Opinion - Straight Talk

Don't invest without a diversification strategy

Bob Rall, principal at Rall Capital Management
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Key Points
  • Experience and academic evidence show that no one, even the best active managers, can consistently predict what is going to happen in the markets.
  • Rall Capital Management builds portfolios using a globally diversified mix of low-cost funds based on clients' risk tolerances and needs — a strategy known as strategic asset allocation.
  • The main purpose of diversifying your portfolio is to reduce the overall risk.
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Properly investing requires taking the time to create an investment strategy so that you have a plan that allows you to stick with it when things get tough. Investing without an established plan increases your risk. Following an investment strategy is something that everyone should be doing to ensure that they are getting the most out of their investments.

There are two basic approaches that you can use to build an investment strategy: active investing and passive investing.

Active investing

Most advisors and investors follow what I call an "active" management style. This is an approach that is based on some type of information that the advisor, or investor, thinks gives them an edge in selecting their investment holdings. They might employ some type of fundamental analysis that is based on corporate earnings, growth projections, economic conditions, etc. Or they may use a form of technical analysis, making decisions based on the price movements of an investment. Technical analysis usually involves some form of charting.

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Our experience and, indeed, academic evidence show that no one, even the best active managers, can consistently predict what is going to happen in the markets — even with all the fancy tools that are available today. For our clients, and for our own investment portfolios, we follow a different approach.

Passive investing

We follow what is often referred to as a "passive" investment strategy. That simply means that we don't try to forecast which investments are going to do well and which ones are not. So we own them all. We build our portfolios using a globally diversified mix of low-cost funds based on our clients' risk tolerances and needs — a strategy known as strategic asset allocation. That means that we own a mix of stocks and bonds that give us broad exposure to many asset classes (such as U.S. equity and real estate).

Broadly speaking, our portfolios are built with stocks and bonds. Then we go a little deeper.

The stock side of our portfolio is made up of:

  • U.S. stocks: From the largest publicly traded U.S. companies to the smallest, not just the Dow 30 or the , we own them all.
  • International developed: Large and small companies from across the developed world, giving us exposure to Europe, Australia and the Far East.
  • International emerging: Large and small companies from the emerging markets around the world. This category gives us exposure to less-developed countries, such as the Philippines, Brazil, Mexico and South Africa. It is important to note that this asset class is very volatile, so we limit our exposure to it.
  • Real estate: These are companies that get their income from rental properties — office-building companies, hotels, storage facilities and retail developers are examples.

The bond side of our portfolio is also diversified. It consists of:

  • Short-term, high-quality: Government and high-quality corporate bonds maturing in three years or less, not just from the U.S.
  • Intermediate-term, high-quality: Similar to our short-term exposure, but these bonds mature in three to 10 years.
  • Treasury inflation-protected securities (TIPS): Basically U.S. government bonds with an inflation rider.

The purpose of diversifying your portfolio

The main purpose of diversifying your portfolio is to reduce the overall risk. We are trying to diversify away as much of the risk that is inherent in investing that we can. It's the proverbial "Don't put all of your eggs in one basket" strategy. We are spreading our investment dollars across asset classes that are non-correlated. We own stocks because they behave differently than bonds, and international stocks because they behave differently than U.S. companies.

Where the riskiest portfolio possible would be holding one stock or one bond, we spread the risk across thousands of different securities. It's important to note that a well-diversified portfolio will not experience all the gains when the market is rising, but it also won't suffer the extreme losses when things go the other way.

Your specific allocation should be based on several factors. You will want to consider your cash needs, time horizon, risk tolerance, risk capacity and need for risk. Someone with an aggressive portfolio will generally own more stocks than bonds. More conservative portfolios will lean more toward bonds.

Investing requires time and attention

It's important to remember that building an investment portfolio is not a set-it-and-forget-it process. Once you are invested, you need to make sure that the portfolio stays in balance. As asset classes move in and out of favor, you want to make sure that your mix stays true. For example, an investor who had a 60/40 stock-to-bond mix at the beginning of 2017 may have finished the year at 70/30 because of the big rally in stock prices. If not rebalanced, the portfolio would be taking on more risk. A disciplined rebalance strategy will bring the mix back to 60/40 by selling some of the stocks while their price is up and buying some of the bonds while their price is lower. Buying low and selling high is how the investment game is supposed to be played.

We know that we cannot control or predict the markets, so we don't try. Instead, we work on controlling what we can control. We can control the risk in the portfolio by the asset allocation mix. We work to control the costs of investing by using low-cost vehicles and limiting trading. We also try to control the tax consequences by managing gains and losses as much as possible.

(Editor's Note: This column originally appeared on Investopedia.com.)

— By Bob Rall, principal at Rall Capital Management