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posted on 09 June 2016

Proactive Investing The Power Of Diversification

by Russ Allen, Online Trading Academy Instructor

Online Trading Academy Article of the Week

In my last article, I suggested that you make an inventory of all of your investment assets, to make sure that you understand what you have to work with. I mentioned that many people may be in a more precarious situation than they realized, because they don't understand or haven't yet utilized the power of diversification. That would be the case if all of your money is exposed to any one market, which would usually be the stock market.

For example, let's say that an investor has the following assets:

  • $150,000 in an employer's 401(k), invested in three different funds

  • $250,000 in an Indexed Universal Life insurance policy

  • $200,000 in a Variable Annuity from a reputable insurance company

  • $100,000 in a stock brokerage account, in a diversified portfolio of dividend-paying stocks

In good market conditions, all of those assets will show good returns. But this combination has a big problem: 100% of these assets are exposed to the stock market. If the market suffers a big drop (and that is always not an if, but a when), all of them will drop in value significantly, and all at the same time. The fact is, there is no such thing as a stock market portfolio that is diversified enough. When the giant sucking sound of the next market crash starts, all stocks will suffer, and the amount of that suffering will differ only in degree.

To make sure that you are not in the position of being fully exposed to a stock market drop of 20% (like 2011) or even 50% (like 2008-9), it is important that you make sure that a significant part of your assets are in completely different markets. There are other classes of assets, that are easy and convenient to own, that do not follow the waves in the stock market. Such things include:

  • Cash (earning interest with no market-based risk)

  • Bonds (earning interest with little risk, depending on selection)

  • Carefully selected insurance products like fixed annuities

  • Precious metals (volatile, but not synchronized with the stock market)

  • Commodities (also volatile, but will retain purchasing power in case of high inflation)

  • Real Estate

  • And others

Every portfolio should include significant percentages allocated to at least three completely separate asset classes. In that way, we should always have some assets that are doing well when others are not doing so well. This will make us better able to weather any economic environment.

For example, look at the chart below comparing the above assets during a particularly difficult period, from early 2008 to early 2011:

A chart of different assets during The Great Recession shows why diversification is a good idea

Note the period from the beginning of the chart to the beginning of 2009. That time included the stock market crash of 2008, when the stock market dropped by more than 50% from top to bottom. This is shown by the red line which represents the stock market. During that period the value of commodities (as represented by oil, the black line) and real estate (light blue line) also plunged.

But, cash (green line), of course held steady. Meanwhile U.S. government bonds (purple line) soared in value, and gold (magenta line) was very strong.

So even in the Great Recession, there were assets that did well. And there will almost always be assets that do well. That is why it is vital that you make sure that your investments include multiple asset classes, and particularly some significant amounts in assets that are uncorrelated with the stock market.

A basic tenet of successful investing is this - avoid concentrating your assets in any one market, and instead harness the power of diversification. That is one of the bedrock principles of our Proactive Investing program, and it should be one of yours.

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