True diversification is one of the easiest ways to ensure that you will have more money five years from now than you had this year. Here is what I think diversification really is (it might not be what you think), how it has done in the past, and why I think it give’s you more return on you time and money than almost anything else!

So what do I think true diversification is? 5 stocks? 10 stocks? 50 stocks? NO!!

To me true diversification is this….Having a portfolio of multiple asset classes!

Whats an asset class?  Here’s the definition, but I have to warn you, the definition…kind of … sucks! Asset Class – A particular type of investment vehicle. The reason this is a terrible definition is because it is subjective.  Think of it like this. What if I told you a Food Class – is a particular type of food. See what I mean, a Food Class could be anything. To one person a type of food class is as broad as fruits and vegetables (stocks and bonds), but to someone else it could be as specific as citrus fruits and all other fruits (value stocks and growth stocks).

Now while I have no good way to define what a Food Class out to be, I think an asset class should be this….an investment that zigs while another investment zags. Now you can find out if an asset zigs while another zags a number of ways, one way to do it is to check there correlation to each other, which is great for identifying this zig zag relationship, but only common sense can ensure that the relationship will continue into the future.

For example stocks and federal bonds have almost always been negatively correlated with each other (nerdspeak for one zigs while the other zags). But this relationship will likely continue into the future because of the common sense reason that when investors sell the risky asset class (stocks) they want to use that money to move into something safer (federal bonds). The decrease in demand for stocks will decrease their price and the increase in demand for federal bonds increases their price and the zig zag relationship will continue.
So here is the question…Is diversification for you? I would say that it is most certainly is if you are a “lazy investor.” By this I mean you want to get good and safe returns on you investment, but you don’t have time or what to spend your time analyzing financial statements.
Here is an easy way to be fully diversified. Buy two index funds, put 50% in each, because one of them will zig while the other zags. Here are the two funds that you should invest in..first an index fund that tracks tracks every stock in every stock market in the world, known as a “total world fund” or “total equity fund.” The other fund to invest in is a “total bond fund,” ideally this would track every long term high grade bond in the world. I have tested this concept by seeing how it would have performed in the past using two investment funds, the results are in the graph and table below. The two funds are the Vanguard Global Equity Fund (which is close to a global index), and the Vanguard Long-Term Bond Index Fund (it invests in long term U.S. Government Bonds and long term high grade corporate bonds). Nerd Note – These results assume that dividends and payments are reinvested and taxes and fees are not included, it also the 50%50% portfolio is rebalanced annually. The same goes for the S&P 500 results so that we are comparing apples to apples. (as a side note I want to say that I’m am not endorsing Vanguard in any way and that this is only one way to create a diversified portfolio of multiple asset classes)

Notice how much smother the rise in the diversified portfolio is. It might not be as exciting as the S&P 500 portfolio but it only lost money in one of the 14 years on the graph, which happened to be the worst stock market crash since the Great Depression. Also notice that the diversified portfolio  made money every year between 2000 and 2003 (the second worst sock market drop since the great depression).

With just these two investments split 50/50 you can be very confident that you will have more money five years from now than you have now. I’m not saying that you will beat the stock market, but you won’t lose money or spend much time analyzing stocks, and to many people this ability to sleep well at night because you know that you are growing your money is worth it.

Thanks for reading and I hope that this helps some of you with your investment decisions in the future.