In the Series 6 articles I covered the basic investment types of stocks, bonds, and cash. I also touched on funds, which represent baskets of stocks or bonds. But what combinations of these investments should a mindful investor prefer? Deciding how much of various types of investments to include in your investment portfolio is broadly termed “diversification” or “asset allocation”. The conventional wisdom is that you should avoid putting all your investment eggs in one basket. This reduces the potential that a one-time event, like a company going bankrupt, would single-handedly severely damage your investment portfolio.
If you search the internet for the word “diversification”, you will quickly come across a quote like this: “The only free lunch on Wall Street is diversification.” Because everybody likes a free lunch, the phrase shows that diversification is a deeply rooted investing tradition. As discussed in Article 2, a mindful perspective tells us that it’s dangerous to accept the teachings of others merely on face value. And I think we should be even more skeptical when everyone seems to like the same thing. For example, almost everybody seems to like potato chips, but they are one of the foods most correlated with long term weight gain. Maybe that’s just coincidence, or maybe potato chips are okay for some folks, but not others. To understand whether the tradition of diversification is truly mindful, we need to dissect the meaning of the word and examine the kinds and potential degrees of diversification.
The term “diversification” is bandied about with great gusto in the media often with scant explanation. In general, there are two broad types of diversification that you will see discussed:
- Diversification across asset classes
- Diversification within asset classes
The first type of diversification is also sometimes called asset allocation. It mainly focuses on the question of how much of each broad class of investments (stocks, bonds, and cash) you should own. The second type of diversification (within asset classes) addresses a finer scale. For example, there are many types and flavors of stock and bond investments that you can choose from as shown in this table. Do we need to diversify across all the flavors or just some, and if some, how do we decide which ones?
|Within-asset-class diversification (a less than exhaustive list).|
|Stocks||Large, mid, small, and micro cap (capitalization)||Region, country, state/province||Consumer discretionary, consumer staples, energy, financials, health care, industrials, technology, biotechnology, materials, telecommunications, real estate, and utilities||NA||There is a vast array of stock investing styles. “Value”, “growth”, “quality”, and “momentum” are some typical examples.|
|Bonds||NA||Region, country, municipality||Government, corporate, inflation protected, convertible, callable, municipal, and zero coupon||2, 4, 6, 8, 10, 15, and 30 year (and others)||Bond ratings from AAA to D (or “junk bonds”)|
Once you decide on your necessary degree of diversification across and within asset classes, there is also the issue of how to diversify. For example, if you want to invest a certain portion of your portfolio in stocks because of their relatively high rate of return, should you invest in the individual stocks of a few select companies, individual stocks from many different companies, or in funds that track the performance of large swaths of companies in the stock market?
The next articles discuss these issues in more detail:
- Article 7.1 – Stock diversification discusses how to diversify your stock holdings and evaluates the need to diversify within this asset class.
- Article 7.2 – Bond diversification discusses the same issues for bonds
- Article 7.3 – Diversification across asset classes discusses the appropriate mixtures of stocks, bonds, and cash to hold in a portfolio of investments.