Practical Diversification Tools

How to build a portfolio that is less volatile than the overall market

By: Jeanie Wyatt

People know their investments should be diversified, but all too often, this gets translated in practice into just owning a bunch of stuff. The goal of diversification is to build a portfolio that is less volatile than the overall market. By doing better than the market during bad times, and while participating in market gains during good times, a diversified investment approach can lead to increased wealth over time while reducing – though not eliminating – risk.

So how do you diversify? By owning assets whose prices don’t move together, but do go up over time.

Own stocks and bonds
The most important decision a long-term investor makes is how much to allocate between risky stocks and safe bonds. In times of high uncertainty, stocks tend to decline as investors pull money out of the equity (stock) market and put it into safer, fixed-income securities like U.S. government and municipal bonds. Bonds are a natural hedge to stocks.

But riskier bonds, like high-yield junk bonds and emerging market bonds, tend to do poorly in times of uncertainty just like stocks. These types of bonds offer little in the way of diversification, particularly in volatile times when you need it the most. Your motto as a wealth grower should be, “I take my risk on the stock side, not the bond side.”

Within stocks, own value and growth
Value stocks (cheap/out-of-favor) and growth stocks (accelerating sales and earnings) tend to move in cycles; when one does well, the other does (relatively) poorly, but both go up over time.

So value and growth stocks are inversely correlated, which makes them a great diversification tool. This inverse correlation holds across small, mid and large company stocks, as well as international stocks. Owning both value stocks and growth stocks a good way to minimize downside risk for the equity portion of any portfolio.

Own stocks in all sectors, but not too many in any one sector
There are 10 broad economic sectors (e.g. health care, energy, utilities, etc.), and the stock price performance of any one sector is notoriously hard to predict. So owning some stocks in every sector is another way to prudently diversify an equity portfolio.

Most stock market bubbles and collapses are really sector bubbles and sector collapses. The key to avoiding these recurrent, yet unpredictable sector blowups, like the recent dramatic decline of the energy sector or of the financial sector in 2008 or the technology sector in the late 1990s, is to limit your exposure to any one sector.

Company stock exposure
Wealth creation requires some concentration of investments. You don’t want to hold too much in any one company (say, more than 3 percent of your portfolio), but you don’t want to hold too little, either.
Many investors follow a 20-to-30 stock rule of thumb as the adequate number of stocks required to achieve market diversification, but those numbers come from research conducted in the 1960s and 1970s. Subsequent research demonstrates that the optimal number of holdings increased over time to no fewer than perhaps 50 stocks, but probably no more than 100.

Size or market capitalization
This is another classification of stocks that displays inverse correlations. Large, mid and small cap stocks often move in distinct cycles, similar to value and growth stocks. Here again the key to leveraging this diversification benefit is to maintain some exposure to large, mid-size and small company stocks at all times.

Diversify internationally
A final level of diversification is achieved by owning stocks across international boundaries. The correlations among U.S. and international stocks have increased over time, which reduces somewhat the benefits of international diversification, but you should still allocate 10 percent to 20 percent of your portfolio to international companies. And instead of stressing about which region of the world is going to do well or poorly, just look for good companies. Think globally, but at the company level, not the country level.

In summary, in order to be properly diversified, an investor should own stocks and safe bonds. Within stocks, investors should own value and growth stocks across all size or capitalizations and in some international companies, as well.

South Texas Money Management Ltd. is an independent registered investment advisor with $2.7 billion in assets under management. It has five locations across the state.The newest office is in Corpus Christi (located at 921 N. Chaparral, Ste. 112), and may be reached at 361-904-0551 or www.stmmltd.com. Jeanie Wyatt, CFA, is the CEO and CIO of the firm.

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