2011’s Top Ten (Part 9)

Among my Top Ten list of financial planning to-do’s for the New Year, number nine is to diversify.

I’ve mentioned before how diversification at the heart of true investment management. It separates the investors from the hobbyists It makes it possible to add a volatile stock to your portfolio without significantly increasing the portfolio’s risk.

How does it do this? By having the different stocks and bonds in your portfolio go up and down in opposite ways, some risky jags cancel out the jigs of other risky assets. So adding some assets can actually reduce this risk. Of course, this is all in theory. In practice, most stocks move together as the market moves. That’s because the market is looking at the economy, and most stocks’ fortunes are tied to the economy.

Of course, there’s diversification and there’s diversification. Some folks think that because they own five different airline stocks they have a diversified portfolio. That’s not really reducing their risk. You need to look at the underlying characteristics of an investment—where it gets its cash from. Consumer stocks are different than industrial stocks which are different from healthcare stocks. If one part of the economy slows down, diversifying across sectors will protect you.

But there are some areas where I don’t like to diversify. I prefer to have a working portfolio that helps people work. That means that speculative investments like gold or art or baseball cards aren’t really investments, they’re a beauty contest where you are judging not the beauty of the object, but how beautiful the other judges think the object is. Collecting coins or stamps may be rewarding hobbies, but they’re not true investments.

Diversification isn’t a free lunch—it doesn’t give you money for nothing. But it does give you peace of mind, knowing all your eggs aren’t in one basket.

Douglas R. Tengdin, CFA
Chief Investment Officer
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