I learned the meaning of "portfolio diversification" in 2000, when the Nasdaq dropped 70%, along with my portfolio. My portfolio was totally homogenous, like everybody else's was at the time -- tech, tech, tech.
Blech.
Investment gurus preaching diversification were right, so I got with the program. I got my revenge in 2008 when the averages were down around 55%, and I only managed to lose 38%. Given that the Fool is supposed to be educational, I thought I'd play Professor Diverse and let readers in on how I built my portfolio. So settle down, class!
It's all about risk tolerance
There are online questionnaires that help determine your risk tolerance. I do them annually. Basically, I'm moderately tolerant. That's a bit like saying I can stand a group of goblins beating me with sticks, but only for so long. I find MSN Money's questionnaire to be a good start. I like this one, as well, but there are many to choose from.
Aside from these, my age-adjusted asset allocation usually comes in around 70% equities. The rest needed to be divided up among other major asset classes. I initially set them all at 5%, but over the years, each class's value changed, and I rejiggered a bit depending on what my gut said.
Yes, my gut. Your gut is important in investing. If you want to be purely mechanical, hire a robot.
Here's what the early 2008 breakdown looked like.
Large-cap value: 21%
Large-cap growth: 16%
Mid-cap value: 4%
Mid-cap growth: 3%
Small-cap value: 3%
Small-cap growth: 4%
International: 19%
Emerging markets: 2%
Real estate: 5%
High-yield bonds: 3%
Muni bonds: 6%
Other bonds: 6%
Commodities: 5%
Cash: 3%
A couple of notes. International and emerging market holdings are index exchange-traded funds, so they cover stocks across many different countries and regions. Also, why are large caps more heavily weighted? That's where gut comes in. Large caps offer more stability in my eyes than small caps. They've usually got a long history behind them, stable balance sheets, and pay a dividend.
I know what you're thinking. How could I have the time for all this? Am I a hedge fund manager in disguise with a staff of thousands? Nope, and that's why you should pay attention.
You're a Fool. Act like one.
An investor can only follow so many stocks. So you have to use index funds, ETFs, and other low-cost vehicles to truly diversify. I established a core position in an ETF or benchmark-beating mutual fund for each asset class. For example, the iShares Russell 2000 Value Index (NYSE: IWN) was my core choice for small cap value stocks.
But I also wanted to beat benchmarks, so I augmented each class with individual stocks. I mined some from Fool newsletter recommendations, from my favorite mutual fund managers, and companies I knew or learned about.
On the international and emerging market side, well, you think I know what the best stock in Albania is? Not a chance. That's why I picked Fidelity Diversified International Fund (FUND: FDIVX), iShares MSCI EAFE Index Fund (NYSE: EFA), and iShares MSCI Emerging Markets (NYSE: EEM) as just three selections. I'm not knowledgeable about bonds, unless they are debt associated with a company I know well, so I chose Fidelity U.S. Bond Index (FUND: FBIDX), among others.
I own real estate with some friends, so that counts. PIMCO Commodity Real Return (FUND: PCRAX), juiced with swing trades in oil and gold ETFs, took care of that class. A few years ago, I also purchased a few individual high-yield bonds from companies I knew were solid, such as DIRECTV (NYSE: DTV), which the company has since redeemed.
I haven't shared everything with you, because my portfolio is right for me, and not for you. You must consider things like estate planning and taxes, and whether you want to reinvest dividends (I do) or need the current income. So don't copy me!
What now, brown cow?
So I did relatively well in the downturn, but what about currently? I invest primarily for the long term, so allocation has remained about the same.
I did make one major change, though. I reallocated most high-yield and muni bond capital into preferred shares of many solid companies. With states and localities in fiscal trouble, and tons of money flowing into bonds, I think there's too much risk there. Preferred shares are yielding as good, if not better, than junk and muni bonds and provide more safety.
The takeaway is, I hope, obvious. Diversify! There are plenty of ETFs and index funds to get you started. Trust me, the next time the Titanic hits an iceberg, you want to be the guy in the lifeboat, not the clueless idiots drinking champagne in the ballroom.
