Dynamic Diversification

I like to think of dynamic diversification as being much like your options when you step up to the plate in baseball. As a hitter, you want to get on base and help your team score as many runs as possible. In most cases that means not trying to hit a home run every time you’re at bat. By taking a bit off your swing, you’re more apt to get on base and help the team score more runs.

It’s the same with investing. Trying to hit a home run every time at bat equates to investing in only the most volatile of investments. The most volatile investments will give you the best chance of making the most money in a short period of time, but if you strike out a lot, which you will when you’re swinging super-hard, you could lose most if not all your money.

Better to take a bit off your swing and try and a hit a single, double, or triple instead, depending on your risk tolerance for investing. Not only will your batting average improve, but you’ll be helping the team score more runs.

That equates to not exclusively investing in that small but hot new tech company, unless you’re investing money you can afford to lose. Even though that single stock may give you the best opportunity to hit a “home run” because of its extreme volatility, it’s better to purchase just a few shares. Mix those shares with the rest of your well-thought-out investment plan where small cap domestic growth investments are mixed with small cap value, medium and large companies, and perhaps an international element too as well as the appropriate percentage of not-so-risky investments.

Individual Securities

Should individual securities be part of your dynamic diversification? That depends on your enthusiasm for following and managing those stocks on a daily basis. That’s what it takes. Sometimes immediate action, like selling or purchasing shares is warranted based on recent happenings. Miss that release of earnings, a negative report from a reputable investment house, or news of a pending multi-billion-dollar lawsuit and you could be out of luck.

Obviously, the more individual securities you hold, the more time and effort it takes to manage. Only if you have the time and interest should you even consider holding individual securities. Blend them in with the rest of your investments as part of your customized investment plan.

For example, say you decide to take a position in that earlier referenced up-and-coming tech company. Integrate those individual shares into your investment plan, blending them along with your other domestic small cap growth investments, making sure the percentage you allotted for that part of your dynamic diversification isn’t exceeded. If need be, liquidate other domestic small cap growth investments to make room. Be sure news about that company is on your daily feed and be prepared to learn a lot about what it is they’re up to.

Your Company’s Stock

What about purchasing shares of company stock where your work? Certainly, following the goings on of your company won’t be nearly as hard since you work there. And there’s something to be said for having some skin in the game. Just be sure it’s not too much skin. If you can acquire that stock as part of your compensation package (stock awards) and/or at a discount [employee stock purchase plan (ESPP)], all the better.

Low-Cost Index Mutual Funds

What’s the big advantage of investing in vehicles like mutual funds and ETFs? You’re turning those day-to-day management of those individual stocks over to either a professional manager and/or a robot. That really cuts down on your investing money management duties and frees up your time for other activities.

Low-cost index mutual funds give you the ability to replicate the movement of a particular index at a very low cost. Spreading investments over multiple funds representing different indexes that represent the areas of your dynamic diversity gives you the ability to super-diversify your investment plan, which should be your aim. Low expenses, no fees to buy and sell, and the ability to reinvest dividends makes them great choices for tax-advantaged accounts.

Exchange Traded Funds (ETFs)

ETFs, in their purist form, have the same goal as index mutual funds: Replicate the performance of a particular index. The big difference is how they’re bought and sold. ETFs transact during the trading day like stock. Index mutual funds can only be bought or sold shortly after the market’s close and after the fund’s net asset value is determined.

If brokerage-free ETFs can be made a part of your plan, they very well may present an even lower-cost investment opportunity than a like index fund. Be sure to consider expense ratios, any additional costs, as well as the ongoing management duties of any investment you’re considering.

Don’t think that a one tenth of one percent savings in your expense ratio is no big deal. It is a big deal, especially if you’re talking about a longer-term investment plan like with retirement. That year-after-year savings can equate to tens of thousands of extra dollars (or more), which is a very big deal.

ETFs do require more management than index mutual funds, so make sure you consider that extra time commitment when choosing:

  • ETFs must be bought and sold during the trading day, so you need to understand how to properly execute a trade to acquire and sell shares. More sophisticated trading tools can make that extra management more tolerable.
  • You can’t automatically reinvest dividends paid by ETFs like you can with index mutual funds. ETFs usually pay dividends on a monthly, quarterly, or yearly basis. Since most investment plans call for the reinvesting of dividends, that means you’ll have to do it yourself which is an ongoing management commitment.

Actively Managed Mutual Funds

Proceed with caution when researching actively managed mutual funds. There are bad actors out there who want to deceive you so they can make more money. Very few actively managed mutual funds beat the performance of their fund’s true benchmark index year after year, which is why you should never trust an investment company’s promotional material when looking at performance and cost. Go right to the prospectus.

Even then, be careful. Some funds try and present a rosier performance by comparing their return to a less appropriate benchmark. For example, a large growth mutual fund may compare themselves to the S&P 500 index because it happens to make them look better, all the while lagging their true benchmark, a large growth index without the value element. Keep in mind you can duplicate that large growth index’s performance cheaply and easily with a low-cost index fund or ETF.

Get the actively managed fund or ETF trading symbol, as well as the trading symbol of the fund’s true benchmark index. Common indexes on the risky side include S&P 500 (GSPC), Dow Jones Industrial (DJI), Russell 2000 (RUT), and MS EAFE. Over on the not-so-risky side there are Bloomberg US Corporate Bond, Lehman Aggregate Bond, and Barclay’s Global Aggregate Bond indexes.

Leave the site and compare the two’s return history at your favorite investor app, whether that be your broker’s software or other reputable site that provides historical returns. Look at year-to-date, one-year, three-year, five-year, seven-year, and if available ten-year returns for both.

Many look pretty good, with returns just a few percentage points below their true benchmark. The unwary may make that investment, thinking a percentage point or two lag is no big deal. You know better.

Most actively managed mutual funds and ETFs don’t outperform their benchmark year after year. If your research shows you that’s the case, go with the appropriate index mutual fund or ETF instead of the actively managed fund. Still, there are some actively managed gems out there on both the risky and not-so-risky sides you may uncover, which is why your investment plan may contain some actively managed funds in addition to the passively managed ones.

Dynamic Diversification

Why dynamic diversification instead of just diversification? Because, just like your dynamic risky to not-so-risky ratio, your diversification needs to change over time. It needs to go from risky to less risky just like your ratios.

When decreasing your risk on a year-to-year basis through your risky to not-so-risky ratios, free up money on the risky side by raiding your highest risk investments. That means raiding international and small cap domestic growth and small value holdings, those being the most volatile, and moving that money over to the not-so-risky side.

More conservative investors and those with goals who are in their latter stages might have already depleted their international and small cap holdings, if they were ever a part of the plan in the first place. In that case, go after the next-riskiest asset class, be it mid-cap or large-cap stock. Continue in this manner until the plan calls for a risky to not-so-risky ratio of 0-100, when risky investments will be completely depleted.

Even then, continue with your dynamic diversification on the not-so-risky side. Start with high-yield corporate and junk bonds, if applicable. Move on to liquidating holdings of medium and eventually short-term bonds until 100% of your money is invested in an insured money market or high yield savings account during the last year of the investment plan. This is true regardless of your risk tolerance or the type of financial goal.