospect believed they were diversified because they owned companies from different industries. This is true to an extent. While their ten stocks provided exposure to different industries from technology to pharmaceuticals – all of their holdings were US large companies.
Most investors confuse diversification with having exposure to different industries or sectors, or the number of holdings in their portfolio. While it is better to own 500 US large company stocks than ten, your portfolio would only have exposure to the US large company asset class. And that is the crux of the issue. Most prospects that walk through our door are heavily invested in US large companies and their portfolios tend to mimic the S&P 500 or DJIA. There are other asset classes to invest in such as US small companies, international large companies, international small companies, and emerging market companies.
The reason an investor wants to make sure their portfolio has exposure to all major asset classes, both in the US and internationally, is academic evidence demonstrates they do not behave in lockstep. There are periods when US companies outperform international companies and vice versa. Just as there are periods when large companies outperform small companies and vice versa.
The beauty of having a truly diversified portfolio is the ability to rebalance to specific targets for each asset class based on market conditions. This enables an investor to systematically ensure they buy low and sell high.
So take a look at your portfolio and make sure you are actually diversified. If not, take the steps necessary to do so. The end result will be a more prudent investment portfolio that will allow you to take advantage of what capital markets have to offer.
