The Nobel Prize-winning economist William Sharpe called it the golden rule of investing. Fellow Nobel laureate Harry Markowitz declared it "the only free lunch in finance." And financial historian and author Peter Bernstein described it as "the only rational deployment of our ignorance." What am I talking about? Diversification, the cornerstone on which every sound investment strategy is built.

Diversifying your portfolio, or "not putting all your eggs in one basket," as your grandmother might have called it, isn't just good old-fashioned common sense. Financial academics have shown it really is the best strategy for the vast majority of investors.

For a start, it protects you from concentration risk, or non-systematic risk as it's often called — in other words, risk that is specific to a particular security or industry. Diversified investors barely noticed the impact of companies like Enron, Lehman Brothers or General Motors going bust, for instance, or the decline of once major U.S. industries like textiles, mining and steel.

As well as reducing risk, diversification has also been shown to produce superior long-term returns by giving investors access to a wider range of investment opportunities.

Leading Academics Have Addressed This Question

But what does a properly diversified portfolio look like? Well, over the years, some very prominent academics have addressed that crucial question.

In a paper published in September 1964 — 60 years ago this month — the afore-mentioned William Sharpe posited the idea of a "market portfolio" — a theoretical mix of assets containing every investable security. In fact no such thing exists, but if it did, this market portfolio might in theory contain every publicly listed stock in the world and every available bond.

As well as offering investors exposure to every single security, this hypothetical portfolio would also be very well balanced. Stocks are considered a risky asset, bonds a safe asset. Historically, stocks have provided very much higher returns than bonds in the long run, but with much more volatility. The beauty of holding both is that, generally speaking, their returns are negatively correlated; in other words, when stock prices rise, bond prices tend to fall, and vice versa.

But would a portfolio comprising every stock and every bond be perfectly diversified? Some, for instance, would argue that a true market portfolio should contain assets other than stocks and bonds — real estate, for example, commodities, and even cryptocurrencies. As we've explained elsewhere, we at IFA disagree: stocks and bonds are really the only asset classes investors need to focus on.

That said, we don't think the every-stock-and-every-bond portfolio is the optimal portfolio either. Let me explain, and I'll try to keep this simple.

Not All Stocks (or Bonds) Are Equal

What you need to realize is, there isn't just one type of stock or one type of bond. So, for example, there are large-cap stocks and small-cap stocks, and growth stocks and value stocks. A diversified investor needs to own all of these different types.

Say you own just two funds — first, a global total market equity fund like the iShares MSCI ACWI ETF (ACWI) or the Fidelity Total International Index Fund (FTIHX), and secondly, a bond equivalent such as the Vanguard Total International Bond Index Fund (VTABX) or the SPDR Bloomberg Global Aggregate Bond ETF (BNDW).

A combination of funds like these is actually very sensible. Because the funds are total market funds, it means the investor owns different types of securities — both small and large stocks, for instance, and both value and growth stocks. But can an investor do even better than that? We say they can, and here's why.

Financial academics including Eugene Fama and Kenneth French have shown how certain types of stocks have delivered higher returns than the broader over the very long term. For example, small stocks have outperformed large stocks and value stocks have outperformed growth stocks. We refer to these as risk premiums or risk factors.

Although, as I've said, a total stock market fund does contain both small and value stocks, it does not provide exposure to either the size factor or the small factor. This may seem like a finer detail, but it's actually very important, because the way to diversify and maximize expected returns is to diversify across factors, and not just across stocks.

The Ice Cube Tray Analogy

How, then, can we diversify a client's portfolio across different risk factors? Well, we do this by "tilting" the portfolio so that it owns more than the market's share of small and value stocks.

Our friends at Dimensional Fund Advisors like to use the analogy of an ice cube tray to explain how tilting works. When you fill an ice tray with water, you try to get the water to spread evenly into each section. This is like investing in broadly diversified low-cost index funds. You're effectively spreading your investments across the entire market, in order to capture the market's general growth, called "beta", cheaply and efficiently.

Factor investing is like tilting the tray slightly. Instead of distributing water evenly, you focus on specific sections, emphasizing characteristics like size and value that have been shown to perform better over time. Essentially, you're "overweighting" investments expected to do well and "underweighting" those that might underperform.

So is factor investing an active or passive investment strategy? Strictly speaking, although it's rather closer to passive, it's actually neither.  Instead it uses data and evidence to try to deliver the outperformance that active investors aim for at a cost that's closer to passive investing. And because factors have been identified in bonds as well as stocks, it's a strategy that can equally be applied to bond investing too.

Again, capturing the total market return by investing in traditional, market-cap-weighted index funds is not a bad strategy at all. But, if you have a long investment horizon and want to give yourself the best possible chance of outperforming the broader market, then factor investing is the way to do it.

How To Invest This Way

So how do we go about it? The first step is to identify your risk capacity, which you can do by completing our risk capacity survey. This is very important to do, because your capacity for risk is unique to you, and if you get it wrong, you could easily become badly unstuck.

Once we know your risk capacity, we can then find a portfolio that matches it precisely. And we don't use that word, precisely, lightly. As Mark Hebner writes in Step 11 of his award-winning book, Index Funds: The 12-Step Recovery Program for Active Investors: "Close enough isn't good enough for investors who want to maximize their ability to capitalize on the trade-off between risk and return.

"For this reason, when selecting a risk exposure, the primary consideration should be identifying and investing in a blend of indexes that most closely matches an investor's risk capacity."

Remember, your future financial security is at stake. You shouldn't be playing a game of hit or miss. So, let's start building your optimal portfolio, based on decades of peer-reviewed academic research.

 

---

HOW CAN WE HELP YOU?

Do you have any questions about this subject, or any other issue related to investing? If you do, we would love to address them in future content.

Simply email your question to [email protected] with your name and where you live and we'll do our best to answer it.

---