Diversify Within Investment Classes
So far we have looked at diversifying between defensive and growth assets in order to set an appropriate level of risk.
To further spread that risk, it is essential to diversify within each category, as well. For example, it would be madness to hold only one share. The company might go bankrupt. It is much safer to invest across many shares.
In this section we’ll go through each class of investments and show how to diversify within it in order to manage risk.
Cash and Alternatives
You might not need to diversify much within this asset class as it is already pretty safe. If you don’t trust the banking system in your country you may want to have accounts with different banks, or with overseas banks. If you are worried about the value of your home nation’s currency you may want to diversify out of that. Those worried about inflation in general may want to have some gold and/or cryptocurrencies for peace of mind.
Here are some samples:
|Savings Account (for daily expenses)||$3,000|
|High-interest, At-Call Account (emergency fund)||$20,000|
Can’t get simpler than that. This is fine for most people. Note that you’ll need at least one account for normal shopping, bills etc. that is easy to access, and which you’ll top up from your income each month. The emergency fund should be a higher-interest account, probably one that can’t be accessed with a card, but one that you can easily and quickly move over to your savings account should the need arise. If you are saving for any near-term goal, you might also have a term deposit/CD.
In the next example, ARS means Argentine pesos. Jose lives in Argentina:
|Savings Account .||ARS 170,000 .|
|Overseas Account 1||USD 10,000|
|Overseas Account 2||EUR 10,000|
Jose has diversified out of pesos because he is worried about inflation, and the accounts are overseas due to the risk of currency controls that might prevent him from easily accessing or transferring the funds. Note that he has diversified into a couple of foreign currencies to further spread the risk.
|Savings Account||$3,000 .|
|High-interest, At-Call Account||$10,000|
Bunker Barry is paranoid about the future of all currencies so he is diversifying into cryptos and precious metals. Note that even within those volatile cryptos he is further diversifying. If bitcoin collapses he still has his Etherium. He also, no doubt, has a radiation-proof basement, a decade’s supply of Spam and enough ammunition to take out the most determined zombie horde.
Remember, it is not essential for most people to diversify more than Steady Jeff does, but if you feel the need, that is how you might do it.
There’s an easy way and hard way to diversify within bonds.
Find a variety of corporate and government bonds, some short term, some long term, some local, some international, and invest in each yourself. Keep track of their maturity dates and any other relevant changes.
Invest in a bond index fund offered by an outfit like Vanguard or BlackRock (there are others). This fund diversifies across many kinds of investment-grade bonds, both government and corporate, in many locations.
If you invest in a bonds index fund, you needn’t worry about which bond is maturing when. You don’t need to worry about how reliable the corporate or government borrower is because the fund is well diversified across many investment grade bonds, so the risk is limited. Check the details provided for the fund to ensure this is spelled out – look for the words ‘investment grade’ and avoid ‘high-yield’, which means risky.
You go to the website, fill in the form, and invest in a bunch of bonds for as long as you like, in the one easy fund. Maximum simplicity plus maximum diversification.
A potential downside of these funds is that, at the time of writing, some of them are investing in insane government bonds that offer negative rates. However, this is a small amount of the overall investment and doesn’t seem to affect returns too badly. I just don’t like the idea of it. If you don’t, figure out how to invest in individual bonds for yourself, or suck it in and accept the unpleasantness.
Edit: some bond index funds are still getting returns of 3-4% in these times of apparently endless low interest rates. That’s better than cash for storing money you may need within the next few years.
Also available on many other platforms.