I am sure you have all heard the phrase “do not put all your eggs in one basket!” Diversification is a core concept for building wealth for the future – whether you have a short-term or long-term horizon. If you put all your eggs in one basket you risk many breaking at once, similarly if you invest in only one type of investment – for example stocks – and only have a handful of those stocks or the stocks are concentrated in a particular industry there is a risk that you will not be able to achieve your investment objectives. Multiple stocks my fail at once – particularly if not diversified across industry’s.
To build wealth for the future you should invest in multiple types of investments – stocks, bonds, cash or money market accounts and alternative investments. I define alternative investments broadly to include anything that is not a traditional long investment in stocks or bonds, either directly or indirectly through a mutual fund or ETF. A “long” investment is simply buying a stock or stock fund and holding it with the expectation of dividends and an increase in the price. Alternative investments can include real estate (public or private), private equity, venture capital, commodities and other similar “long” investments in instruments that are not publicly traded stocks and bonds. I believe they should also include alternative strategies such as a covered call strategy (where you buy a stock but sell someone else an option to buy it from you – usually at higher price), investing in convertible bonds (bonds convertible into stock), long-short funds (investing in a fund that buys some stocks and sells other stocks short – not for the faint hearted!), as well as many other potential strategies.
By investing in multiple types of investments you take advantage of the fact they do not tend to move together (they do not all rise or fall at the same time). Within each type of investment, you also want to be diversified. You want multiple baskets with multiple eggs in each basket. Just as the investment types do not move together, individual investments can also move in different directions – not all with succeed or fail at the same time.
So how many baskets should you have? All investors should have at least three – stocks, bonds and cash/cash equivalents. Most investors should have four – stocks, bonds, cash/cash equivalents and alternative investments. This is particularly important for institutional investors (pension funds, trusts and similar investors) as the “traditional” 60% stocks and 40% bonds portfolio is no longer optimal from a return relative to risk perspective. The proportion of your investments in each basket will depend primarily on your risk tolerance, investment time horizon, expected returns of each type of investment (basket) and the expected correlation of the baskets (how much they move together). For individuals, you should also keep a core cash/cash equivalent holding of 12-24 months of planned expenses so that you are not forced to sell other investments at the worst possible time.
How many eggs in each basket? Unless you are planning on researching, monitoring and managing your investment portfolio full time and have the needed knowledge to analyze financial statements and the economy you should have many eggs and acquire them using diversified funds such as mutual funds and ETFs. You should also make sure the funds are diversified to include exposure to different industries, company sizes, geographical diversification (global!) and styles (growth, value, and similar factors).