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3 Big Advantages to Having A Balanced-Diversified Portfolio
Submitted by Justin Hayek on September 8th, 2015Many people have heard of a "balanced-diversified" portfolio but few know what it really is, its advantages and even fewer put it into practice.
What is a balanced-diversified portfolio?
The best way to define it is: a portfolio invested in multiple asset classes with a number of securities held within each asset class. The asset classes in question are stocks, bonds, cash, preferred shares and real estate. Within each asset class, a number of securities should be held in order to provide sufficient diversification. Though there is no hard and fast rule on how many securities constitutes sufficient diversification, academic research has shown there should be 20+ securities per asset class. Below is a graphic of what a diversified-balanced portfolio looks like:
Advantages to a balanced-diversified portfolio
Though there are more than just these three advantages, these are the key benefits to this portfolio investing approach:
1. Protect your portfolio from the unexpected. If investing has taught us anything, it is to expect the unexpected. Sometimes the actual outcome was not anticipated or an unexpected event occurred. When this happens, if you are not properly positioned, it can have a catastrophic impact on your portfolio. With a balanced-diversified portfolio, the financial impact of these ruinous situations can be significantly reduced.
How this works is quite simple. Of the asset classes discussed earlier, each asset class has an environment in which they perform best. For example, when the stock market is performing poorly, either be it because of a slowing economy or an event causing havoc in the markets, bonds typically move higher in value. Where this may come into practice is say your portfolio was 100% invested in stocks, and a repeat of the September 11th terrorist attacks occurs.
The chart below captures the time frame of August 31, 2001-September 29, 2001. The blue line represents short term government bonds while the red line represents the US stock market (S&P 500).
At the time, your 100% stocks portfolio would have seriously declined in value because money was flowing out of stocks into the safe haven of bonds, driving the prices of bonds higher. The portfolio concentrated in stocks would have been down 14% at that time, meanwhile the portfolio invested in say 50% stocks and 50% bonds would be down half that at most (-6%)! This is because your exposure to the decline in stocks was cut by half, meanwhile the value of your bonds moved higher. Unexpected events occur all the time, best to be prepared for the worst but hope for the best.
Chart source: Yahoo! Finance
2. Limit downside risk. This point was touched on above but we'll elaborate on it further. With a balanced-diversified investment strategy, you can limit the downside to your portfolio. A mistake most investors and advisors alike make is they focus strictly on stocks. Investors focus on stocks because its all CNBC and BNN talk about all day and it is the most understood of the asset classes. Most advisors focus on stocks for the same reasons plus there is an inherent conflict of interest that exists (more on this some other time). But by focusing your investments in one asset class, such as stocks, your portfolio is prone to significant risk of a decline.
That is because historically, stocks have been the most risky of the asset classes discussed. Take a look at the bar graph below. What this represents are portfolios of various weightings between stocks vs bonds - from a low risk portfolio (0% stocks & 100% bonds) to high risk portfolio (100% stocks & 0% bonds). What should be apparent is that as your portfolio becomes more concentrated in stocks the higher the risk. Just take a look at the worst annual returns as you approach 100% stocks!
Image source: Vanguard
By reducing some of your portfolio's exposure to stocks and implementing bonds, preferred shares and real estate, you can create a portfolio with less downside risk without sacrificing a desirable rate of return.
3. Avoid single security risk. Often times when a hot new company appears to be the 'next big thing', the temptation to invest a significant amount is too great. You buy. Next thing you know, the stock is trading well below your entry point, though the story has not changed and everything on the surface appears to be good. You then average down at a 'bargain price' with the hopes of recouping those paper losses. You know where this is going...fast forward a few months, the stock is now down 50+% and the once darling stock is now in the dumps. You now have little to no chance of recovering your initial investment. The unfortunate thing is that this happens far too often. We don't have to go too far back in history to see examples of this story play out; Bre-X, Nortel, Research In Motion.
The mistake was not making investments in these companies, it was to have too much riding on these high flyers. By investing in a balanced-diversified portfolio, you can avoid this pitfall. That is because a balanced-diversified portfolio's exposure to one down-in-the-dumps company or security is not great enough to have a detrimental impact on your portfolio.
Though what we covered is only scratching the surface on what constitutes a balanced-diversified portfolio, the advantages should be clear and compelling enough to warrant everyone reassessing their own investment strategy.
-Justin