The Proper Path to Diversification

08/10/2012 7:30 am EST


Sheldon Jacobs

Author, Investing Without Wall Street, Five Essentials for Financial Freedom

It is important to diversify so investors get at least the market return, says Sheldon Jacobs, who shares his preferred step-by-step process for diversifying a stock portfolio.

We're talking about diversification here today with Sheldon Jacobs, and things you can do and things you can consider when diversifying your portfolio. Talk about some things I should consider when I'm talking about diversification.

Diversification is surprisingly easy. Once you set an asset allocation, then your next step is to diversify properly, which is really kind of a second step below. It's also called second-tier diversification.

Take equities, which is what's critical. You may not be so diversified in cash or bonds, but it's less critical. You think equities; you want to be diversified so you get at least the market return.

There are a number of ways to do it, but this is how I recommend you do it. You start by buying a total stock market fund. We're talking about our equity allocation right now. This is all within equities. You start with a total stock market fund, which basically is a fund that buys everything, usually about 3,300 or 3,400 stocks. You buy that and that gives you the proper diversification within the equity allocation.

You want to go one step farther about that because there are four companies who provide total stock market funds. They're Fidelity, Schwab, Vanguard, and T. Rowe Price. They're all capitalization-weighted, all four funds.

Capitalization-weighted means that you're overweighting some stocks or underweighting other stocks, and you want to avoid that. You wind up with a large-cap bias because that's the nature of that type of mutual fund. You don't really want the large-cap bias.

There's a simple solution to that: you simply pick whatever total stock market fund you want, and then you add a small cap fund to it. I use a ratio of one to four. For $4 in a total stock market, you have $1 in a small-cap fund...and you are beautifully diversified.

Now, if you did it with individual stocks, you would need at least 40 stocks minimum. That's a lot of work. This way there is virtually no work. I have statistics that show that you can probably outperform a lot of professionals with just these two funds.

In fact, a couple of years ago I was in a contest in the Chicago Tribune. A one-year contest. I recommended two indexed funds, and a year later we got the results, and there were eight professionals in this contest. I ranked second. Now think about this. Only one professional beat me. I outperformed six professionals with two indexed funds. That tells you something, you know?

It doesn't need to be over-complicated to get a good, diversified portfolio.

It's very simple. And I'm not saying you won't do better if you do more studying. If you come here to the MoneyShow and you really analyze it and become a professional, I would imagine you can do better. But the point of it is that an average person who is not really that much into investing, these two funds will do you just as well as spending hours and hours of work.

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