A Detailed Diversification Strategy: Part I - The Risk-Averse Investor

by: Stan Stafford

When it comes to the subject of diversification, there are plenty of differing opinions. These opinions range from what's the real definition of diversification to whether or not a need for diversification actually exists. I'm a strong believer in the theory that diversification plays a key role in successful wealth management.

What is Diversification?

I'm always surprised when I find people that don't understand the main objective of diversification. Diversification has little to do with profits and everything to do with losses, limiting your risk to big losses that is. (This doesn't mean that we ignore profits completely.)

Explanations for diversification can range from the simple:

"Don't put all your eggs in one basket"

To the complex:

"The expected return on a portfolio is a weighted average of the expected returns on each individual asset: \mathbb{E}[R_P] = \sum^{n}_{i=1}x_i\mathbb{E}[R_i]

where  x_i is the proportion of the investor's total invested wealth in asset  i ".

No matter how detailed you want to make the definition, the overall goal is to limit your risk exposure to losses.

Is Diversification Necessary?

Over the next twenty years, thousands of stocks will be available to invest in. During this time, one of those will perform better than all of the rest. So if you are lucky enough to pick that one stock (or one of the possible several) that will perform great over the next twenty years, then diversification might not be really necessary. But, if you are willing to take that kind of chance on either a single stock or a handful of stocks, then you're not that far away from those who have a retirement plan that consists of buying a few lotto tickets every week.

Whether you are one year away from retirement or thirty years, I believe that diversification is necessary. Whether you are a small investor, investing a few thousand dollars a year, or a large investor, investing five to six figures a year, I believe that diversification is necessary. While I'm resolute in my belief that diversification is important for everyone, I'm also a firm believer that there isn't one strategy or allocation breakdown that can be applied to everyone.

Types of Investor

A person's tolerance for risk is one of the key factors that determine what kind of investor they are. For the purposes of this discussion, I have broken investors into the following five types:

  1. Risk Averse
  2. Conservative
  3. Balanced
  4. Growth Oriented
  5. Aggressive

Overview

The remainder of this article will focus in on the risk-averse investor. I will put forth what I consider to be sound diversification allocations for the risk-averse investor based on criteria such as 1) years away from retirement and 2) amount of money invested.

These are not meant to be used as a blueprint but are instead a sample guide to use in terms of maintaining an appropriately diversified portfolio.

A Few Notes

  1. For working investors, before investing in anything else, I think it wise to max out 401k and/or IRA contributions (especially when a company match is included).
  2. Many 401k plans have limited choices in terms of available funds/investments to contribute. For the purposes of this article, I will assume no such limits, presuming one can adjust their individual plans based on the types of funds/stocks available to them.
  3. For the purposes of this article, I will consider all "investments" as indefinitely investable, meaning money from these investments will not be needed in the short term for common household expenses or emergencies (such as a broken furnace, etc.).
  4. I will focus on four classes of assets 1) stocks, 2) commodities, 3) fixed income assets, and 4) cash and cash equivalents. I understand that other investments such as real estate and collectibles will fit into the portfolios of some, but feel that the majority of investors focus on the four asset classes mentioned.

Risk Averse

Some people have the wrong idea that diversification doesn't work for risk-averse investors because they are not willing to accept the associated risks of certain investments such as stocks. However, a risk-averse investor does not avoid risk, but simply limits the amount of risk they are willing to take.

Even the most risk-averse investors, who keep their savings under their mattresses, take risks. But because these investors are very conscious about limiting their risks, some types of investments are typically beyond their scope. These include futures, options, and, for the purpose of this article, commodities.

Because of the often wild swings in prices related to commodities, I don't think they are a suitable investment for a risk-averse investor. However, I do believe that stocks, bonds, and cash equivalents are all legitimate investment opportunities for even the most risk-averse investors.

Investor With 20+ Years Until Retirement

This group includes investors with 20 or more years remaining before planned retirement. While all groups in the risk-averse classification prefer to avoid vulnerability to risk, this group will be slightly more open to risk than the other groups simply because of the amount of time they have until retirement.

A portfolio for this group of risk-averse investor might look like:

I feel like this is an appropriate allocation to avoid high losses and maintain a sense of stability, while still providing an ability to generate growth and income as the years go by.

Since 40% of investments are allocated to cash equivalents, let's start there. I would recommend having a mix of cash in savings account(s), CDs, Money Market accounts, and T-bills. The percentage of how much to divvy up between these four investment choices will depend on the current rates available. Since these are all very liquid assets, it pays to shop around and make sure that you are getting the best rate you can, based on how liquid you want the investment to be.

Another thing to keep in mind is that depending on just how risk averse an investor is, they may want to keep their investment in money market accounts to a minimum. These accounts are set up to protect the value of your dollar, but they are not protected by FDIC or the US government in the same way that savings accounts and CDs are.

For fixed income, I believe that an appropriate mix for a risk-averse investor is 60 percent government treasuries and 40 percent bond funds. The government treasuries can include treasury notes, bonds, and TIPS while the bond funds should be strictly limited to investment grade funds.

For stocks, a risk-averse investor will most likely want to avoid buying individual stocks and instead focus on stock funds. The best stock funds for risk-averse investors are index funds (funds that are setup to mirror an index such as the S&P 500). If a risk-averse investor does get an itch to invest in individual stocks, I would suggest picking stocks from generally safe sectors such as utilities or consumer staples. I would also suggest only picking stocks from these sectors that have a history of paying a dividend (to help protect against stock price decreases). A few stocks that I like from these sectors include Procter & Gamble (NYSE:PG), General Mills (NYSE:GIS), The Southern Company (NYSE:SO), and Duke Energy (NYSE:DUK).

Investor With 10 to 20 Years Until Retirement

This group includes investors with 10 to 20 years remaining before planned retirement. The investment choices for this group of investor will be pretty similar to the last group, but since retirement is a bit closer, they may want to reduce their risk to fluctuating stock prices somewhat.

A portfolio for this group of risk-averse investor might look like:

The only real difference between this chart and the first one is that 5% of investments moved from stocks to cash equivalents. I feel like the fixed income allocation percentage should stay the same for this group of investor with the only difference being the length of the government treasuries or bonds purchased (i.e. focusing more on perhaps 7 and 10 year Notes instead of 30 year bonds).

Investor With 5 to 10 Years Until Retirement

This group of investor can start making actual plans for retirement as it is no longer an abstract idea that is far, far away. As retirement approaches, these investors will be deciding what they are going to be doing with the money they have saved (continue saving, travel, vacation home, etc.) while ensuring they have plenty to cover practical needs such as living and medical expenses.

A portfolio for this group of risk-averse investor might look like:

As you can see, more than 50% of this group's investable assets are now allocated to cash and cash equivalents. This may seem like a lot, but for a risk-averse investor this could actually be a fairly conservative estimate.

At this time, I feel that risk-averse investors will want to limit the majority of their fixed income investments toward government bonds/funds rather than maintaining the 60%/40% split I suggested for the investor group still 20 years away from retirement.

Also, the stock investments (which should already be index fund related) should cover broad indexes at this point. Instead of a Dow index, focus on large index funds. But note, that usually the broader the fund, the higher the associated fees will be. So, a Wilshire 5000 based index fund will most likely have higher transaction fees than a S&P 500 based index fund.

Investor With 1 to 5 Years Until Retirement

Imminent approach, retirement is within reach. This group of investors are either confident that they have saved enough or fearful that what they currently have will not be enough. What they do not want to worry about is losing what they already have saved. That's why I feel at this stage, risk-averse investors will want to shy away from stocks altogether.

A portfolio for this group of risk-averse investor might look like:

While this allocation doesn't look very diversified, for a risk inverse investor nearing retirement I believe it is diversified enough. Remember the main goal of diversification is to avoid risk. This allocation definitely avoids a lot of risk by investing in only what is considered to be the safest of investments. And hopefully with retirement near, the investor has invested enough that generating growth is no longer a necessary requirement of their portfolio.

Size of the Investor

Let us assume that a "small investor" has less than $500,000 in investable financial assets. For "large investors," let's assume they have more than $500,000 in investable financial assets.

Does the size of the investor change the appropriate asset allocation?

First, we should look at some of the advantages/disadvantages associated with being a small or large investor.

  1. Cost - this is definitely a disadvantage for the small investor. Small investors usually purchase small blocks of shares and thus have a higher percentage of cost related to the transaction fees.
  2. Information - another possible disadvantage for the small investor. Small investors typically have to rely on their own knowledge/fact finding to determine whether or not an investment is solid. Large investors often have professionals helping them make these decisions.
  3. Market Timing - a possible advantage for small investors as they can often go from fully invested to cash within a day, something that isn't necessarily possible for larger investors.
  4. Flexibility - I think this is a tie as both groups enjoy flexibility, but different kinds of flexibility. Large investors have more flexibility in terms of the kinds of investments possible to them; while small investors are not limited by some of the constraints large investors often have in place.

I honestly don't feel that the size of the investor will make all that much difference in terms of asset allocation of a portfolio. This will obviously differ by individuals, but, in general, I believe that a risk-averse investor investing $5,000 will have close to the same investing principles as a risk-averse investor investing $500,000.

While I don't think that the asset allocation would change much based on the size of the investor, I do think it is definitely possible that the mixture of investments within each asset class would change. While a large risk-averse investor may want to make sure that they have at least $250,000 in an FDIC insured account, a small investor wouldn't have that same goal as it could take several years for them to even attain $250,000 in investable income.

Conclusion

Risk-averse investors will always want to have a good amount of their money in low risk investments such as cash and cash equivalents. But if they are truly risk averse, they will have some diversification in their assets. I feel that the allocation strategies I laid out based on years from retirement are a great starting point for risk-averse investors to determine their own individual diversification plans.

In part II of this article, I will be flipping sides and focusing on the aggressive investor with a focal point on individual stocks and my opinion on appropriate allocation strategies across sectors, global regions, and market caps.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.