Diversification Explained

What is Diversification?

A great presentation about the benefits of diversification is presented by Charles Schwab as they develop their “Intelligent Portfolio” for small net worth individuals. While they present a compelling case, the fact is, it results in a portfolio that consists of 19 securities! Try building and maintaining that with your $400 monthly investment.

And, the performance comes no where near a simple investment in VTI.

Diversification by Asset Class

Many financial advisors recommend that your portfolio be diversified by asset class. That is, have your funds distributed among several, non-correlated classes of assets.

Examples of asset classes are

  • domestic stocks
  • international stocks
  • emerging markets stocks
  • bonds,
  • real estate,
  • precious metals,
  • commodities,
  • cash.

Diversification by Sector

Another type of portfolio diversification is diversification by sector of the economy. The idea is that an investor should distribute his money among several sectors of the economy. Here are the sectors, serveral of which should be represented in your diversified portfolio.

  • Consumer Discretionary (12 Industries)
  • Consumer Staples (6 industries)
  • Energy (2 industries)
  • Financials (8 industries)
  • Health Care (6 industries)
  • Industrials(14 industries)
  • Information Technology (8 industries)
  • Materials (5 industries)
  • Telecommunication Services (2 industries)
  • Utilities (5 industries)

Diversification by Market Capitalization and Style

Finally, there is the idea of diversification by Market Cap (total value of a companies outstanding shares); “cap” is shorthand for capitalization. Reading from left to right, top to bottom, the Market Barometer represents the performance of:

  • Large Cap Value stocks, Large Cap Blend stocks, Large Cap Growth stocks,
  • Mid Cap Value stocks, Mid Cap Blend stocks, Mid Cap Growth stocks;
  • Small Cap Value stocks, Small Cap Blend stocks, Small Cap Growth stocks
MorningStar's Stock Categories

MorningStar’s Diversification Grid by Market Capitalization and Style

over one week, one Month, three months,  One year, and in three years.

Principle Behind Diversification

The idea is that not all asset classes, sectors, and categories will be moving in the same direction at the same time. By having your assets distributed among several asset classes, sectors and/or categories, the violent swings of the market will be dampened. You own both the zigs and the zags.

The Callan Periodic Table

One of the strongest arguments for a Diversified Portfolio is a table developed by Callan Associates which presents different asset classes and styles ranked each year by their performance.

Callan Periodic Table 1995-2014

The above table demonstrates conclusively that there is no one asset class or sector that is consistently up or down (just have a look at MCSI Emerging Markets). The distribution of returns is obviously random. The conventional wisdom is that in order to have a strong portfolio, one’s portfolio should be invested in several of the categories.

The Diversified Portfolios of Future Advisors

Future Advisors is an investment advisory firm that advocates a highly diversified portfolio and they will help you (for a fee) construct a diversified portfolio that “they think” is a good one. Below are their rationales for including the various asset classes that they do.

Why this asset mix?

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s