Diversifying is one of the most basic rules when investing.
It's the "don't put all your eggs in one basket" strategy. The basic thought process behind diversifying your investments is that if you spread your investments around, you'll reduce the risk of losing money, because when one of your holdings moves lower, another is likely moving higher. For example, bonds usually move higher when stocks move lower, and vice versa.
We know we are supposed to diversify, but a lot of investors don't do it very well. Many account owners think their portfolios are diversified when they aren't. Here are some of the most common diversification mistakes investors make.
Owning several mutual funds and thinking the number of funds held makes them diversified. Say you hold an fund, a large-cap growth fund, a large-cap value fund and a dividend-growth fund. You may think these four different funds provide good diversification, but they don't. If you looked at the stocks held in each of those funds, you would find they are all invested in the same asset class: large U.S. companies.
Owning an S&P 500 fund and a bond index fund and thinking you have a good mix of stocks and bonds. This example is better than the first one, but the mix is still not providing good diversification benefits. The S&P 500 fund provides exposure to the 500 largest companies in the U.S., but none of the 2,500 or so other publicly traded U.S. companies. There's also no exposure to international stocks or bonds.
Invest globally. When building a portfolio, it's important to look beyond the borders. "Home country bias" refers to the tendency of investors to focus on the investments within their own country. For example, U.S. companies make up about 50 percent of the total market capitalization in the world, yet the average U.S. investor has about 70 percent of their portfolio in U.S. holdings. A recent study in Sweden showed investors in that country put their money almost exclusively into investments from Sweden, even though their country makes up about 1 percent of the world's capitalization.
Invest across asset classes. When building an investment portfolio, focus on diversifying across the various asset classes. The first step is to determine what percentage should go into the two largest, broad-based asset classes — stocks and bonds. A conservative investor might have 30 percent to 40 percent of their money in stocks; a more aggressive investor might have 60 percent to 80 percent. The balance in each situation would be allocated to the bond side of the portfolio.
Determine your geographical allocation. The next step would be to allocate geographically. Put 50 percent to 60 percent of the stock allocation into U.S. stocks, representing the U.S. capitalization mentioned earlier. Next, allocate between 25 percent and 30 percent of the stock into international developed countries in Europe, Australia, Asia and the Far East. Invest the remaining stock allocation into emerging markets, which gives exposure to companies in China, India and other developing countries. Follow a similar approach with the bond side of the portfolio, with more exposure to the U.S., which makes up about 60 percent of the world bond market.
Finally, diversify within the geographical asset class. Spread your investment dollars across companies of different sizes. Make sure you have exposure to large, medium and small companies in domestic, international and emerging markets.
Diversification reduces risk in a portfolio by allocating investment dollars across asset classes, countries and industries. The goal is to maximize returns by lessening the chance a major market event would have a devastating effect on an entire portfolio. That's why it's so important to get it right.
(Editor's Note: This column originally appeared on Investopedia.com.)
— By Bob Rall, principal at Rall Capital Management