Friday, August 31, 2012

My Keys to Diversification

Diversification is one of those ideas and concepts that everyone in the financial world has an opinion on. While everyone agrees that is important to maintain a diversified portfolio, the definition of a well diversified portfolio is as wide as the world’s oceans. Most common though is one laid out by financial advisors that you pay for advice. These guys say that a well diversified investment portfolio consists of: stocks, bonds, real estate, commodities and cash.

In going from 0 to $1 million I have my own unique take and implementation of diversification. To me diversification is about spreading risk for increased opportunity growth. In my investing strategy I only invest in 4 types of mutual funds and hold those positions for at least 5 years. I do not consider cash an investment. I use cash for two instances: (1) emergencies and (2) less than 5 year planned purchases. Consequentially my cash held for emergencies allows me to raise deductibles on insurance and lower my monthly premiums, that’s called financial planningJ!

 But back to diversification. I stay away from bonds because they generate low rates of return in long term investments that barely keep pace with inflation, plus bond prices jump around just as much as single stocks and historically generate low rates of returns. On that note as well I avoid single stocks like they are the plague. Nothing screams “Undiversified” to me more than carrying more than 10% of your portfolio in a single stock, only to see that company go bankrupt, go through a scandal that plummets the stock price or the IPO fails (see facebook). None of my portfolio holds any commodities. The only gold I own is on my left ring finger. If the economy collapses and we go into a “Mad Max” world gold will be meaningless. A gun with ammunition and a bottle of water will get you anything you want in a post-apocalyptic world, not gold nuggets.

My practice in diversification boils down solely to what I have invested in the stock market. When investing I only invest for the long term with proven mutual funds that have been around for at least 10 years. So when investing I’m not trying to keep up with inflation or stay slightly ahead of it. My goal when it comes to inflation is to kick it in the teeth.

So I look to maximize my investing efforts with diversification across 4 types of mutual funds. The first of my four mutual fund categories is Aggressive Growth, otherwise known as Small-Cap mutual funds. In this category the mutual fund is spread across up and coming businesses that have the potential for dynamic long term growth. The next is Growth, aka Mid-Cap mutual funds. These provide a bit more stability than Aggressive Growth but still maintain sizeable earning and growth potential. The third slice of my diversification pie is Growth and Income, also known as Large-Cap mutual funds. These are large dinosaur companies that don’t move with great volatility during bull & bear markets but produce consistent long term growth and generate sizeable dividends. The fourth and final piece is International. In the previous three categories I am concentrated in the US market. With this one I get a bit of global flavor in the mix. With international mutual funds I can participate in the growth of the middle class in China, benefit from growth and development in Brazil from the coming World Cup and Olympics and even get to ride out Europe once the Euro-zone mess is figured out.

Don’t let financial goobers and the, “too sophisticated for their own damn good,” let you think that their way to diversify is the only path. To me diversification is about maximizing growth in long term investments. In my humble opinion if I am worried about money that I need to use within 5 years losing value, then I should not have it invested period.

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