The Importance of Diversification in Building an Investment Portfolio

Are you a self-directed investor? Chances are, if you’re reading this, you do manage at least some portion of your asset portfolio. Congratulations for taking the lead to a brighter future. No one is going to look after your investments as carefully as you will.

As your own ‘Director of Investments’, you’re familiar with the basics of wealth building – the tried and true axioms of prudent investing. You don’t speculate, you don’t gamble and you never listen to your brother-in-law’s tips. Another good move. There are gamblers and there are investors, and over the long term, the investors have proven to be the winners in the get rich sweepstakes.

One of the fundamental fundamentals of conservative investing is diversification, or, in other words, don’t put all of your eggs in one basket. You wouldn’t put all of your nest egg into one company would you? Or, one mutual or managed fund? No, of course not. Even the bluest of blue chip companies have their ups and downs. IBM, aka, Big Blue, has sold at over $USD120 a share. In ’02, it sold at below $USD60. Had you put all of your eggs in that basket you would have lost a basket full of cash.

Diversification is simply a matter of spreading the risk around. You can do that buying shares of individual companies in different industries – a good drug company, a consumer goods behemoth, heavy manufacturing, media and so on.

Many individual investors have turned to mutual or managed funds, which offer varying degrees of diversification. Broad market funds, Vanguard’s Windsor fund or Fidelity’s Magellan fund, are good examples of popular, broad market funds.

Balanced mutual funds offer expanded diversification by holding both stocks and bonds, which usually move in opposite directions during market swings. So, when the stocks are doing well, the bond portion of the portfolio will lag and vice-versa.

There are sector funds which narrow diversification to a single sector of the economy. There are exchange-traded funds (ETFs) that are built like mutuals but are traded like stocks.

There are indexed bond funds, junk bond funds, funds that specialize in a particular geographic region, or even a single country. There are CDs, government bonds, asset allocation funds and more. In fact, there’s a fund or investment vehicle for just about any wealth-building strategy you could devise.

But what do all of these investment vehicles have in common – the stocks, funds, bonds and such? They’re all paper assets. Oh sure, you’ve diversified through funds, developing your own portfolio, but all of your assets are still in paper. So, the question becomes: are you diversified enough!?

The alternative to paper assets is tangible assets – things you can touch, eat, hold in your hand and even live in! That’s right, your home – perhaps your most valuable asset – is a tangible. It’s an investment in which you live. In fact, real estate ownership is often the fast track approach to increasing personal wealth. Donald Trump didn’t work his way to wealth, he bought and sold real estate, one of the best tangibles available to the average investor.

But property ownership comes with its own attendant headaches. Tenant calls at 3:00 AM, upkeep, deadbeats and other hassles prevent the average investor from moving into real estate. Real estate isn’t always liquid and you have to paint the darn thing!

Which brings us to commodity investing – putting some of your portfolio into tangibles that don’t wake you in the middle of the night because the furnace conked out. Now, before you run screaming from the room at the very thought of buying pork belly futures and other ‘exotic’ investment vehicles, that’s not what we’re talking about here. No pork bellies, cotton, wood, no cattle, wheat or sorghum. Nobody even knows what sorghum is!

But everyone knows what gold is. And silver and platinum. These are precious metals that have served as currency, or the foundation for paper money, since our ancestors were chasing mastodons across the plains. In the form of coins or ingots (blocks or bars), you can hold these metals in your hand, bury them in the backyard or keep them in a safe deposit box. Precious metals are the precious darlings among commodity traders.

Gold, and other precious metals, provide ballast for your portfolio. Prices are closely tied to inflation rates, with ups and downs more a factor of stock market uncertainty rather than the usual driver of commodity prices – good old supply and demand. When other markets become edgy, because of world events, for example, many investors move a portion of their portfolios into gold and other precious metals as a hedge against falling stock prices.

Diversifying a small portion of your portfolio into precious metals better equips you to ride out the peaks and valleys of stock market performances. It protects your paper
assets by providing price stability over the long-term. And, it moves some of your wealth out of paper and in to tangibles.