By Chris Cook
Many investors make a simple, yet correctable mistake in their portfolios—they believe they hold diversified investments when in actuality they don’t, leaving them unnecessarily exposed to market volatility. So how does this problem happen, and why do so many investors build a narrowly or poorly focused portfolio? It begins with the systemic failure of traditional investment strategies. In this article, we’ll look at the fallacy of traditional investment portfolios, and why you need “real” diversity in your investments for growth and protection.
Traditional Portfolio Strategies
In theory—and through much of U.S. economic history—the basic premise of traditional portfolio strategies has worked. These strategies promised capital security through asset allocation and diversification. Under the old model, diversification worked because it offered a portfolio protection against market risk (e.g., if the U.S. waned, you had other investments in other parts of the world to counterbalance that loss). Unfortunately, we now live in an increasingly interdependent and global marketplace, one that hinders this old approach, keeping it from controlling risks or maximizing gains.
Let’s take a closer look at how the old strategies are devised. These portfolios are built using complex formulas that rely on market timing and spreading holdings across a variety of asset and sub-asset classes, as well as through utilizing different styles of investing. Asset classes include stocks, bonds, cash, real estate and commodities. Styles include growth, value or some combination of the two.
Investors see additional diversity by including equities from companies of various sizes—small and large cap. Or perhaps they seek out companies and assets from different industries, geographic locations or investment platforms, all in the pursuit of perceived diversity. However, these strategies, in my opinion, are too complex, too convoluted and leave too much to chance, whims and market timing. In short, they lack real diversification, the type of diversification that investors require in today’s increasingly unpredictable marketplace. (For related reading, see: The Pitfalls of Diversification.)
Indexed Portfolios Issues
What about indexed portfolios? While an index like the S&P 500 does an excellent job of tracking the market’s performance, its success hinges on capitalization or cap-weighted assets. This over-reliance on the biggest companies exposes investors to bubbles.
We saw this take place in the tech bubble collapse of 2000. If your portfolio mirrored the S&P 500, you rode the wave up, but the tech sector eventually accounted for 21.2% of the entire index.1 That’s too much depending on one sector, and we saw what happened when the tech bubble burst.
Achieving Real Diversification
I believe investors achieve real diversification through equal sector allocation across the different sectors of the economy. This strategy will allow you to maximize your portfolio’s diversification, providing you with the ability to realize overall market movement, while spreading the risk broadly and equally across the various investment sectors.
Historically, divisions have been sliced up into either nine or 10 sectors, but in real diversification, we took it a step further and added real estate because of the sway it holds in our marketplace. In our real diversification strategy, those sectors are:
- Consumer discretionary
- Consumer staples
- Real estate
Building a portfolio based on these sectors works on different levels. First, each sector is its own unique economic entity. These sectors react differently, often independently, to outside market conditions. By spreading your market exposure to any one sector (or any one equity, for that matter) you are minimizing your losses.
Essentially, you are spreading your risk across 11 sectors. If one sector collapses, your portfolio’s losses can be limited because of the real diversification of your investments. To make this investment strategy work, you’ll want your investments spread evenly across the 11 sectors. That means weighting your assets equally, or 9.09% of your equities in each sector. (For related reading, see: Shifting Focus to Sector Allocation.)
Real diversification helps protect against risks that are company or sector specific, but what if there is a market-wide crash due to interest rate swings, recessions, wars or other risks? It could be catastrophic to any portfolio that doesn’t include a stop-loss mechanism. In building a portfolio with real diversification, I believe in including a stop-loss order whether for the portfolio overall or individually for each sector, so if values drop a set amount your mechanism will be triggered, which could save you from major losses incurred from any bear market.
Your Investment Portfolio Today
Finally, what does your portfolio look like today? Does it take on the behaviors of the traditional portfolios or does it more accurately reflect the real diversification portfolio I’ve described above? If you’re not sure, begin by asking yourself the following questions: How many economic sectors are represented in your portfolio? How are those sectors weighted? Have you considered what would happen to your nest egg if another market collapse occurred like the one we experienced in 2008? Once you have clarity about the portfolio you have today, you can begin making strategic decisions about building a more diversified portfolio for the future.
(For more from this author, see: Why Traditional Investment Strategies Don't Work.)
1Chris Cook, “Slash Your Retirement Risk: How to Make Your Money Last with a Simple, Safe, and Secure Investment Plan” pgs. 159-160
This article was originally published on Investopedia.