Opinion | The New Diversification

Today’s investor has more choices and ways to diversify than ever before. Traditionally, diversification has been a game of only a few different asset classes: investors have had to choose between a combination of stocks, bonds, and mutual funds in order to manage and grow wealth.

But thanks to changes in SEC laws and the growing popularity of investment partnerships and certain opportunities such as cryptocurrency, more avenues are opening to allow diversification over a number of asset classes for the benefit of the investor. From seasoned investors to the average working person looking to grow their assets, this new 21st century diversification is beginning to include more possibilities and with patience and trust in a well-managed long term strategy, the modern investor’s financial future is looking brighter than ever.

Of course, skeptical investors are going to have a glaring but valid question: how do we know “Diversification 2.0” is a valid strategy? The answer should be satisfying for most, if not all, of these doubters: because the Yale Endowment did it, and earned an 11.3% return on its portfolio.

As recently as the 90s, the Yale Endowment had 80% of its portfolio invested in traditional stocks, bonds, and cash, with a much smaller percentage put into real estate, private equity and venture capital, and of course, there was no cryptocurrency back then. Nowadays, Yale has completely flipped towards investing 88.5% of its $27.2B portfolio into alternative assets and puts an emphasis on leveraged buyouts, private equity, natural resources, real estate, and absolute return strategies. In comparison, only about 4% of the pot is invested in U.S. equities today.

There’s a structural reason that institutional investors just like the Yale Endowment are moving away from such a deep trust in U.S. equities. Since the 1990s the number of stocks on the US stock market has shrunk dramatically which leaves less diversification of returns over the remaining number of companies. In fact, since the 1990s, the number of companies in the stock market is less than half of what it was, decreasing from 8000 to 3627 companies by 2016.

Long-term thinking is still crucial to the success of this updated strategy. Without an outlook that recognizes the very real possibility of fluctuations in the securities markets, the reckless investor may make rash investment decisions which could hamstring the success of the portfolio down the line. Diversification serves to protect investors from systematic risk by ensuring that all the investors’ eggs are not in one basket, and the longer the investor holds on the better odds their chances of recouping these losses. To sum it up, the best choice any investor can make is to formulate a game plan that includes a solid, diversified portfolio and to trust that game plan.

Investors adopting a plan that embraces the 21st-century diversification principles enjoy the benefits of both stability and possible risk-reward scenarios, depending on their portfolio mix. While certain assets, like real estate, tend to be more stable, investments in startups and cryptocurrency invite more risk and subsequently contain the possibility of higher rewards.

One of the most important concepts behind this practice is ensuring that none of the asset classes in your portfolio are too related to each other; this way, the underperformance of one will not have an overly negative effect on the whole portfolio.

True diversification is key to a healthy portfolio. Spread the assets across as many classes as your risk profile allows. In this way, you minimize risk and maximize returns.

Related Links:

Investor's Manual: What Is A Mutual Fund?

Investor's Manual: What Is An Exchange-Traded Fund (ETF)?