Diversification is intended to reduce the volatility of price movements in individual securities, but many people are not sure what proper diversification looks like.
It depends.
You should definitely have exposure to at least two asset classes: equities and bonds. Within each asset class, diversification is also important. In your equity portfolio, you should have exposure to stocks with various capitalizations (such as Large Cap, Mid Cap, and Small Cap), various geographical areas (such as the Europe), Developing Markets, and Emerging Markets.
In your Fixed Income portfolio, you should have exposure to short term bonds and long term bonds, government bonds and corporate bonds, AAA rated bonds and junk bonds, and so on.
The idea is to spread your exposure and upside potential across many assets, where their movements are correlated to some extent but different assets will hedge against losses in the others. If your portfolios are of a significant size, you might look to additional asset classes such as Hedge Funds, Real Estate, Commodities, and finally, Venture Capital.
Even for everyday investors today, exposure to these formerly exclusive asset classes is now accessible through low-cost ETFs, Mutual Funds, even co-op private equity groups that can be found online with minimal initial investment levels.
It is not easy to determine the right mix of assets, because this requires predicting the future. The most important thing we want to warn you about is that most of the time, an asset class which has performed very well in the recent past is not very likely to continue to perform as well in the following years.
As we like to remind people in this industry with the disclaimers in many prospectus packets, “Past performance is not a guarantee of future results.” For example, if during the last year, Growth Stocks outperformed Value Stocks, it is very likely that the situation will be reversed the following year. If Small Cap stocks performed better than Larger Cap stocks, it is very likely that next year, the situation will be the opposite.
Beware of December articles with titles like “The Best Mutual Funds of 20—.” We can almost guarantee that you will not find a majority of these funds on next year’s list.
For example, growth stocks were the best performers for four years (1995-1998) but were the second worst choice for the following four years.
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