These portfolios are not properly diversified. Heed the words of Dr. Markowitz on the very idea of diversification:

Not only does the E-V hypothesis (MPT) imply diversification, it implies the “right kind” of diversification for the “right reason.” A portfolio with sixty different rail-way securities, for example, would not be as well diversified as the same size portfolio with some railroad, some public utility, mining, various sort of manufacturing, etc.

The reason is that it is generally more likely for firms within the same industry to do poorly at the same time than for firms in dissimilar industries. Similarly in trying to make variance small it is not enough to invest in many securities. It is necessary to avoid investing in securities with high covariances among themselves. We should diversify across industries because firms in different industries, especially industries with different economic characteristics, have lower co-variances than firms within an industry.

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Proper diversification in a portfolio requires 2 components:

1) Diversification Within Asset Classes

Diversification within an asset class reduces a portfolio’s exposure to risks associated with a particular company, sector, or market.

If you want to invest in established large companies based in the U.S., you shouldn’t just buy the stock of a select few. You should try to invest in as many as possible within that market segment. For example, you could just buy the S&P 500 index and own 500 of the largest domestic firms. Doing so will eliminate some idiosyncratic risk, and reduce overall volatility while providing the same level of returns.

This holds true across any asset class, not just large cap stocks. Let’s take a look at Vanguard’s comparison of risk (volatility) between individual stocks and the average mutual fund within various asset and subasset classes.

Idiosyncratic Risk

As you can see, mutual funds have far lower standard deviation than individual securities within each asset class. This is a perfect example of Modern Portfolio Theory in action.

Continuing with our example above, instead of simply buying large domestic stocks, why not look into small company stocks and international stocks? They are still stocks, but each market segment is not perfectly correlated, which provides additional diversification benefits. Just take a look at the reduced volatility achieved by adding 20% foreign developed stocks to a portfolio comprised of the S&P 500 (large domestic stocks).

Volatility and Risk

The same benefit is achieved when diversifying across sectors. Don’t just buy health care stocks, buy consumer staples, and energy, and financials, and everything else that you can. Each additional sector provides additional diversification benefits.

2) Diversification Across Asset Classes

Diversification across asset classes reduces a portfolio’s exposure to the risks common to an entire asset class.

Continuing with our example above, why limit yourself to 100% stocks? You can add real estate, bonds, and cash to the mix.

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Historically, the returns of most major asset categories have not moved up and down at the same time. Stocks, bonds, cash, real estate, and commodities often behave very differently at any given time. One may go up, the other may plummet. By investing in different asset classes that move up and down under different market conditions, an investor can reduce overall portfolio volatility and protect against significant losses.

For example, take a look at a portfolio that can be split between stocks and bonds.

Diversification

Of course, stocks have outperformed bonds with higher volatility. But what’s most fascinating is that a portfolio comprised of 100% bonds is actually less efficient that one with 80% bonds and 20% stocks. They have the same volatility, but the portfolio with stocks will achieve a higher return. This is the direct result of diversification and MPT.

Summary

Don’t get lost in the details. The end result of theory and research is application, and it should be relatively easy to apply this knowledge.

Invest in broad indexes and stop trying to pick a few stocks.

In doing so, you’ll eliminate idiosyncratic risk almost entirely, and therefore be compensated for all of the investment risk present in your portfolio.

With low cost index providers like Vanguard, you can own tens of thousands of companies by simply purchasing a few ETFs. For example, an acceptable portfolio for the average American investor might contain:

40% – Total U.S. Stock Market (VTI)
25% – Total International Stock Market (VXUS)
20% – Total U.S. Bond Market (BND)
10% – Total International Bond Market (BNDX)
5% – U.S. Real Estate (VNQ)

If you want to “outperform the market”, you can further spice things up with small cap index ETFs, value tilted index ETFs, emerging market index ETFs, etc. These investments still track an index, and are widely diversified.

But if you choose to chase excess returns, realize that you are essentially betting against market efficiency and hoping that a particular market strategy which may have outperformed in the past, will continue to outperform in the future. I won’t argue with you here, but do remember that past returns are no guarantee of future returns…

This article has been republished with permission from Cash Cow Couple.