Diversification Is Sometimes an Illusion: This Investing Approach Makes It Real
A broad range of stocks, bonds and savings vehicles doesn't equate to a truly diversified portfolio. This wealth adviser's unique take on spreading your investments can help.
Wise investing calls for diversifying your portfolio, so that's what people try to do.
They spread their money among several stocks. They add bonds because bonds are supposed to be the "safe" part. They toss in mutual funds and exchange-traded funds. For a little principal protection, they may include a CD and a savings account. And then they relax because they think diversification has been achieved.
But it's often an illusion.
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Take a closer look at those investments and you'll see they have something in common. Other than the CD and savings account, they're all bought and sold in the same markets, priced by the same market forces and exposed to the same fundamental risk. Bonds may feel safer than stocks, but they are still market investments, with no guarantee of principal.
2022 proved the point. The S&P 500 lost roughly 18% that year, and the broad U.S. bond market fell about 13%, one of its worst years on record. Investors who counted on bonds to cushion a stock decline watched both fall together.
True diversification, in its most meaningful sense, requires assets that are not highly correlated. In other words, assets whose values do not rise and fall together in response to the same conditions.
Fortunately, there is a way to pursue true diversification: Spread your investments among three worlds — the Market World, the Protection World and the Alternative World. At our firm, we refer to this trio of options as the Triversified™ Approach.
Investing's necessary trade-off
Every investment balances three attributes. The first is reward — the potential for growth and income. The second is safety — the protection of principal and predictability of outcomes. The third is liquidity — how quickly an investment can be converted to cash without a meaningful loss in value.
No single investment can maximize all three. Trade-offs are inevitable, but you want those trade-offs to be intentional, not happenstance.
How the 'three worlds' work
Each world emphasizes two of those attributes and gives up something on the third. That's what allows them, as a group, to do what none can do alone.
The Market World. This prioritizes reward and liquidity. Investors have access to the universe of publicly traded securities: Stocks, bonds, ETFs, mutual funds and more. They can buy and sell on any trading day, and the potential for growth over the long term is significant.
What the Market World can't offer is safety in any guaranteed sense. For stocks and bonds alike, principal is always at risk and returns are never promised.
The Protection World. This prioritizes safety, along with varying degrees of liquidity. It includes FDIC-insured CDs and savings or money market deposit accounts, as well as insurance-based instruments such as annuities and certain life insurance structures.
Depending on the tool, principal can be protected by FDIC insurance or by contract, and some annuities can provide principal protection and income for life regardless of market conditions. Insurance guarantees are backed by the claims-paying ability of the issuing company.
What the Protection World demands in return is a ceiling on reward, and in some cases, limitations on liquidity.
The Alternative World. This prioritizes reward and stability. Alternative investments, such as private credit, private real estate, structured income strategies and similar instruments, operate largely outside the rhythms of public markets.
Because they aren't bought and sold on an exchange, their values tend not to swing daily with the headlines the way the market does. Their limited liquidity is precisely what makes that stability possible.
The trade-off is access to your money. Redemptions may be limited to set windows, and these investments carry their own risks, including credit risk and the potential for loss.
Breaking free of the illusion
None of these worlds is sufficient on its own.
The Market World without the Protection World leaves the investor exposed to unpredictable sequence of returns risk and without an income floor.
The Protection World without the Market World sacrifices the long-term growth that a multi-decade retirement requires.
Either world without the Alternative World leaves meaningful yield potential and higher volatility on the table.
Together, the three worlds form a more complete investment architecture, one in which every dollar has a purpose and every trade-off is intentional.
No approach can eliminate risk. But a portfolio built this way is designed to help pursue growth, generate more reliable income and protect what matters most across a wider range of economic conditions than any single world can on its own.
A successful retirement isn't achieved by finding the best stock, timing the market perfectly or discovering some market secret that few others know about. It's achieved by understanding the rules that govern how capital behaves across all three worlds and building a portfolio accordingly; one that is truly diversified, and not an illusion at all.
Ronnie Blair contributed to this article.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
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