Portfolio management: Diversification for dummies

Is it insulting to use the word dummy in reference to anything? It used to be, but not anymore -- not since the immensely popular "Dummies" series of guides started being put out by Wiley Publishing. I have six of them myself, and there actually is a Diversification for Dummies.

When it comes to portfolio management, diversification is a key component. We all know about eggs and baskets. And that's why people accept it and allocate their portfolio accordingly. The process is simple; you typically put money in stocks, typically a little less in bonds and typically keep some in cash. Although this will not be appropriate for everyone, a common allocation for a diversified portfolio is 50 percent in stocks, 40 percent in bonds and cash and 10 percent in riskier or speculative assets. Presto, you're diversified.

What may be a little less understood is the thought process behind diversification. After all, why should you diversify just because everybody else is? Maybe you want your entire portfolio in bonds, or cash, or gold for that matter. One of the strongest arguments behind diversification is that it actually works to protect the value of your portfolio by allocating portions of it to areas that you wouldn't otherwise feel comfortable with. The irony is, avoiding entire asset classes in favor of others to protect your wealth may actually leave you more exposed. Here is a parable about how diversification actually works.

Let's say you have money you would like to invest in a local business. You notice that the local sunscreen plant (Sunboldt) has been thriving due to the summer sun, and so you decide to invest with them. As a result of their success, you see your money begin to grow and feel comfortable that you made the right choice. However, a few months later, it starts to rain (please). You think nothing of this at first, until you notice that your gains from Sunboldt have recently begun to decline rapidly. In fact, at this rate of decline, your account is about to drop below your initial investment. What went wrong?

The world of investing can act a lot like the weather. No matter how clear the forecast, events outside of your control cause unintended outcomes, otherwise known as risk. Diversification works to offset this risk by allowing your money to be in multiple places at the same time. So if you would have invested in the local sunscreen plant and the local umbrella factory, your portfolio could be making money whether it rains, pours or is beautiful. The idea is to offset losses in one market by gains in another market, all the while keeping a constant and reliable rate of growth.

One of the keys to diversification is a statistical measure called correlation. In investing, correlation measures the degree two asset classes move together. A reading of 1.0 means two assets move in tandem and -1.0 means they are polar opposites. Stocks and U.S. Treasury Bonds have a very low correlation, making them ideal portfolio partners. This simple risk management principal is the rationale behind the diversification in modern portfolios. In the example above, investing in sunscreen and umbrellas is similar to investing in stocks and bonds. Diversification is also used within these two asset classes to broaden your investments even further.

It's important for you to know how well your current portfolio is diversified. Reviewing your investments at least quarterly will help you ensure that your current diversification strategy meets your long-term investment needs. After all, you don't want to be the one caught in a rainstorm with a handful of sunscreen.

Until the next time, we'll watch your money.

These are the views of Nick Bertell and not necessarily those of Summit Brokerage Services, Inc. and any of its affiliates and should not be construed as investment advice. Investing involves risk including possible loss of principal which you should be prepared to bear. Diversification does not guarantee profit, nor does it protect against loss in a down market. Redwood Coast Financial Partners, an independent firm with securities offered through Summit Brokerage Services, Inc., member FINRA/SIPC. Advisory Services offered through Summit Financial Group, Inc., a Registered Investment Advisor.