The closest thing to a free lunch on Wall Street may be the edge you can gain in your portfolio from diversification. A failure to diversify can be devastating to your portfolio, and it can take years to recover. The basic lesson is simple: You must diversify your portfolio. Very young and risk thirsty investors may make a rational decision to invest in an all-equity portfolio, but I would encourage them to backtest the efficient frontier of even a small percentage of diversifying elements before they do. Those of us who are older and more risk-averse don’t have the luxury of experiencing the thrill ride of extreme investing. We usually understand that we need to diversify, but we end up thinking we have diversified when we have not.
True diversification requires that you understand the concept of correlation, which is also known as covariance. If you buy a small cap fund, a large-cap fund, a value fund, and a growth fund, you have four different funds. That may sound pretty diversified, but it is certainly not. There is a high degree of overlap between growth and value, and the correlation between their returns is going to be very high. Small caps and large caps tend to have some movement that is independent of the other, but the trends are similar in direction most of the time. The scariest thing about this portfolio is that all of the funds are composed of stocks. What do you suppose will happen if the stock market “crashes?” The covariances grow, and they sink like the Titanic. You cannot escape the covariance problem with a single asset class.
To achieve true diversification, you need things that are not at all correlated or, better still, things that have a negative correlation. Since those two criteria don’t exist in the real world, we want to choose a broad basket of assets that have the lowest correlations possible between assets. Bond returns may not be sexy, especially in these days of low and rising interest rates, but you absolutely must own some if you are at all risk-averse.