Being diversified isn't as easy as it used to be, but it's more important than ever.
It's important because the financial markets are moving fast. Place all of your bets in tech stocks or real estate or gold, and you can give back in days what it might have taken you months to earn.
If you mix it up by adding, say, bonds to stocks, or foreign stocks to U.S. holdings, or real estate and commodities to the traditional stock and bond portfolio, you smooth out the bumps.
A diversified portfolio, put together in the right proportions, can reduce risk without giving up return. That's the Nobel Prize-winning idea behind modern portfolio theory.
To make it work, you have to monitor your mix and put it back into balance at least once a year. Once a quarter might even be better.
Do this right, and you can even create a portfolio that has higher returns over the long term than any individual asset within it, says Jerry Miccolis of Brinton Eaton, a Morristown, New Jersey, money management firm. He calls this bump-up in returns a seemingly magical outcome that flies in the face of intuition.
Over the last 20 years, a portfolio invested half in the Standard & Poor's 500 stock index and half in a commodities index would have returned 13 percent a year, according to Miccolis' computer simulation. But the stock portfolio alone would have returned 12 percent and the commodities, 11 percent, he said.
The approach works because if you are regularly rebalancing your portfolio, you will sell the overvalued assets and buy undervalued ones, catching more of the profits when each particular asset has its day.
Easy, right? Foolproof even? Alas, not at all. As modern portfolio theory gets more and more respect, it gets harder and harder to implement, for a number of reasons.
In the first place, asset classes are getting sliced and diced into ever smaller definitions. Individual investors can get confused about how diversified they want to be. Is it sufficient to hold some foreign stocks? Or should it be a certain kind of foreign stocks? Is gold a sufficient anti-inflation diversifier, or should you also hold silver, paper companies, oil stocks and inflation-protected bonds?
A second reason for trouble in this area is that investors are fallible. They can overdo their investments in a niche diversifier and end up with an unbalanced portfolio, warns Alan Skrainka, chief market strategist at Edward Jones. Or they can start diversifying and then stop, forgetting to sell the overweight and buy the weakling.
But the third reason is perhaps the hardest to overcome. Those outlying assets just don't add the counterweight that they once did.
Foreign stocks used to be a nice balance to domestic stocks, for example. But that was before everyone started buying foreign stocks and before the economy became as global as it is. Now American and European stocks track much more closely than they ever did.
Adding bonds to a stock portfolio can soften periods of free-falling equities markets, but in recent years, neither has been a big earner.
And now that once almost-perfect inverse correlation between commodities and stocks is moving toward zero, Miccolis says. Since commodities have become so popular, they are starting to act more like financial industry stocks, he says.
So how do you diversify in today's market? Here are a few tips.
-- Start simple, Skrainka says. Build your portfolio around a large, diversified stock fund. If you add some bonds and/or certificates of deposit, you're already somewhat diversified.
-- Choose those niche diversifiers carefully. Foreign stocks can be a great addition to your portfolio, but emerging market funds are likely to balance domestic shares better than large-cap foreign equities from developed countries. Similarly, you might be better off with some shares of a commodity fund, instead of simply trying to choose gold or silver, or oil.
-- Keep niches in their place. Miccolis' firm typically confines real estate to less than 14 percent of a portfolio and commodities to less than 13 percent. Skrainka is telling investors to keep small categories, like natural resources funds, high-yield (aka junk) bond funds or emerging market investments to 5 percent or less.
-- Go the distance. In recent years, real estate, commodities and emerging market investments have all soared. That means that if you're a good diversifier, you're probably selling them now, not buying them.
If you own none of those categories, you might be getting in late. But if you tuck them into their spot and forget about them for months and years, the time will come when you'll be glad you diversified.