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Are You Diversified?

by Lazy Man on 01/1/08

Jim Cramer of CNBC hosts a show called Mad Money. If you’ve seen a few episodes, you are familiar with a view call-in segment called, “Are You Diversified?” The challenge is for users to call in and list five stocks that own and ask if they are properly diversified. I chuckle a little each time that I watch the segment. I wouldn’t consider anyone with five stocks “diversified.” Nonetheless, the exercise serves for good entertainment (if you are into the stock market) and a learning opportunity (for beginner investors in the stock market).

I believe in diversifying my investments with mutual funds and/or exchange traded funds (ETFs). How you allocate your investments depend on a number of factors. If you are young or like rolling the dice, you may find that investing in stocks suit you best. If you are older or risk adverse, you may want to want to hold more bonds, certificates of deposits (CDs), and/or possibly some real estate investment trusts (REITs).

Personally, I like to invest in a little bit of everything. My reasoning is that some asset or market is always going to being doing well. I have about 40% of my money in US stocks. Half of this money is small stocks and half is in large stocks. One way to invest in both styles with one purchase is to buy the Vanguard Total Stock Market Index ETF (VTI). I have another 35% of my money in international stocks, specifically Vanguard’s FTSE All-World ex-US ETF (VEU). I invest 10% of my money in real estate through Vanguard’s REIT index ETF (VNQ). Usually the domestic stock market and the real estate market do not go down at the same time (with the last month has been an exception). I also invest 10% of my money in bonds through Vanguard’s Total Bond Market Index (VBTLX). Like with real estate, this gives me protection against a falling stock market.

The last 5% of my investment is with Prosper.com. One of the reasons I lend money on Prosper is that it further diversifies my portfolio. I have a few friends who got depressed when the Dow drops from 14,000 to 12,700. I slept very well at night knowing that 60% of my money was invested elsewhere.

In my opinion the biggest benefit to this plan is those good nights of sleep.

Lazy Man has been a lender at Prosper since February 2006. His lending has been written up in the Globe and Mail, Canada’s largest national newspaper. He is the author of the personal finance blog, Lazy Man and Money. He enjoys watching Boston sports while sipping diet cola.

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6 Responses

Mike | January 1st, 2008 at 5:01 pm

If you’re a real freak for numbers, a great book on diversification is the The Intelligent Asset Allocator. They cover the mathematics of why diversification works and how to plan a portfolio. It’s a great read.

PrivateLender | January 1st, 2008 at 5:07 pm

Prosper loans can be thought of as “people bonds” (versus “corporate bonds” or “government bonds”) and having up to 5% of one’s portfolio in this new asset class (for the individual investor) is a good diversification strategy. People bonds are correlated more with the job market than the stock market, so defaults will likely increase during the next major recession (whenever that might happen). Investors can minimize the likelihood of potential defaults by lending to higher-credit-grade borrowers who are not financially distressed.

Jorge | January 2nd, 2008 at 1:10 pm

One thing to consider about diversification with regards to securities, if you are “too diversified,” by definition you will never be able to beat the market averages. I read The Warren Buffet Way by Robert Hagstrom, and he discusses how Buffet’s view of diversification is the polar opposite of modern portfolio theory. One big reason that Buffet consistently outperforms the market is because he invests in just a few great companies that he is very familiar with at the right price, rather than trying to spread the risk over too many different investments. According to Buffet, “Diversification serves as protection against ignorance. If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There is nothing wrong with that. It’s a perfectly sound approach for somebody who doesn’t know how to analyze businesses.”


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