Diversification: A Biblical Instruction Of Primary Importance
October 23, 2013
Investment risk management for the individual equity investor is fairly simple, and can be summed up in one word: Diversify. To diversify your investments means quite simply not putting all of your eggs into one basket. It is easy for us as investors to become convinced of a particular viewpoint or a particular future outcome. However, as the Bible clearly instructs us, we will always face uncertainty. The Bible also tells us to study, analyze, and interpret information. We are instructed to assess situations and craft our strategy based upon that assessment. But we are also told that some uncertainty will always remain. Therefore we are instructed to employ diversification as a risk management tool. For a more in depth discussion of the scriptures relating to these and other topics, please see our free report: What Every Christian Investor Needs to Know.
Now that we know diversification is the proper approach, how do we employ it as a strategy? A good financial advisor could be a tremendous help in this regard, except that many of them are just going to recommend actively managed mutual funds. If you are determined to build your own portfolio without suffering the lag in performance caused by mutual fund fees, you can still do so without sacrificing the benefits of diversification. Let's look at a simple example.
First, let's say Bob is 30 years old, and starting today with no investments of any kind. Bob is opening a Roth IRA and a brokerage account with a total of $1,000 and plans to contribute $500 per month indefinitely. Bob's goal is to build a portfolio of equities with his contributions. Bob should start out with a detailed plan that covers his targeted allocation to various classes and sectors. For example, Bob may decide he wants to hold anywhere from 25 to 45 stocks at any given time. He may want to have 60% of his portfolio in large cap stocks, 20% in mid cap stocks, and 20% in small cap stocks. He may want to allocate 60% to U.S. stocks and 40% to international equites. He may decide that his sector allocations will generally match those of the overall market, never to exceed some predetermined limit of deviation. For example, Bob may decide that his own sector allocation will never be more than 2 percentage points above or below the market size of that sector. So, if the financial sector represents 15% of the overall market, Bob may decide that his portfolio will fall within the range of 13-17% allocated to the financial sector. These numbers are just examples, but the point is that he really needs to set these targets in advance and have them in mind as he builds his portfolio. Otherwise, he could end up a with a huge jumbled mess of a portfolio that isn't well diversified at all, or isn't tailored to meet his goals based upon his financial situation.
Once he has a good plan in place, an easy to implement approach would be to find one or two stocks each month that he believes to represent attractive value and to be a good addition to his portfolio for the purpose of diversification. Bob can take his time to research one company at a time. This alleviates the burden and pressure of trying to build a diversified portfolio all at once. Further, he has plenty of time to view each decision in the context of his overall goals and his current portfolio. After 1-2 years, Bob can have a well diversified portfolio and can divide new contributions among the existing securities he holds, so that he can focus on monitoring the condition of his portfolio. Monitoring the condition of your assets is a Biblical instruction (Proverbs 27:23). Of course, as he decides that it is no longer prudent to hold certain securities, he will also be looking for new potential investments. This should be relatively infrequent. Constantly rotating in and out of stocks based on short term views is what gets many individual investors into trouble. The focus should always be on the long term. If you don't have a long term focus for the equity portion of your portfolio, I would question why you have an equity portion of your portfolio.
Beyond the ability to diversify across specific stocks and sectors, investors should strongly consider diversifying across countries and currencies. They also should consider diversifying across various categories within specific asset classes. For example, equities are typically categorized according to large, mid, and small capitalization companies. Further, they are sub-categorized according to growth and value characteristics. Quite a few studies make the case that asset allocation is the primary driver of investment returns. Therefore, it is proper and wise to ensure the full benefit of diversification by considering many different factors in our attempt to build truly diversified portfolios.
While there are major cost saving benefits for individuals who wish to build and manage their own portfolios, there is work required. But, it is work that can be very interesting and fun. Also, the benefits are tremendous.
With our Dividend Focus monthly reports, we seek to help readers in their quest to achieve the goals outlined here. If you are ready to start researching and analyzing investment ideas, feel free to check them out.
If you enjoyed this article or found it useful in some way, please help us get the word out by sharing this link on social media (you can use the buttons to the left of the page). You can also follow us on Twitter: @wisdomsreward and Facebook:Facebook.com/WisdomsReward