Successful investing means not only capturing risks that generate expected return but reducing risks that do not. As mentioned, not all risks are rewarded. The Fama/French Three Factor Model identifies three risks that are rewarded for stocks: market, size and value. Other risks do not reliably reward investors. These types of risks include holding too few stocks or bonds (concentrated holdings), betting on countries or industries, following market predictions, and speculating on "information" from rating services. Diversification can eliminate these unwanted risks.
Invest in Thousands of Securities
Diversification benefits are immediately captured by investing across thousands of stocks. This eliminates company specific risk (also known as non-systematic risk) including the risk of fraud or bankruptcy. This is a story we all know well: Enron, Global Crossing, Bear Stearns and Lehman Brothers are good examples of the perils inherent in taking company-specific risk.
Combine Different Asset Classes
We advocate diversification by investing in both stocks and bonds which have dissimilar returns during various economic environments (also known as low or negative correlation). In other words, generally speaking, safe bonds tend to go up when stocks go down.
We also advocate including real estate (through Real Estate Investment Trusts or REITs) in a portfolio. This asset class combines characteristics of stocks and bonds. With its potential for resistance against inflation, real estate provides unique diversification benefits. Further, the REIT structure gives investors access to global commercial real estate investments.
Diversify Across Global Equities
For stocks in particular, we advocate global diversification. This includes US developed markets, non-US developed markets and emerging markets.
Keep in mind, however, global diversification of stocks does not protect portfolios from deep market declines. Risky assets (stocks, real estate and high risk bonds) may not be highly correlated during “normal” market conditions. But these asset classes can go down in tandem during market downturns. The purpose of global diversification for stocks is to increase expected return for a given level of risk over long periods of time. The asset that can reliably reduce portfolio volatility during market declines in the short run is low risk bonds.
Invest in Different Types of Bonds
We promote diversification across different types of bonds. Our portfolios include:
- Treasury bonds
- Treasury Inflation Protected Securities
- Municipal bonds
- Corporate bonds
- Global bonds that are partially or completely currency hedged