Re-thinking Diversification

How to manage the growth expectations of your “nest egg”

You have likely heard the term diversification at some point in your life. Frankly, it’s a term that is overused, but that might be because it’s so important to seek out as an investor. In straightforward terms, diversification means not putting too many eggs in one basket.

In the investment world, diversification implies owning different types of assets (stocks, bonds, etc.) that don’t perform exactly the same all of the time. That may sound a bit counterintuitive, but if you agree with the premise that no one can predict the direction of the markets correctly most of the time, then this methodology should be the best strategy for the long-term investor. I don’t know many people in our industry (or otherwise) who predicted the US markets would be up over 15 percent so far this year.

The more technical term for putting money into different types of investments is asset allocation. Sometimes, our industry can use some confusing terms, but the idea of asset allocation is not difficult to grasp. In order to be properly diversified, your asset allocation mix needs to be a blend of non-correlated things – which implies two types of assets don’t move in the same direction at the same time.

If two assets act exactly the same as each other, then they are perfectly correlated to perform similarly. When one type of investment goes up, the other goes up the exact same amount at the exact same time. And when one type of investment goes down…well, hopefully you get the idea: two perfectly negatively correlated investments would move in the exact opposite directions.

As an example, an S&P 500 index fund (essentially, a representation of the US stock market) and Google stock acted very similarly over the month of October 2017 (or had a high correlation). So, if you had all of your money split equally between an S&P 500 index fund and Google stock, you would be considered poorly diversified. All of your money would move in the same direction (either up or down) most of the time. This may feel good when your account is going up, but you might be setting yourself up for failure in the event the market declines.

A better option to diversify your S&P 500 index fund may be to own something like a bond market index fund. So, if the US stock market were to go down, you would expect your bond holding to move up (or at least remain stable) most of the time. This is where some of the disappointment can occur, especially in the type of market we have been recently experiencing (read – it’s been going up for quite some time).

In the case of the more diversified illustration listed above, we as investors have to fight human nature. We are disappointed that we didn’t have ALL of our money invested in the S&P 500 index fund when it was going up; so human nature entices us to move the half of our money in that boring bond fund into the S&P 500 index fund. This is often a mistake, as it may derail efforts to prudently grow your nest egg.

Remember, your asset allocation should fit your goals and objectives. Your mix should be unique to your specific needs and will not look similar to a co-worker’s. Different phases in your life may dictate different objectives. If you are disappointed the value of your account isn’t increasing as much as you think it should, resist the temptation to make short-term adjustments which may ultimately hurt you in the long run.

When (not if!) the market does go down, you may be glad you kept some of your money in that boring old bond fund.

Nathan Gilbert
About Nathan Gilbert 8 Articles
Nathan Gilbert is an Investment Advisor and Managing Partner with Meridian Financial Partners in Warrenton, Virginia. Meridian is an independent, fee-only investment advisory firm providing financial planning and investment management. Mr. Gilbert was born and raised in the area and currently resides in Haymarket with his wife and three children.

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