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  • Writer's pictureKen Holman

Why Diversification is Key to a Healthy Investment Portfolio

As an investor, how do you protect yourself from the uncertainty of an unstable economy and the volatility in the market? Most investment strategists would recommend diversifying your portfolio. Diversification is the process of spreading your investment capital across different asset classes, industries, and geographic regions. This approach tends to reduce your overall risk. Although it does not guarantee you will not experience losses, diversification is key to maximizing your long-range financial goals.

Below is a pyramid that illustrates where different investment vehicles are on the risk scale. This was created by Dave Ahern in an article entitled, “The 8 Main Types of Investment Risk.”

If you’re going to weather the economic storms that are coming, the best way to protect your investment portfolio is to make sure it’s diversified. I’ll discuss how to diversify your portfolio but first let’s address the economic climate we’re facing today.

The Federal Reserve is continuing to hold interest rates high because inflation has not been bridled. The current annual inflation rate for the 12 months ending March 2024 is 3.48% which continues to buck the Fed’s targeted rate of 2.00%. That’s lower than last year’s rate of 4.98% but still above the long-term average rate of 3.28%.

Investors have been hoping that inflation would begin to come down so that the Fed can start easing the Fed Funds rate down which currently site in the range of 5.25% to 5.50%. High fed funds rate means higher interest rates banks charge which puts pressure on businesses to layoff workers to compensate for lower earnings.

The Fed is in a real conundrum. It would like to begin lowering rates to ease the economy into a soft landing, thus avoiding a recession, but that doesn’t seem to be happening. Even though unemployment seems to be strong, the real truth is there is weakness in the labor market that some are talking about.

For example, as Andrew Hollenhorst, Citi Banks Chief US Economist said in an CNBC interview, “There’s this very powerful and seductive narrative around a soft landing, and we’re just not seeing it in the data.” If you look beneath the surface, the number of full-time workers has decreased and the number of hours worked has fallen. Sectors such as the restaurant industry have stalled on hiring.

What happens in the labor market is key to the economy. Now the unemployment rate is expected to start rising and, as Hollenhorst puts it, this is a sign “that we’re going to have a more material decline in the US economy.” Couple that with weaker consumer spending with retail sales declining and credit-card delinquency rates and consumer debt rising makes it difficult to see the future without a significant market correction happening.

So how do you diversify your portfolio to avoid some of the headwinds we are going to face in the near future? I would suggest you diversify your portfolio in the following ways:

  1. Divide your portfolio into three buckets with 10% in cash, 60% in traditional investments like stocks and bonds and 30% in alternative investments like income-producing real estate.

  2. Diversify your traditional investment portfolio into the following categories:

    1. Large cap domestic stocks 30%

    2. Small cap domestic stocks 20%

    3. Domestic corporate bonds 15%

    4. Real Estate Investment Trusts 15%

    5. Government bonds 10%

    6. International stocks 10%

  3. Purchase income-producing commercial real estate in any of the following categories:

    1. Multifamily housing

    2. Industrial

    3. Retail

    4. Hospitality

The reason for 10% in cash is to take advantage of future opportunities that will arise as the economy rebalances.

The reason for 60% in traditional stocks and bonds in a diversified portfolio is to avoid the potential risks that will undoubtedly occur as the economy readjusts. Some may question why REITs get a 15% allocation. That is because REITs are not real estate investments in the true sense that they afford investors the typical benefits afforded real estate investors but they do provide high cash distributions. Note that I did not include options, futures, collectibles, or cryptocurrencies. These can be included in the speculative stock category mentioned below.

The reason for 30% in alternative real estate investments is to take advantage of rising values as interest rates begin to drop later in the year. Some argue that stocks provide a higher long-term yield than real estate but it has been my experience the income-producing commercial real estate typically provides yields that are one-and-a-half to two times higher than traditional stock investments with less volatility.

Here are some suggestions on how to diversify your stock portfolio as given by James J. Cramer as given his book “Real Money:”

  1. Pick a stock of a company from your neighborhood, something you know or can relate to. These are usually well-run national companies that operate locally.

  2. Pick an oil stock or other highly respected energy stock.

  3. Pick a brand-name blue chip that sells at a high yield.

  4. Pick a financial company because they represent one of the largest portions of the S&P 500.

  5. Pick a speculative stock but don’t invest too much, maybe something in telecommunications.

  6. Pick a stock or stocks in consumer staples, healthcare, or utilities.

  7. Pick a high-quality cyclical stock when it is clear that the economy is going to go bust and the smokestack stocks are being trashed repeatedly.

  8. Pick a stock in information technology or communication services.

  9. Pick a young retailer that hasn’t expanded to the majority of the country but likely will over the next few years.

  10. Pick a “hope for the future” non tech stock, perhaps a biotech company or another kind of company from the S&P 600, which is the mid cap index.

Finally, diversification is an attempt to protect your investment portfolio against losses. If you’re an older investor, you may want to consider giving more weight to bonds rather than stocks. Diversification is not designed to maximize returns but rather to minimize investment risk in an unpredictable economy.

The key to diversification is to own investments that perform differently in similar markets. When stock prices are rising, bond yields are generally falling. There are 11 different stock sectors that comprise the stock market. Don’t get overweighted in any one sector and don’t buy so many stocks that you can’t manage your portfolio efficiently. Most advisers suggest between 10 and 20 stocks.

The goal of diversification is to buy assets that do not move in lockstep with each other. There are plenty of different diversification strategies to choose from, but the common denominator is to buy investments in a range of different asset classes. As we navigate these uncertain economic times, make sure your investment portfolio is diversified.

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