Investing Basics for Beginners Installment #3: Never Put All Your Eggs in One Basket

[Read Installment #2 here. Read Installment #4 here.]

“Diversification is not only the first important thing investors should think about, but the second and the third, and probably the fourth and fifth, too.”

-John C. Bogle, founder of the Vanguard Group

Imagine you are in a casino and are about to play roulette. You can choose to put all your chips on a single number. If you win, you will win big, and if you lose, you lose everything.

Another option is to spread your chips onto several spots, giving you a higher chance of winning something but at the same time ensuring you cannot win as big as you could have if you had put all your chips on one spot.

Which option are you more likely to choose? If you pick the second option, you are choosing to diversify your risk.¹ This is the last time in this series, by the way, that I will make any comparison between gambling and investing. Investing is not akin to gambling (though its cousins, trading and speculating, are more akin to gambling).

In Installment #2, I talk about the various risks associated with investing. There is no such thing as a risk-free investment. There are, however, many ways to lower your risk: getting smart about investing is one way; avoiding strategies and schemes that are really gambling is another.

The word that describes the totality of all your investments is “portfolio.”  Making sure your portfolio is properly diversified is one of the most important things you can do to minimize your investment risk. To use a metaphor, don’t put all your eggs in one basket.

Diversification Within an Asset Class

To diversify properly, you must understand that there are two levels of diversification: (1) diversification within an asset class; and (2) diversification among asset classes (commonly referred to as “asset allocation”).

A silly analogy: I collect comic books. Various publishers are to asset classes as various titles published by a particular publisher are to the assets within each asset class. So, if I own titles such as Fantastic Four, Daredevil, Hulk, and Iron Man, I appear to be well diversified in comic books published by Marvel.

But what about DC Comics (publisher of Superman and Batman)? What about Archie Comics? I would not be diversified among publishers at all.

Publicly traded common stock is one asset class. Publicly traded debt instruments (a/k/a, bonds) are another. Cash is a third. Private equity is a fourth. Precious metals is a fifth. Real estate is a sixth. Private company stock is a seventh. Venture capital is an eighth. The list goes on and on.² The list, by the way, is not straightforward because there are lots of overlaps. For example, if you decide to invest in real estate, you then need to decide what type of real estate to invest in: commercial or residential? If commercial, then retail, industrial, or office? If residential, then single or multifamily? Or perhaps you want to invest in agricultural real estate, in which case you then need to decide what type of agricultural real estate. On top of all this, you need to decide if you will invest directly or will invest through a fund (in which case, the question of what asset class you are investing in is begged: is it real estate or is it private equity?). All of this is for another installment. Some investment advisors and academics, however, take the position that all asset classes are subsets of the “big four”: (1) cash and cash equivalents; (2) equity investments in companies (i.e., note and bonds); (3) debt investments (i.e., loans to companies or governments); (4) real assets (i.e., direct ownership of land, commodities, antiques, or anything else having inherent value; and alternative assets (e.g. investments in venture capital, private equity; or hedge funds).

If you own stock in IBM, Apple, Walmart, Deere, Visa, and Walgreens, then those investments are in the first asset class mentioned above (i.e., publicly traded common stocks).

Assuming that owning these six stocks would constitute a well-diversified portfolio of publicly traded stocks (I am not suggesting that it would; it is just an assumption for this paragraph; whether it would or not is a question for a different installment³ Generally speaking, the way to diversify your publicly traded stock portfolio is to own multiple stocks in contrasting industry sectors, (e.g., consumer goods, health care, and technology). This is easily understood if we look at it from the opposite direction: do you think owning stock in American Airlines, United Airlines, Hertz Rental Cars, and Marriott would represent a well-diversified stock portfolio? Of course not. ), then that is a good thing. But, it is not good enough. Why? Because one’s portfolio of publicly traded stocks is only one part of one’s overall investment portfolio. That is, it is just one asset class.

As I say above, you should typically be diversified within each asset class, and you should engage in asset allocation among asset classes.

Asset Allocation Among Asset Classes

One reason to allocate your investment dollars among different asset classes is that the investments within any given asset class tend to fluctuate in value, to at least some degree, in tandem. I’ll say it a different way: if you own any specific publicly traded stock and the overall stock market goes down, the stock you own is also somewhat more likely to go down because the overall market did not go down. The opposite is also true.⁴ This concept, in the context of publicly traded stocks (and other investment securities) is commonly expressed by referencing what that stock’s “beta” is. Beta is a measurement of a stock’s volatility of returns relative to the entire market. Beta is an example of a larger concept: “correlation.” Correlation refers to how strong or weak a tendency exists for the price of any two asset classes or any two specific investments in the same asset class to move in the same direction. For example, if an asset class has a negative correlation with stocks, it typically will drop in value when stocks rise in value, and conversely, it will typically rise in value when stocks drop. Read Alternative Asset Investments May Help When Stocks Decline for more information.

The concept of “volatility” is important to understand here. The term refers to the fluctuation of the price of any given investment in any given timeframe. Volatility is always a relative term because knowing the volatility of one investment does not mean much without knowing the volatility of other possible investments.

Even when investments grow in value over time, they seldom grow without experiencing a periodic decline. Publicly traded stocks, in particular, commonly go up and down more than certain other investments. That is, they are, as an asset class, more volatile than certain other asset classes. Yet, they also tend to have much higher rates of returns over long periods of time than other asset classes. Taking care to allocate your investment dollars among asset classes helps guard against the volatility of any single asset class.

The longer your investment horizon (i.e., the more time you hold an investment), the less important volatility is. Stated another way, an investment losing value is generally easier when you are younger because you have more time to hold onto that investment to recover in value and then ultimately increase in value. When you retire, on the other hand, you may need to sell an investment at any given time, including when the market values that investment temporarily lower than it may in the future.

It is for this reason that most investors tend to (and, in any event, should!) reallocate from more volatile asset classes to less volatile ones as they age. Speaking simply, it is why most retirees have a much higher percentage of their investments in fixed-income securities than in equity securities (whereas the reverse was true for younger investors).

It’s worth reiterating one concept before we move on: the concept of diversification is commonly misunderstood to mean that as long as you invest in a broad array of stocks, you will be well diversified. Diversification within an asset class, of course, is important, but diversification among asset classes is even more important.⁵ Please read More Venting About the ‘Democratizing’ of Investing to reinforce what I am saying here and to warn you against moving too fast to look for new asset classes to invest in.

The Need to Continuously Consider Reallocating & Rebalancing

Assume you create a “perfectly balanced” investment portfolio: your hypothetical portfolio is allocated among asset classes, and within each asset class, your specific holdings are also well diversified. Let’s assume you create this portfolio tomorrow. Will it remain perfectly balanced the next day? A week later? What about a month, a year, or a decade later?

The answer is no. Factors that may trigger an asset class to perform poorly can enhance the returns for another asset class. And likewise, factors that may cause one particular holding in an asset class to perform poorly may cause another to perform well. The result is that your original allocation and diversifications will not stay the same on their own. For example, you might start with 30% of your portfolio invested in stocks but see that rise to 70% due to market gains. To reestablish your original asset allocation mix, you’ll either need to sell some of your stocks or invest new earnings in other asset categories.

These actions are what is commonly referred to as “rebalancing.” That is, rebalancing is the steps that an investor takes to bring her total investment portfolio back to its original asset allocation mix and/or to bring the investments in each class back to their original level of diversification.  Again, it is necessary because, over time, some investments will grow faster than others, and this will push your holdings out of alignment with your investment goals.

If, at this point, your reaction is to wonder why you would shift money away from an asset class or a particular asset when it is doing well in favor of an asset category or asset that is doing poorly, then you are asking the right question.  The answer is that by cutting back on current “winners” and adding more current “losers,” rebalancing forces you to buy low and sell high. On the other hand, you should not rebalance blindly. This is just a general rule, and there may be excellent reasons not to rebalance.

If you decide to rebalance, there are three ways you can do so:

• You can sell investments (I am using the term “investments” here to refer to both asset categories and specific assets within categories) where your holdings are overweighted and use the proceeds to buy investments that are underweighted.
• As you invest more money, you can focus on increasing your holdings of underweighted investments until your portfolio is back in balance.
• If you are continuing to add to your investments, you can alter your contributions so that more goes to underweighted investments until your investments are back in balance.

Before you rebalance your portfolio, you should consider whether the method of rebalancing you decide to use would entail transaction fees or tax consequences. This is a good example, by the way, of how not using a financial or tax adviser can be penny-wise and pound-foolish.

Some financial experts advise rebalancing at regular intervals, such as every six or 12 months. Others recommend rebalancing when your holdings of an asset class increase or decrease more than a certain pre-set percentage. In either case, rebalancing tends to work best when done on a relatively infrequent basis.

What About Mutual Funds?

Some investors own mutual funds as a way to diversify. Mutual funds make it easier for investors to own a small portion of many investments. A total stock market index mutual fund, for example, owns stock in thousands of companies, providing a lot of diversification in a single investment.

A mutual fund does not necessarily guarantee diversification, however, especially when the fund focuses on only one asset class or one subclass of one asset class (for example, a mutual fund that invests in the publicly traded stocks of one particular industry).

If you decide to invest in narrowly focused mutual funds, you will then potentially need to invest in numerous mutual funds in order to achieve your desired level of diversification. Also, ironically, as you increase the number of mutual funds within your portfolio, there is a great chance that more than one of them will own some of the same underlying securities as another.

When most people think of mutual funds, they think of mutual funds that invest in publicly traded equity securities (i.e., publicly traded stocks). However, as I imply above, mutual funds can invest in many different types of asset classes.

I am not suggesting you stay away from mutual funds. Indeed, much of my investment portfolio is invested in them. And, for smaller investors, I think mutual funds are the way to go.

What About That 40/60 Stock/Bond Thing?

Historically, the prices of publicly traded stocks and bonds have generally moved in opposite directions, so a loss in one of these asset classes could be buffered to some degree by a gain in the other. Therefore, an allocation consisting of those two asset classes, with some cash or cash equivalents added into the mix, typically provided the asset allocation diversity needed to adequately manage risk among asset classes. For this reason, it remains common for investors to have a “60/40” allocation, meaning that 60% of their investment portfolios should be invested in stocks and 40% in bonds until the investor reaches a certain age, at which time the ratios should flip.

However, as investors saw during the global sell-off in 2007-2009, traditional asset classes like stocks and bonds can occasionally move downward simultaneously. And certain alternative assets have been proven to have either little-to-no correlation or even negative correlation with the price behavior of stocks or bonds.⁶ Read 3 Ways Investing in Hedge Funds Can Boost Portfolio Performance Based on Financial Goals for more about this.

For these reasons, while the old 40/60 allocation approach isn’t a bad one (provided that it includes taking a certain amount of cash off the top to be held as cash or cash equivalents), there are better approaches.

Don’t Confuse the Riskiness of an Investment with its Liquidity

A common misconception about illiquid assets (e.g., private equity, venture capital, hedge funds) is that they are riskier than more mainstream investments like stocks, bonds, and mutual funds. This is false. It is true that most alternative assets are less liquid than mainstream investments, but this does not mean they are riskier. Liquidity and risk are separate concepts.

The more liquid an asset is, generally speaking, the less of a return you can expect. This is a simple concept: money under your mattress is purely liquid, but it earns no interest at all (and, in fact, because of inflation, it loses value with each passing day). Money in a savings account is considered liquid as well, though the interest it earns is minuscule; agree to a six-month CD, and the bank will typically pay you more interest; a one-year CD will typically get you even more.

But are any of these various investments riskier than others? No, of course not. In fact, it can be argued that keeping cash under your mattress, which is the most liquid of the above investments, is the riskiest. After all, you know your cash will lose value because of inflation. And, someone could steal your bed, whereas the FDIC insures your bank deposits.

Nonetheless, it is also easily understood that an investment in the stock market is both less liquid and riskier than keeping your money in the bank.

Now, compare an investment in a publicly traded stock with an investment in a private company, whether it is a direct investment or an investment through a VC fund or a PE fund.

The public company investment is generally understood to be a more liquid asset (though, as online platforms and portals become more pervasive, this may change), because the investor can generally sell public company stock online with the push of a button or a call to her broker. But is the public company investment less risky than the private company investment?

This is a complicated question, the answer to which is “maybe.” The riskiness of an investment in a private company is not necessarily more or less than one in a public company solely by virtue of the fact that it is private; the assessment of a company’s riskiness should be made on a company-by-company basis. All that said, however, the level of government regulation of public companies (including required disclosures and penalties for failing to make them) coupled with the “intelligence of the market” cannot be ignored. So, while the answer is maybe for some people, the answer for the vast majority of investors is that investing in public companies is far safer than investing in private ones. Read Accredited Investor Installment #13: Closing Thoughts for more about this.

***

Jonathan Friedland is not an investment advisor. He holds no relevant licenses, nor does he have formal education in the area of investing. He is, however, an avid and reasonably successful investor in both private and public companies who has few other hobbies, a day job that has forced him to learn some of the same skillsets that some financial advisors have, and who is passionate about financial literacy. This article, like all articles published by Financial Poise, is subject to these legal disclaimers. This series draws in part on information that is publicly available at investor.gov and other websites owned by the U.S. federal government.

• Basic Investment Principles 101 – From Asset Allocations to Zero Coupon Bonds
• Personal Finance & Investing Fundamentals 2.0]

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Article Footnotes:

• 1
  This is the last time in this series, by the way, that I will make any comparison between gambling and investing. Investing is not akin to gambling (though its cousins, trading and speculating, are more akin to gambling).
• 2
  The list, by the way, is not straightforward because there are lots of overlaps. For example, if you decide to invest in real estate, you then need to decide what type of real estate to invest in: commercial or residential? If commercial, then retail, industrial, or office? If residential, then single or multifamily? Or perhaps you want to invest in agricultural real estate, in which case you then need to decide what type of agricultural real estate. On top of all this, you need to decide if you will invest directly or will invest through a fund (in which case, the question of what asset class you are investing in is begged: is it real estate or is it private equity?). All of this is for another installment. Some investment advisors and academics, however, take the position that all asset classes are subsets of the “big four”: (1) cash and cash equivalents; (2) equity investments in companies (i.e., note and bonds); (3) debt investments (i.e., loans to companies or governments); (4) real assets (i.e., direct ownership of land, commodities, antiques, or anything else having inherent value; and alternative assets (e.g. investments in venture capital, private equity; or hedge funds).
• 3
  Generally speaking, the way to diversify your publicly traded stock portfolio is to own multiple stocks in contrasting industry sectors, (e.g., consumer goods, health care, and technology). This is easily understood if we look at it from the opposite direction: do you think owning stock in American Airlines, United Airlines, Hertz Rental Cars, and Marriott would represent a well-diversified stock portfolio? Of course not.
• 4
  This concept, in the context of publicly traded stocks (and other investment securities) is commonly expressed by referencing what that stock’s “beta” is. Beta is a measurement of a stock’s volatility of returns relative to the entire market. Beta is an example of a larger concept: “correlation.” Correlation refers to how strong or weak a tendency exists for the price of any two asset classes or any two specific investments in the same asset class to move in the same direction. For example, if an asset class has a negative correlation with stocks, it typically will drop in value when stocks rise in value, and conversely, it will typically rise in value when stocks drop. Read Alternative Asset Investments May Help When Stocks Decline for more information.
• 5
  Please read More Venting About the ‘Democratizing’ of Investing to reinforce what I am saying here and to warn you against moving too fast to look for new asset classes to invest in.
• 6
  Read 3 Ways Investing in Hedge Funds Can Boost Portfolio Performance Based on Financial Goals for more about this.