Investment Diversification – Is There a Magic Formula?

If you’ve been investing your money for some time—or at least studying up on the subject—you’re no doubt aware of the importance of diversification. The purpose of diversification is to reduce the risk inherent in investing, which improves investment performance (by minimizing losses) in the long term. Coming up with the right diversification formula then seems like a critical component of any investment plan.

And it is. But the open question is, which formula? No one claims that investment diversification is an exact science, but there are at least a couple of models that have become so common that they’re assumed to be winners.

Fixed allocation. In this model you set a specific allocation, say 60% stocks, 30% bonds, 10% cash, and keep it no matter what happens. Through bull markets and bear markets, you stay faithful to the diversification plan, rebalancing periodically to make sure that you don’t become “overweight” in any one investment class. The advantage of a set allocation is that it imposes discipline on your investment habits in that you’re much less likely to make investment decisions based on emotional factors.

Stock allocations should be in inverse proportion to your age. This one is even more common. Simply put, the younger you are, the higher the percentage of your investments that are committed to stocks, the older you are, the less you should have in stocks. Under this model, a 25 year old might commit 80%-90% of his portfolio to stocks, while a 70 year old might allocate only 30%. The theory is that the younger investor, having a longer time horizon, has more time to overcome investment reversals.

Though some combination of the two is typical, the problem with both models is that they’re extremely general and may not adequately address market conditions or personal circumstances. There are factors that must be built into any diversification plan that may require ongoing flexibility.

Market conditions

One of the problems with fixed allocations is that they don’t adjust for market conditions. A 75% stock allocation may be too risky in a market that’s doubled in the past two years. Conversely, a 25% stock position may be unnecessarily conservative in a market that has fallen 50% in the same time frame. How do you invest safely?

While it makes sense to maintain at least some investment in stocks regardless of market level or direction, there are times when higher or lower allocations are the order of the day. One of the most fundamental rules of stock market investing is “buy low, sell high”. You need to have the flexibility to buy when stocks are cheap, and begin selling when they aren’t. Fixed allocations remove this option.

Still another market factor is the performance of non-risk alternatives, like bonds and cash. A low interest rate environment will make bonds and cash pure capital preservation assets, rather than sources of reliable investment returns. In such an environment, stocks become more attractive, at least until the rate picture reverses.

Inflation is another market factor that can make stocks more attractive than fixed investments, since bonds in particular fare especially poorly in inflationary periods. Inflation might also necessitate taking positions in real estate or commodities, which will add another layer to the diversification mix.

Risk tolerance

Age inverse allocations are based solely on a single factor, which is of course your age. However personal risk tolerance is at least as important. A 30 year old who’s risk adverse may not be at all comfortable holding 75% of her money in stocks, while a 75 year old may be more than willing. Neither investor should completely ignore age as an investment criteria, but appetite for risk—or the lack of it—is at least as important.

Personal financial circumstances

How you allocate your investment mix has as much to do with personal financial circumstances as any other factor. If you’re well employed in a very stable field, and/or if you have substantial assets overall, you may be willing and able to take on a greater level of risk than the average investor.

If however you work in a field where layoffs are frequent, you have a relatively small investment portfolio or you’re carrying substantial debt, you need to be more conservative with your investments. Any personal financial circumstances that might predictably require the liquidation of investments within the next year or two should automatically limit you to non-risk investments.

As much as we might long for a single diversification model that will bring us something close to guaranteed investment success with minimum input, the reality is that no such model exists. Circumstances change and we need to adjust as they do.

Perhaps investing is just like the rest of life—inherently uncertain. The Bible addresses the issue of certainty in the book of James:

…you who say, “Today or tomorrow we will go to this or that city, spend a year there, carry on business and make money.” Why, you do not even know what will happen tomorrow … Instead, you ought to say, “If it is the Lord’s will, we will live and do this or that. —James 4:13-15

So back to the question in the title, is there a magic formula? Adequate, yes; magic, absolutely not. And guaranteed? Never!

How do you handle investment diversification? Is there a model that you think has the potential to be successful over the long term? Meet us in the comments!

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