Diversification: The Safe Money Machine

 

Select a well diversified portfolio

 

Suppose you want to invest in stocks, real estate, gold, or other assets that offer the potential for strong growth. How do you do it without losing your shirt? Given the financial turmoil and meltdowns of recent years, how can anyone know enough to select the right investments? Why not employ the same strategy top money managers use?  Why not diversify your portfolio, and do it the right way?

 

Diversification:  A Proven Strategy

 

Diversification is a time-tested strategy for successful investing—one that the mainstream media often misinterprets or ignores. Why? Could it have anything to do with the fact the media sells advertising to brokerage companies, who make money when their clients buy and sell investments on a frequent basis? With correct diversification you don’t need to do that. You seldom buy or sell, and you don’t need to watch the markets like a hawk.

 

As a concept, diversification goes far beyond “spreading risk”. In fact, few people realize the hidden power of this strategy.  To most it means buying a number of stocks instead of one.  That way if one tumbles in price, at least there’s hope one or more of the others can make up the difference. While spreading risk this way is a basic part of diversification, it is only the beginning of the real story. Handled correctly, diversification offers a number of remarkable benefits.

 

Diversification:

 

  • Provides a proven system for consistently buying low and selling high.
  • Significantly enhances the safety and stability of your portfolio.
  • Requires no special knowledge or ability to pick stocks.
  • Offers considerable freedom in selecting investments.
  • Works during all investment cycles—from boom to bust.
  • Is a proven method for generating wealth over the long run.

 
A safe and effective diversification strategy requires a well-designed portfolio and the discipline to stay in the game even when it appears the market may tank. Fortunately, managing a well-diversified portfolio is easy and almost automatic.  Best of all, your investments are shielded against disastrous loss even in the worst of times.

 

Maximum Safety For The Ambitious Investor

 

Aggressive investors are those who accept the higher risks involved with owning stocks, gold, or other assets that experience wide fluctuations in price (You may want to review the article, “What Kind of Investing is Best?”). Most safe investors prefer the reliability and safety of guaranteed savings accounts. However, there is another strategy for safety that combines the power of these two different styles of investing.  Defensive Asset Allocation is a specific type of diversification designed to smooth out big dips in the road.

 

A number of mutual funds base their investment strategy on this type of diversification.   The managers of these funds select a high percentage of both stocks and bonds.  A good example is the Vanguard Wellington Fund (VMELX).  Funds like these take advantage of the fact that stocks and bonds behave differently in different economies, so that they smooth each other out overall.

 

Stocks versus bonds.

Stocks and bonds tend to move in different directions, which balances your portfolio.

By no means are you required to own a mutual fund to deploy this simple form of defensive asset allocation. You could buy individual stocks and bonds or exchange-traded funds (ETF’s), instead. When the economy is strong your stocks will rise, but your bonds will fall in value as the government raises interest rates to head off inflation. (Bonds go down when interest rates go up.) The opposite occurs in a recession. In other words, your stocks and bonds will tend to move in opposite directions, leveling out large swings in your portfolio’s value. This smoothing effect is not perfect, because stocks and bonds often move at different times. Yet it is real, and it significantly decreases the risk of catastrophic loss.

 

To have a more stable and less “twitchy” portfolio allows you to sleep better at night.  The good news is you don’t need to sacrifice growth for this added safety. For example, if you select a stock that posts a significant increase in value, it can lift your entire portfolio out of the doldrums.

 

The more diversified your portfolio, the more stable it becomes, but only if you pick asset classes that behave differently in under different economic conditions. For example, if you chose only “growth stocks” and “blue chip stocks”, you wouldn’t stabilize your portfolio, because those investments are too similar. In a major market decline, most stocks are hit hard.

 

Gold and jewelry.

You might even consider gold or jewlery as part of your portfolio.

Although you might not expect it, to make your portfolio more stable it can help to include “nonstandard” and volatile investments such as gold, real estate, foreign currency, or collectibles. Why? Because each one responds differently to the economy and market conditions. Ideally, as one investment falls others will rise, so the overall portfolio will hold steady or grow. It’s equally important to include cash, such as savings accounts, money market funds, bank CD’s, or treasury bills. Cash is very stable, and sometimes needed in a crisis. However, in times of high inflation or government crisis, defensive asset allocation can actually be safer than keeping all your money in a savings account. Certain investments such as gold, jewelry, and silver coins still retain value in the midst of war, famine, hyperinflation, or extreme social unrest.

 

Is it complicated to choose a portfolio that is stable under any condition? No, in fact it may be far easier than you expect.  Your portfolio can be very simple, as long as it is properly balanced to address all economic conditions.

 

 

Harvesting Gains On Market Swings

 

Diversification automatically makes money in the long run, even without picking individual stocks.  This remains true even if the economy gyrates up and down. Let’s look at one very simple example to see why.

 

Starting Portfolio:

 

Create a defensive asset allocation portfolio diversified for safety. For example, you might pick stocks, bonds, gold, and cash, with equal amounts of each. Notice we are not picking particular stocks, although we could if desired. If you aren’t sure what to buy, a mutual or exchange-traded fund can cover all bases. Suppose you have $40,000 to invest. Here is one way you could do it:

 

Split your first portfolio equally.

 

Year #1:  A Mild Recession.

 

At the end of the first year, check your portfolio. Suppose there was a mild recession during the year. Your stocks fell in value. Your bonds rose a bit as interest rates declined, plus they paid their normal interest. Your gold increased in value as the world felt some alarm. After one year, you now have:

 

Year 1 portfolio results.

 
At first, a 4% return may seem modest. However, if you had only owned stocks you would have lost 10%. If you had held no gold you would have broken even. All things considered, 4% is not bad. You made money in a recession year.

 

Now rebalance your portfolio. That is, at the end of each year be sure to buy or sell enough of each asset class to make them all equal again. Why? Because this restores equal earning power to each class. It is impossible to reliably predict what will happen next year, so you are giving each of your investments the same chance to rise. After you rebalance, here is how your portfolio looks at the end of year #1:

 

Rebalance your portfolio each year.

 

Year #2:  A Strong Recovery.

 

At the end of year two, check your portfolio again. Let’s say this year there was a strong rebound in the economy. Your stocks rose sharply. Your bonds fell in value as interest rates rose, but they still earned interest. Your gold stagnated, and fell one percent. So after year #2, here is what you have:

 

Year 2 portfolio results.

 

Again, 5.2% is not huge, but it is respectable. Without picking individual stocks and without trying to guess where the markets were headed you earned solid returns on your money. Now, you rebalance again and wait another year.

 

Year #3:  The Economy Overheats.

 

This year the economy overheated. That means it stayed strong enough that inflation began edging upward.  Once again, your bonds dropped in value as interest rates rose, but they continued earning interest, which offset the decline. Your stocks did well, although investors were becoming jittery. Since inflation seemed more likely, your gold spiked upward as the world feared its money would continue losing value. At the end of year #3, you have:

 

Year 3 portfolio results.

 

This year you had a more solid gain, even though inflation hit the economy. After three years, you have an overall gain of 18.2%, with a lot of stability. As always, you rebalance the portfolio to make all classes equal again.

 

Year #4:  Worldwide Panic and Depression.

 

This year disaster struck. The market plunged a dizzying 50%, then “recovered” for a net loss of 37%. The money supply imploded, leading to deflation and massive unemployment. However, your bonds rose sharply in value, as interest rates plummeted and investors flew to safety. Your gold rose also, because it is considered a safe haven, even though most commodities fell in value. So after this terrible year, you now have:

 

Year 4 portfolio results.

 

Here is where broad diversification shows its power. Although the world is now in a depression and the stock market has plunged 37%, your portfolio lost only 1.3%. You are one of the “lucky few” investors not devastated by the economy.

 

What makes diversification an automatic money machine? Notice that when you rebalance this time, you will need to buy a lot of stock, but stock prices are now very low. Plus you will need to sell some bonds, but bond prices are now high. In other words, every time you rebalance, you automatically buy low and sell high. By buying stocks at this point, you are positioning yourself for the next recovery, without even trying.

 

This is a critical advantage of the defensive asset allocation diversification strategy.  Almost all other systems of investment require you to time your investments based on some educated guess of the best time to buy and sell.  Yet no one really has any idea which way the markets are headed.  Even the best technical analysts will admit that in spite of what their charts are telling them about the direction of the market, anything can happen.  The bottom line:  There’s no point in trying to outguess the market.  What you need is a strategy with a built in method for maximizing gains and minimizing losses.

 

Getting Real

 

How real was our simple example? It is very similar to a real method known as the “Permanent Portfolio”, developed by famed financial adviser and author Harry Browne (Fail-Safe Investing). A recent analysis showed that from 2000 to 2007, this portfolio would have returned +3.2%, +0.9%, +7.0%, +14.0%, +6.6%, +8.1%, +11.0%, and +12.9%. In the financial panic year of 2008 when the stock market plunged 37%, this method returned +1.9%. Its average return for these nine tumultuous years was +7.2%, with no losses.  In the 36 years from 1972 through 2008, it showed an average return of +9.7% with only two losing years, -3.9% in 1981 and –2.5% in 1994.

 

It is worth noting that the “simple” balance of assets in the Permanent Portfolio was carefully designed. Gold does very well in inflation. Cash does very well in deflation. Stocks do very well in bull market prosperity. And bonds do very well in recession. Other people have tried variations of the portfolio, with mixed success. For example, there is a “Permanent Portfolio Fund” (PRPFX) that originally modeled Browne’s strategy, but now uses a more varied  asset allocation that adds silver, Swiss Francs, real estate, and natural resources. Although it still outperforms a good percentage of the market, averaging 10.64% in the past ten years, it did suffer about an 8% loss in 2008, which the original Browne strategy did not.

 

Please remember that future performance is always different than past performance. For example, gold and bonds have now reached historic highs, and both could easily reverse. Still, this approach has a long history of success under many economic conditions, including the high inflation of the 1970’s.

 

Exciting Wins Versus Steady Success

 

Many people hear of stock mutual fund returns of 18% or 25%, and fail to realize numbers like this are rare, and few funds can maintain rates this high over a period of years. To invest with most managed funds is to trust that the management will stay “hot”. In reality, a safe average return of 7.2% is both solid and respectable. Over the long run, it’s hard to find any investment that performs at the same level and offers less risk.

 

To put a return of 7.2% in perspective, a lump sum invested at 7.2% would double in 10 years, or quadruple in 20 years. If you saved $100 a month at 7.2%, you would have over $50,000 in 20 years, which is more than double what you invested.

 

The best money managers utilize broad diversification, even when they attempt to “spice up” their returns by including high paying investments. They know diversification increases safety, and it helps them show solid returns for their clients.

 

Ways To Diversify

 

You'll sleep better.

You’ll sleep better with a well-diversified portfolio.

Many financial advisers don’t know the benefits of a true defensive asset strategy.  If they recommend an asset allocation, it may stress either income assets like bonds, growth assets like stocks or some combination of the two. For example, a growth oriented portfolio might hold 30% large cap stocks, 30% small cap stocks, 20% bonds, 10% foreign stocks, and 10% cash.” Though many would consider this “diversified”, an allocation containing 70% stocks is bound to be unstable in a market panic.  In a major decline, most stocks will fall, which means there aren’t enough bonds in the mix to offset a significant reduction in stock prices.  This mix also includes no gold or other precious metal assets to counteract a surge in inflation. A better strategy is to select distinct asset classes to protect against each of the worst potential disasters, and to apportion them appropriately.

 

Other possible asset classes for diversifying your portfolio include real estate, fine art, collectibles, precious gems, or foreign currencies. There are many types of stocks that could be used, such as growth, value, foreign, emerging markets, dividend-paying, and so on. Some mutual funds and exchange-traded funds are composed of the various stock types and others are based on bonds, commodities, real estate investments, or a combination of the above.  It pays to understand the differences between various funds and the costs associated with owning them. You can find this information in a prospectus (often available on-line, from the fund or from your broker).  The wise asset allocator will study how various asset classes respond to different economic conditions.

 

In a defensive portfolio, an asset class can be broad and diverse such as “stocks”, or narrow but economically important, such as cash or gold. It depends on your goals as you design the portfolio.

 

By design the “Permanent Portfolio” (above) included one broad asset class, stocks, and three narrow, yet economically important asset classes: gold, cash, and long term treasury bonds. The “stocks” class was intended to mirror the performance of the broad stock market, as measured by the S&P 500 index, because the overall market experiences strong gains in times of prosperity. The asset gold was chosen because Browne determined it is the single best inflation hedge there is—much more powerful and reliable than any other asset available. This is likely due to its long history as the most trusted form of money in all eras and all economies. Long term treasury bonds were included because of their guaranteed safety, and because long bonds have the largest swings in price. As Brown put it, “Since there may be times when the bond category will have to carry the entire Permanent Portfolio, you want a bond with the potential for big price movements.”

 

When one of your classes is designed to represent a broad, diverse market such as the stock market, it is essential to diversify the investments you put into that class. For stocks, the best way is to use a broad index fund, such as an S&P500 index fund or a total stock market index fund. If you wanted to use particular stocks, for safe diversification it is often recommended that no more than 5% of a stock portfolio be held in any one stock. You could include a few percent of each stock you desire and fill the rest of the stock asset class with a market index fund.

 

Many people rebalance their portfolios yearly. Others rebalance their portfolios more than once a year, such as any time an asset moves a significant amount in price, say 5%.  Remember:  In order to maximize your returns over the long term, rebalancing on a consistent basis is critical.

 

As we’ve seen, diversification is much more than a way to reduce losses. It is a way to automatically capture market gains in a wide range of assets. It dramatically improves safety, and eliminates any need to know the future or to pick winning stocks.

 

As with this or any other investment idea, it pays to do your research and seek professional advice before risking any of your funds.

 

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