Diversification & Valentines

With displays of Valentine candy in every store, now is the perfect time to talk about chocolate. A creative financial advisor might even steal Forrest Gump's analogy and say, "Diversification is like a box of chocolates."

Except that it isn't.

True, a box of chocolates has a lot of variety. Cream centers. Caramels. Nougats. Nuts. Dark chocolate. Milk chocolate. Truffles. Yet it's all still chocolate.

Buying that box is like investing your retirement savings in a variety of U.S. stocks. Even if you have a dozen different companies, they are all the same basic category of investment, or asset class.

Suppose you give your true love a slightly more diversified Valentine gift made up of chocolates, Girl Scout cookies, baklava and apple pie. That compares to investing in different types of stocks like U.S., international or emerging markets. But everything is still dessert.

You are a wiser investor if you take your true love out for dinner and have a meat course, a salad, vegetables, bread, dessert and wine. Now you start to see real diversification. In addition to U.S., international, and emerging market stocks (all dessert), you have some other asset classes like U.S. and international bonds (meat), real estate (bread), cash (salad), commodities (veggies) and absolute return strategies (wine).

This kind of asset class diversification is the best investment strategy for long-term growth. My preference is eight or nine different classes. For many clients, I recommend a mix of U.S. and international stocks and bonds, real estate investment trusts, a commodities index fund, market neutral funds like merger arbitrage and managed futures, junk bonds, and Treasury Inflation Protected Securities (TIPS).

Fluctuations in the market tend to affect the various securities within a given asset class in the same way. Most U.S. stocks, for example, generally move up or down at the same times. So owning shares of several different stocks won't protect you against changes in the market. When a portfolio is well-diversified, the volatility is reduced even during times when the markets are moving strongly up or down. 

When I talk about investing in a variety of asset classes, I don't mean owning stocks, real estate, gold or other assets directly. For individual investors, mutual funds are a much better choice. Occasionally, someone asks me, "But why should I have everything in mutual funds? That isn't diversified, is it?"

Mutual funds are not an asset class. They are just the container that holds the investments.

Extending the metaphor: A mutual fund isn't like a type of food; it's like the plate you put the food on.

A single plate might hold one food item or servings from several different food groups. More specifically, mutual funds are pools of money invested by managers. One fund invests in real estate investment trusts (REITS). Another chooses international stocks for their high returns. Still others invest in a diversified mix of asset classes.

Annuities and individual retirement accounts aren't asset classes, either, but are also examples of different types of containers that hold investments. If you use your IRA to purchase an annuity, all you're doing is stacking one plate on top of another. It doesn't give you another asset class; it just costs you more for the second plate.

Having a box of chocolates for dinner might seem more appealing in the short term than eating a balanced meal. Investing in the "get-rich-now" flavor of the month might seem tempting, too. Yet in the long run, asset class diversification is the best way to make sure you have a healthy investment diet.

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Rick Kahler, CFP, is president of Kahler Financial Group in Rapid City, S.D.
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