How Many Asset Classes Do You Need To Be Diversified?
Diversification is a fundamental tenant of portfolio theory and an integral part of any well-thought-out investing strategy. That said, the law of diminishing returns still applies. The diversification benefit of adding a second and third asset class to your portfolio is substantial. Adding your 9th? Not so much.
How Many Asset Classes Is Enough?
There are no tried-and-true rules regarding when you should stop adding additional asset classes to your portfolio. Certainly if you get to the point where you have too many to keep track of easily you’ve gone too far. But how do you know when you’re diversified enough barring a logistical nightmare? In my opinion, you can and should own as many asset classes as meet the following criteria, assuming their management isn’t prohibitively time-consuming.
Returns Commensurate With Risk
Many asset classes such as domestic equities, short-term treasury bills, and real estate offer adequate returns in exchange for the risks of owning them. Others, such as junk bonds (and arguably corporate investment-grade bonds) do not. Yale endowment fund manager David Swensen devotes an entire chapter to these core asset classes in his highly-recommended book Unconventional Success. You should obviously only own asset classes that adequately compensate you for their risk factors.
Some asset classes that meet this requirement:
- Domestic and Foreign equities
- Short-term Treasury bills
- Real Estate (Preferably REITs)
- Treasury Inflation Protected Securities (TIPS)
- Commodities (in low-cost ETF form, never via direct ownership)
And some that do not:
- Private Equity
- Hedge Funds
- Junk Bonds
- Most Real Estate Partnerships
- Venture Capital Funds
- Many Corporate Bonds Regardless Of Credit Quality
Traded On Highly Liquid, Public Markets
Markets require a relatively high trading volume in order to set prices efficiently. While experts in a given field may be able to take advantage of illiquid, non-public markets to find good deals, 99% of investors can’t and shouldn’t try, as they are far more likely to get ripped off. Liquidity also helps you get a decent price if you need to sell out for some reason (an emergency medical bill, perhaps). Chances are, if there isn’t a low-cost mutual fund (preferably an index fund) or ETF available, an asset class doesn’t meet this requirement.
Sufficiently Regulated
Recent crisis notwithstanding, the Securities And Exchange Commission (SEC) does a very good job of protecting the little guy from the big guy. Owners of publicly-traded stocks and bonds can at least be certain that somebody has vouched for the quality of the accounting practices of a given company. It’s not perfect, but it is surprisingly good. Unfortunately, the media undermines the public’s trust in the SEC regulations by focusing obsessively on their exceedingly rare failures. Enron was a very, very rare exception, not the rule.
Inexpensive And Convenient Way For Small Investors To Gain Access
Mutual funds and ETFs fit this criteria, hedge funds, private equity, and illiquid private partnerships do not. It takes all of 3 seconds to sell an ETF for very close to the current market price. With private equity and hedge funds, you are often restricted from withdrawing your investment to just a few predetermined times per year at a highly unpredictable price.
Provide At Least One Specific Diversification/Investment Benefit
In order to be worth owning, an asset class should possess at least one redeeming characteristic be it low correlation to the other asset classes of your portfolio (e.g. large-cap domestic vs small-cap international stocks), being a mostly-reliable inflation hedge (TIPS, commodities), or providing some other significant benefit. If an asset class brings only a small additional diversification benefit, I wouldn’t bother.
Asset Allocation In Action
For a practical example of a reasonably-diversified portfolio in action, check out my current Roth IRA asset allocation. For a list of recent changes I made to my allocation and my reasons for making them, you should also check out my post on the subject.
While not perfect (I plan on adding commodities and TIPS eventually), I think it is a simple, diversified, easy-to-implement asset allocation without going overboard. If you have no idea where to start, you could do much worse than to start with my portfolio and adjusting the bond allocation to suit your own risk tolerance (I’m still in my 20’s).
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Great post. This reminds me of a quote by Jim Cramer: “You don’t want to own too many stocks in your portfolio, or you end up running your own mutual fund!”
Think what you will of Cramer, but he can be entertaining from time to time.
Also, I would argue that Junk Bonds can offer adequate return for the risk. They’re somewhere between “investment grade” bonds and stocks. You can get much higher return than traditional bonds, but you still get something (in theory anyway, being that you have first dibs on any assets of the borrower) should the underlying borrower default whereas in if a company goes bankrupt, your stock is worth little more than the paper certificate is could once be redeemed for.
I don’t know if David Swenson is still the manger of the Yale Endowment Fund. But this fund’s strategy, like that of other elite universities who emulate it, did not do well over the last year as noted in the Wall Street Journal and other publications. These funds actually sub-performed the U.S. stock market, precisely because of their “alternative” investments. Endowment funds who used more traditional investments like stocks and bonds did better.
Still, those categories you list as meeting satisfactory critera are solid. Roger Gibson, who literally wrote the book on asset allocation, Asset Allocation, is well-respected by his peers for his work in this area of investing. He suggests that a good portfolio will include seven major asset categories: short-term debt, intermediate/long U.S. bonds, non-U.S. bonds, U.S. stocks, non-U.S. stocks, real estate-linked securities (including hard ownership), and commodity-linked securities. Including these categories in a portfolio should help to both minimize risk and increase returns. As you noted, increasingly smaller incremental returns can be had by adding more subcategories under each category.
As to Mike’s suggestion that junk offers a good risk/return profile, consider that junk tends to be correlated with stocks, and bonds in general are high-tax securities. For most investors, bonds are not really meant to be high-return vehicles. They are chosen because they are relatively low in volatility and because they don’t correlate well with stocks.
Good post, Kyle