The Error-Proof Portfolio: Take Diversification to the Next Level

Diversification has been called "the only free lunch in finance." A lot of hard data illustrate the benefits of building a portfolio that's diversified across asset classes and investment styles, and dividing your eggs across multiple baskets has commonsense appeal, too. If you don't know whether stocks will continue their current run or take a breather, if small caps will outperform large, or if interest rates will go up or down--and no one truly knows those things--diversifying is a sensible way to hedge your bets. It also helps ensure that your portfolio will perform reasonably well in a variety of market environments.

Yet as widely accepted as diversification is at the portfolio construction level, investors could benefit by construing it even more broadly. In general, diversifying makes sense any time you're uncertain about an outcome (and that's pretty much all the time, as I argued in this article).

Here are some examples of diversification interpreted more broadly.

Time Diversification
Perhaps you've determined that an asset class makes sense for your portfolio from a long-term perspective--commodities, maybe, or bonds--but you are worried about the timing of your purchase. If you buy at the wrong time, when the asset is richly valued and could be due for a fall, you could lose part of your money right out of the box.

In such instances, dollar-cost averaging--or diversifying your purchases by buying smaller pieces of the investment at multiple predetermined intervals rather than adding a position all in one go--can be your best friend. Of course, there are no guarantees--you might buy an investment that subsequently goes up and up and up, in which case you would have been better off buying the position all at once. But the bottom line is that you don't know what it will do, so diversifying your purchases across multiple time frames helps accommodate a range of outcomes.

The same concept holds true for any investment that offers a fixed payout, such as an annuity or individual bonds or certificates of deposit. You may be able to obtain a higher rate down the line by waiting, particularly if interest rates go up, but it's hard to know that for sure. In such instances, laddering your purchases across multiple time frames can give it exposure to multiple interest-rate environments and increases its potential for higher payouts down the line.

Tax Diversification
Diversification of tax treatment is another way to spread your bets around, and that's why I've been urging investors to obtain Roth treatment for some of their retirement assets.

No, I don't know for sure that tax rates in general will go up, though some of the currently low tax rates are set to expire at the end of this year, barring Congressional action. Nor do I have a clue about whether any of you will be in higher or lower tax brackets in the future.

What I do know, though, is that if you've been working, saving, and investing for a while, you probably already have a sizable share of your retirement assets in investments that will be taxed when you begin taking withdrawals--whether you hold the money in traditional IRAs or 401(k)s or other company retirement plans. For that reason, it's a good strategy to get at least some of your retirement assets into the tax-free withdrawals column--that is, Roth--via new contributions to a Roth IRA, converting assets from traditional IRAs to Roth, or Roth 401(k) contributions.

Vehicle Diversification
If you get a group of investors together in a room, you'll find that most of them are strongly biased toward a specific investment vehicle or another: individual stocks, index mutual funds or ETFs, or actively managed funds. There's nothing wrong with having an opinion on which is the best mousetrap for investing in the market, but neither is there any imperative to choose a side in this debate. Even if you feel strongly in favor of one vehicle or another, leaving open the possibility that the other side could be right, at least some of the time, shows humility--always a good thing when it comes to investing.

Adding a slice of a passively managed index fund or ETF to a portfolio anchored in actively managed funds can help improve the portfolio's risk/reward profile, according to a Vanguard study. Broad stock-market index funds and ETFs can also be the better choice for your taxable accounts because they tend to distribute few capital taxable gains on a year-to-year basis.

By the same token, index enthusiasts might consider steering at least a small share of their portfolios to actively managed funds with sensible strategies and low costs. Of course, indexing is a perfectly respectable approach for the whole of a portfolio, but it's also true that some active managers have been able to outperform over time. Including one or two active funds in your portfolio leaves open the door to that possibility.

Finally, if you're primarily an individual-stock investor, supplementing your stock picks with a broadly diversified mutual fund or ETF may help smooth out your returns and reduce your portfolio's risk level. Ratchet your fund exposure up or down depending on how well you've done with your stock picks.

"All-In" Diversification
Most of this article has focused on various levels of diversification when it comes to your investment assets. But diversification can also be a useful concept when thinking about your total money picture: any real estate or business interests you own, for example, as well as the stability of your own earnings.

For obvious reasons, if a lot of your personal wealth is tied up in your home or business, a big priority for you should be to diversify into more liquid assets that have little correlation with real estate or with your firm. Creating a net worth statement can help you get your arms around how well-balanced your whole portfolio is.

In a similar vein, Ibbotson Associates' concept of "human capital" can also be helpful. The core idea is to evaluate your own earnings power based on your life stage and what you do for a living, and use that to help shape the investment assets that you own. A tenured college professor, for example, can rely on a very safe and stable stream of income during his or her working years and may have a pension to boot. For that person, a higher-than-average stock stake would be perfectly reasonable. On the flip side, someone whose earnings stream is volatile or subject to periodic disruptions--a commission-based salesperson, for example--will want to keep more of his or her portfolio in safe and steady investments, because there's a realistic possibility of needing to tap those assets to fund living expenses at various points in time. 

A version of this article appeared April 26, 2010.

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