Are You Diversified Enough?

The stock market has been jittery in recent days. If you are investing for the long term that should mean very little to you, but of course no one that has a sizable stake in the market can resist the temptation to check the daily stock quotes and fidget when a nice chuck-o-change disappears in a puff of smoke. Myself included.

It's days like these that remind us all of the importance of portfolio diversification. I remember well the days back in 2001 when I bought into the NASDAQ 100 ETF (NASDAQ: QQQQ) and considered myself well diversified. Well, I have learned the error of my wicked ways: the fact that you own an index or two does not mean that your portfolio is adequately diversified, especially if said index covers only one sector or industry.

Incidentally, my ill timed purchase into the QQQQ was at $67 per share, and came after the NASDAQ dropped from its fictitious 5,000 point level all the way to 2,700. I thought I was getting a bargain for sure...

The benefit of diversification comes from the fact that different assets and asset classes tend to not move in complete lock-step, i.e. when one stock goes up, another may go down, thus off-setting the gain or loss and reducing overall portfolio variability and risk. If you were in the market on Feb 27, 2007 you could not help but notice that virtually ALL stocks went down that day. So much for diversification? Nope. It turns out that it is not enough to be diversified across multiple stocks or even stock indexes. You also need to be diversified across asset classes. While stocks crashed down to earth on Feb 27th, bonds soared.

Stocks and bonds are not the only asset classes out there. For example real-estate and commodities are other asset classes into which one can diversify. These too do not move in tandem with the market. In fact, for much of recent history, investments in real-estate had little correlation with the over-all stock market. To see for yourself, compare the performance of the Vanguard REIT Index (VGSIX) to that of the S&P500 Index.

In addition to diversifying across asset classes, diversification across geographies is also key. Since U.S. equity markets tend to act in unison, investing in foreign markets can reduce risk even further.

Of course, there are some days when everything across the board, whether U.S. or international, whether gold or real-estate all come tumbling down. Those days are known by the technical term "really crappy days". These days are the exceptions that prove the rule: diversification is the corner-stone of every good portfolio.