Diversified portfolios are the 8th wonder of the modern world. OK, maybe not that spectacular, but extremely important to millions of investors. In a world where individuals are increasingly responsible for their own financial futures, risk (defined as variability of returns) must be mitigated, while allowing (and encouraging) growth in the overall portfolio. A tall order, to be sure. Alone, no individual Asset Class provides both safety and opportunity.
While researchers have identified three key elements of success in portfolio construction and management, multiple studies have concluded (1) Market Timing is insignificant as a driver of long-term success, (2) Securities Selection contributes very little to overall results, and (3) Diversification amongst Asset Classes is the main element of success. In practice, properly mixing assets from various Asset Classes drives over 90% of long-term portfolio returns.
It stands to reason that more attention should be paid to Diversification than to those other two factors combined. Why, then, do so many advisors and investors concentrate on the Selection and Timing of buying and selling individual stocks? Or, if I might, trading?
Primary Asset Classes include Domestic Stocks, Domestic Bonds, Foreign Stocks, Foreign Bonds, Real Estate, Cash (and equivalents), and Alternatives, such as Commodities. Diversification involves the selection of portfolio assets from at least two, and preferably more, of these categories.
Even the smallest portfolios can benefit from Diversification. For young and/or novice investors, an all-stock portfolio may be exciting, but their portfolios will benefit over time from Diversification into other Asset Classes. Many people choose Target-Date Funds, which are often called Retirement Date Funds. These funds are diversified, using Bonds and, frequently, International Stocks. Simple to buy and sell, especially in these days of commission-free trading, these funds provide excellent Diversification to even the smallest investors.
Certified Financial Plannersâ (CFPsâ), operating as Registered Investment Advisors (RIAs), apply Asset Allocation techniques to develop and manage individual portfolios, based on individual risk tolerance and the financial goals of investors. For assistance in finding Advisors working in these arenas, we suggest the Certified Financial Planner Boardâ website (letsmakeaplan.org), and the National Association of Personal Financial Advisorsâ website (napfa.org). When shopping for a Financial Advisor, look for the “fee-only” designation to be sure the Advisor is a fiduciary at all times. Do not be fooled by claims of “fee-based” advisors, who are not required to act as fiduciaries at all times.
Next week we will address the age-old dilemma regarding how many stocks are required to sufficiently diversify a portfolio.
Van Wie Financial is fee-only. For a reason.