3 reasons why you aren’t diversified

Few investors truly understand what it means to have a diversified portfolio. Most believe that owning 20-50 stocks, or a few mutual funds, means that they are diversified. But they are dead wrong. “Dead” because without being properly diversified, in extreme market situations, a portfolio can permanently lose capital and never recover. Those who owned a “diversified” portfolio of technology stocks in early 2000 when the Nasdaq reach 5000, have never recovered. Neither have those who held a “diversified” portfolio of financial stocks like General Electric (GE) and Bank of America (BAC) going into 2008.

Proper diversification is about managing risk — making sure that when the markets are down, you lose as little as possible, and when they are up, that you recover and capture your fair share of returns. Being well diversified is the “only free lunch” in finance because using methods from proven and scientific knowledge about investing, you can dramatically lower risk without suffering a reduction in returns … and it really is free!

Just like following a prized recipe, the ingredients of diversification are simple to acquire, but rarely followed. Here are three tests to make sure you have a truly diversified portfolio.

Asset Classes. A well-diversified portfolio is not about US stocks — it includes at least six asset classes. You should have at least 5% of your portfolio—but no more than 30% — in all six core asset classes: U.S. and foreign developed countries (Europe, Japan, Asia), emerging-market countries (Brazil, Russia, India China) bonds, real estate and commodities.

Like each instrument in a jazz band, each one of these asset classes plays a valuable role in different economic circumstances. US Treasury bonds protect against economic meltdowns like the one experienced in 2008, but they lose value from inflation and slow down overall portfolio growth. Real estate hedges against inflation, provides a steady income stream, and can appreciate like stocks, but it is not immune to economic cycles. How much to invest in each asset class differs depending upon your stage in life — but everyone should have all six. A retiree seeking income, may have 80% of his portfolio in bonds, but also own global equities as an inflation hedge.

The term asset class is widely misunderstood. Industries and sectors are not asset classes. Economic sectors (technology, utilities, financials, basic materials, or consumer durables) are not asset classes. Nor are the industries within a sector. The software, communication equipment and computer hardware industries are within the technology sector. For U.S. investors, foreign countries are not asset classes.

Number of Securities. Within each asset class, diversified means you must own hundreds of stocks or bonds to reap the returns of that asset class. You do not want any individual company or country (besides the U.S.) to have an impact on your portfolio. A typical MarketRiders portfolio includes over 6000 stocks and 3000 bonds.

For example, if you want exposure to emerging markets, owning 20 stocks from a few different countries won’t do it. Owning a China fund like iShares FTSE China 25 Index Fund (FXI) is not enough diversification. But Vanguard’s Emerging Markets ETF (VWO) allows you to own over 900 companies in 28 countries, giving you fantastic diversified exposure. You are riding entire economies of many countries without worrying about getting hurt by an individual business within them. Sure, you’ll miss the joyride you get owning an Apple (AAPL), but you will also miss the dread when a company like Citibank (C) loses 80% of it’s value.

Funds, Not Stocks. It is nearly impossible to be well diversified owning individual stocks. Trading costs and the software required to own the necessary number of stocks required are beyond the reach of individual investors. So you must own funds.

Actively managed mutual funds have wide discretion in how they can invest. Most funds can invest 10%-25% outside of their “advertised” charter. You could invest in a Foreign Developed country fund and find that a large percentage of your investment is in the U.S. You can’t manage your allocation when your managers don’t have to stick to their charter. It would be like having your guitar player suddenly decide to start playing a flute.

Owning ETFs gives you razor-sharp precision in your allocations. If you own, for example, the iShares Small Cap US Stock ETF (IJR) you won’t find foreign stocks in that holding. And ETFs are dirt cheap — our portfolios are built solely with ETFs and have an average expense ratio of .2% which is an average of 80% less than a mutual fund portfolio. Cheap and precise … how do you beat that?

Look under the hood of your portfolio. Do you own over 10,000 securities? Are your funds overlapping, giving you double or triple ownership in the same stocks? Is your money spread all over the world, in all sectors, all industries, and in all kinds of debt? If not, you are missing that free lunch, and during the next recession, you will feel it way more than those of us who have taken true diversification to heart.