How to Add Real Diversity to Your Portfolio

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We diversify our lives in many ways. We may drive more than one car, have something different for dinner every night (hopefully), get our news from a variety of sources and watch sports, soaps, how-to and reality shows on TV. The point is that diversification is not some new theory--we've been doing it our entire lives. So don't let the word "diversification'' trip you up when it comes to investing. It shouldn't be a foreign concept; diversification simply reduces risk. It isn't complicated and it can come in many forms.

For example, you can diversify by averaging into a position--that is, putting a steady sum each month or quarter into a security or fund instead of putting in one lump sum. This approach, known as dollar-cost averaging, means you'll effectively be buying more when the price is lower and less when it is higher. It lets you avoid worrying about trying to time the market and get in at a bottom. Dollar-cost averaging is a way to avoid market timing, a very difficult thing to do even for the pros; think of it as a sort of insurance plan against buying high and selling low.

Diversification also means spreading your money around so that you're not just dependent on any one stock, sector or asset class. Ask anyone who loaded up only on tech stocks in the late 1990s or homebuilder stocks during the housing boom--it was fun until it wasn't. Asset prices never go just one way and different asset classes rarely move in precisely the same direction at the same time. So consider diversifying across several asset classes--stocks, bonds, commodities such as gold, real estate through publicly traded real estate investment trusts, master limited partnerships, even cash.

Don't stop there. You should also diversify within asset classes. Don't just buy U.S. stocks; buy some foreign ones as well. Think about countries with strong economic growth potential, places such as Europe's Nordic countries, Australia, or Singapore. If possible, choose more than one investment style as well. Try pairing value stocks (securities considered mispriced relative to their fundamentals) with growth stocks (securities exhibiting above average relative growth in earnings), so that when one's out of favor, the other may be on the rise.

Also, always allocate part of your portfolio to dividend-paying investments. They represent money in the bank--companies such as Exxon, Johnson & Johnson and Procter & Gamble have managed to pay and raise their dividends regardless of the economic and market environment over the years. In the past century, half of the returns in the market have come from dividends. In the roller-coaster 2000s, dividends were virtually the only return investors received. Now Apple, Oracle and Cisco--some of the biggest tech stars that eschewed dividends in the '80s and '90s--are paying them. Who knows, maybe Google will pay a dividend someday too.

As for bonds, it's not all about U.S. Treasurys--in fact, at today's ultra low rates, Treasurys may be worth avoiding. High-yield bonds are one option, aided by strong corporate cash flows, healthy balance sheets, decent earnings and historically low default rates. These characteristics also are benefiting investment-grade corporate bonds, but high-yield bonds have an added benefit of above-market yields--and thus extra income. Currently, high-yield default rates are around half of historical norms, and high-yield bonds are relatively less sensitive to interest rate, which means they are likely to be impacted less when rates eventually do go up. Emerging-market bonds currently offer a similar risk-reward profile--above-market yields and, because of the relatively stronger fiscal health and robust growth profile of their underlying countries, relatively low default risk.

The best thing about diversification is that you don't have to necessarily do it all yourself. There are mutual funds that can do it for you by dividing their investments across asset classes. You still have to do some homework to make sure the funds you choose are not all diversifying into same thing, but that's simple enough to do. In the crash of 2008, some diversified mutual funds were down 22 percent or less--a pretty good relative performance compared to the Standard & Poor's 500 index's 37 percent decline.

Finally, diversification can mean adjusting your portfolio to your life cycle. When you're young, you're going to want to be more heavily invested in stocks because studies show that, over time, stocks generate among the best returns above inflation. But as you age and come closer to retirement, you are going to want to adjust your portfolio to preserve some of that wealth you created--maybe by diversifying away from some stocks and into more income-generating investments--to protect against equity market downdrafts.

The bottom line: When you're thinking about what to do with your money, think about what you do with your life. Diversification can mean generating income from a variety of sources. It can mean fewer fears by not relying on just one stock, or just one sector, or just one asset class. And it can mean having the flexibility to make adjustments as you age. In short, diversification can mean investing the way you live.

With more than 14 years of investment experience, Linda Bakhshian co-manages the Capital Income Fund, Equity Income Fund and Muni Stock Advantage Fund at Federated Investors. Linda is a CPA and a chartered accountant. She earned a bachelor's degree from the University of New England (Australia).

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