There aren’t many opportunities to get a free lunch from Wall Street, but proper diversification is one way you can come close.
Time after time, academic research has shown that diversification — essentially the choice of asset classes — has far more impact on long-term success than almost anything else an investor does.
This column, adapted from a chapter in my book Financial Fitness Forever , is the fourth in a series addressing the four most important choices every investor faces. The others involve where you put your trust, whether you try to beat the market, and how you deal with risk.
Think of a chef preparing a stew. The choice of ingredients — and the proportions — will largely determine the final result.
The same is true for investors. You can’t put just anything into a portfolio and expect success. In my first book, Live It Up Without Outliving Your Money , this topic took six chapters. Here, I’ll focus on the basics and point you to additional resources.
Gathering the ingredients
It’s easy to ignore the details of diversification, but I hope you won’t.
When you cook a meal or wash your car, a lazy approach usually has no lasting consequences. Tomorrow is another day.
Managing your life savings is different. A mediocre result can last a lifetime — and the consequences can be life-changing.
Many investors try to get by with just three mutual funds: one for U.S. stocks, one for international stocks, and one for bonds. While that approach is simple, it leaves a great deal of potential on the table.
You gain a significant advantage by also owning small-company stocks and value stocks, as well as foreign stocks — which now represent more than half of the world’s total market capitalization.
Over long periods, stocks of small companies have produced higher returns than stocks of large companies. Research dating back to 1926 shows a clear and persistent difference.
Where size and value fit in
Over many periods, small-company stocks — think of Microsoft in 1987 — have outperformed large-company stocks — think of Microsoft in 2015.
Individually, small and young companies are risky. But when you own them by the hundreds or thousands through mutual funds, you increase your odds of capturing the future giants. As an asset class, they have historically rewarded investors willing to tolerate volatility.
I’m not suggesting you put all your money into small-company stocks. But allocating a portion through broadly diversified funds allows you to benefit from what academics call the size effect.
Another crucial asset class is value stocks — companies with low prices that are temporarily out of favor. These stocks are risky on their own, but when owned in large numbers they have historically produced superior returns.
The difference is not trivial. And the value effect shows up most powerfully among small-company stocks. Over long periods, small-cap value stocks have been especially productive.
Putting the world to work for you
Once you accept the importance of diversification — and decide to include small-company and value stocks — investing internationally requires very little additional effort. I call this putting the world to work for you.
I recommend that roughly half of your equity investments be in international stocks, including international value stocks, international small-cap stocks, and international small-cap value stocks.
Emerging-markets stocks also deserve consideration. They have demonstrated an ability to deliver premium returns at reasonable levels of risk.
Even if international stocks don’t increase long-term returns, the added stability they provide can be invaluable — especially for retirees making withdrawals. In some cases, international diversification can mean the difference between a portfolio that lasts a lifetime and one that runs out too soon.
Where real estate fits in
There is one more asset class I recommend: commercial real estate — office buildings, shopping centers, apartments, hospitals, and other income-producing properties.
Investors can access this asset class easily through mutual funds that invest in real estate investment trusts, or REITs.
The primary benefit of commercial real estate isn’t necessarily higher returns, though that can happen. The real advantage is improved diversification and reduced overall volatility.
I’ve covered a lot of ground here, and you may be wondering whether all this diversification is really worth the effort.
I believe the answer is yes. One of my favorite articles, The Ultimate Equity Portfolio , shows that broad diversification has historically reduced risk rather than increased it.
When all is said and done, the evidence for diversification is so strong that this should be an easy decision. Depending on your situation, proper diversification could be worth $1 million to you — or even more.
Whether or not you follow my recommendations, choosing your asset classes is one of the most important decisions you will make as an investor. I hope you will take the time to make it carefully and thoughtfully.
To hear the audio version of the book chapter on which this article is based, check out my podcast, “How Will You Diversify Your Investments?”
Richard Buck contributed to this article.