When in Doubt - Keep Your Investments Diversified

Question: My diversified portfolio of stocks and bonds was down about 3% in the last quarter.  However, the U.S. stock market, as measured by the S&P 500, was up during the same period.  Should I be worried?  Should I move all my investments into U.S. stocks? Or Municipal Bonds?  Or Dividend-paying stocks?

Answer:  Moving all your investments into just U.S. stocks would not be prudent and would subject you to unnecessary risk.  The S&P 500 index is hovering above 1650 this week. Think about what happened not so long ago when the S&P 500 dropped by 57% from a high of 1595 on October 9, 2007 to a low of 677 on March 9, 2009. Could you handle that kind of a drop? 

The same goes for holding only municipal bonds. You expose yourself to the risk of default and the risk that your portfolio won’t keep up with inflation.  If Detroit’s bankruptcy allows Detroit to reduce legacy costs and get a fresh and viable start, how many other municipalities will follow their lead?

If you only own dividend-paying stocks, you are taking the risk that the companies you own will perform poorly or fail.  You need to stay fully diversified.  Sure, in the second three months of this year all the bond sectors were down and most of the equity asset classes were too.  The U.S. stock market stood out from the other equity asset classes with a positive return.  But that won’t always be the case.  Like they did in 2012, international stocks sometimes outperform U.S. stocks.  Don’t be led astray by short-term performance.  Stay diversified. 

If you don’t believe me, there is excellent guidance on how to be a prudent investor available to you at no cost.  The guidance is written into California law for trustees, but makes sense for everybody.  It provides rules to follow for managing investments.  These rules spawned from common sense over time and are supported by academic research and practical application.  Every serious investor, even if not a trustee, should base their investment philosophy on these rules.  You can find them here.

Paraphrased here due to lack of space, the Act says that your investment and management decisions respecting individual assets and courses of action must be evaluated not in isolation, but in the context of the your portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to you.  This means that you should plan your investments to provide you with the income and growth you need and subject to the amount of risk you are willing to take. 

Furthermore, when you evaluate investments for your portfolio, look at how they will benefit the whole portfolio.  Sometimes an investment that appears risky on its own (emerging markets stocks as an asset class is a good example), when added to a portfolio, can lower the risk of the overall portfolio. 

The Act also says that when you make and implement investment decisions, you have a duty to diversify unless you have a good reason not to.  My advice is to maintain the diversified portfolio that you designed to provide you with income, keep up with inflation, and manage risk.