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Investment Diversification And Ways To Achieve it

By Tom 12 Comments

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Investment Diversification

Investment Diversification

As investors, we hear a lot about investment diversification.  Furthermore, there is an old saying:  no one should put “all of their eggs in one basket”.  Why?  

Because investment diversification reduces the risk of a large loss in one holding wiping out an entire portfolio.

Investment portfolio diversification is a timeless investing principle.  In addition, investment diversification serves to increase risk-adjusted return on investment.

TWO PRIMARY FORMS OF INVESTMENT DIVERSIFICATION

The two most typical forms of investment diversification definitions we hear about are:

  • International diversification, and
  • Diversification across asset classes

INTERNATIONAL INVESTMENT DIVERSIFICATION

There is money to be made by investing all over the world.  Rather than just your home country.  International diversification addresses that concept.

ASSET CLASS INVESTMENT DIVERSIFICATION

Diversification across asset classes focuses on the investor’s risk tolerance.

Most importantly, no tolerance for the loss of your capital?  You should stick to cash and short term bonds.  Opposite, do you want more potential return and are risk tolerant?  Then, put some money in small capitalization growth stocks across the globe.

Related:  How to build a Vanguard 3 fund portfolio paying dividends

A THIRD FORM OF INVESTMENT DIVERSIFICATION

I think of diversification in a third way.  That is, diversifying up and down the corporate capital structure.

As an accounting teacher, I tell my students that for every asset a company buys, they must finance it in some way.  Especially relevant, they finance each asset within their capital structure.  As a result, corporate capital consists of liabilities and equity.

As investors, we can participate in the profits of a company by investing our hard earned money.  We can also participate in all forms of financing including loans and bonds up and down the capital structure of businesses.

Here are several examples.

Short-Term Floating-Rate Demand Notes

Do you want to squeeze a little more return from your liquid cash holdings?  Many companies issue these notes direct to private investors.  They look and act like money market mutual funds with check writing privileges.  In reality, you are investing in ultra-short term unsecured notes of the company.

While taking on single company risk with your money, you are rewarded with a higher interest rate.   Normally a higher rate than the typical money market fund or savings account.  Some well-known companies offer these notes like Caterpillar Financial Services, Duke Energy and Ford Motor Credit Corp to name a few.

Bank Loans

Many companies finance their capital requirements through bank loans.  These typically take the form of senior, floating rate debt.

Senior means the bank has a security interest in specific assets of the company if the company can not repay the loan.  Floating rate means the interest rate changes frequently based on the current level of interest rates.

Hence, bank loans are like a floating rate mortgage on your home.  The bank holds a security interest in the property if you default.  And, they adjust your interest rate as market rates change.

As an investor, by resetting the interest rate on a periodic basis, your potential loss of principle in a rising interest rate environment is reduced.  And, unlike more traditional notes and bonds, the investor’s interest payments rise along with market-based rates.

The best way to access bank loans is through a fund or ETF.  One of my favorite mutual funds in this area is the Fidelity Floating Rate High-Income portfolio (FFRHX).  The expense ratio is a little higher than I would like, but I think active management can pay off in this area.  Why?  Many companies that use bank loans tend to have more debt.   Consequently, they can be riskier.

Bonds

In exchange for an investor’s cash, bonds are quite simply a promise to pay the bond holder a series of fixed interest payments during the life of the bond.  In addition, a bond includes a promise to pay back the principle when the bond matures.

Bonds come in various maturities ranging from a few years to 30 years or more.  In addition, they can have special features like being callable at an earlier date than maturity.  Or, be convertible into the company’s stock.

Bonds carry more interest rate risk than bank loans since their interest rate is fixed.  As a result, a bond market value will move in an inverse relationship with market interest rates.

In contrast, the bond value will move in a direct relationship with the company’s credit score.  In other words, a lower credit score means a lower market price for the company’s bonds and vice versa.  These risks can be reduced by buying individual bonds of credit worthy companies and holding them to maturity.

You can purchase individual bonds through your broker or by purchasing a mutual fund or ETF.  I prefer the ETF route.  You can’t go wrong with a bond ETF from Vanguard.   Low cost and instant diversification can be achieved from the Vanguard Intermediate-Term Corporate Bond ETF (VCIT).

Preferred Stock

Preferred stock is a hybrid security that has a mix of bond and common stock characteristics.  The investor doesn’t have the upside potential like common stock.  Rather, the investor receives high income from a hefty dividend yield.  In addition, the investor receives preferential treatment above common stockholders on the receipt of those dividends.

Banks, insurance companies and utilities are big issuers of preferred stock.  Like bonds, you can buy individual company issues through your broker or invest through mutual funds and ETFs.  The I Shares US Preferred Stock ETF (PFF) is one example of a low-cost fund with many preferred stock holdings.

Common Stock

By owning common stock of 1 or more companies, you are part owner in that business.  And, participate in all the potential rewards and risks that go with ownership.

I favor blue chip stocks that pay dividends.  I like the company doing the work for me.

WRAPPING IT UP

Review your investment holdings periodically.  And when you do, don’t forget about good investment diversification practices.  Take a look at all the ways businesses finance their cash needs through their capital structure.  See if any of these financial instruments should have a larger place in your portfolio: 

  • Short-Term Floating-Rate Demand Notes
  • Bank Loans
  • Bonds
  • Preferred Stock
  • Common Stock

Already have these investment bases covered.  Then, you may want to consider some hard assets for your investment portfolio.

Do you diversify across the entire corporate capital structure?  Do you have a different investment diversification strategy?  In addition, are there other forms of corporate financing you invest in but are not discussed here?

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Investment portfolio diversification is one key to investing money wisely. Click to read and learn how to go about it in this investing for beginners article. #investing #investingmoney #howtoinvest #investmentportfolio #investingforbeginners

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Comments

  1. dividendgeek says

    December 27, 2018 at 9:58 pm

    Or you could own a target date fund 🙂 I am not sure if too much of slicing and dicing helps. Bogles recommendation is to keep the mix as simple as possible. I stick to US equities, international equities and bonds. I don’t own much of small/mid cap.

    Reply
    • Tom says

      December 28, 2018 at 5:27 am

      Just exploring some options DG. And agree, can’t go wrong with keeping it simple. Tom

      Reply
  2. DivvyDad says

    December 28, 2018 at 9:01 am

    Nice post Tom, and admittedly I have never really considered the diversification across the corporate capital structure. I’ve looked at preferred stock a little bit but haven’t taken any action on that front–might be a good task for the coming year.

    Reply
    • Tom says

      December 28, 2018 at 9:25 am

      I think it’s the former corporate finance guy in me that led me to that perspective DD. I think with the interest rate increase cycle starting to be closer to the end than beginning, it’s not a bad time to take a look at both bonds and preferreds. Tom

      Reply
  3. Div.Income says

    December 29, 2018 at 8:35 am

    Hi Tom,

    nice post but I am not really sure if too much diversification is really good. Nevertheless I want to have a look at a Bond ETF as well. Through the increasing interest rate it is probably not wrong to be invested in the sector as well.
    Besides that I more or less diversify my stock picks by sector, currency, country etc.

    Reply
    • Tom says

      December 29, 2018 at 9:39 am

      Diversification is definitly a balancing act and too much of anything is not necessarily a positive. I think it is a good time to look at a low cost bond ETF. I have been adding to one of mine recently. Tom

      Reply
  4. Miguel (The Rich Miser) says

    December 29, 2018 at 11:35 am

    Hi Tom,

    Super-informative post! I’m saving this one for my next round of “active” investing. In particular, I had forgotten all about preferred stock.

    Cheers,
    Miguel

    Reply
    • Tom says

      December 29, 2018 at 1:02 pm

      Thanks Miguel. Preferred stock is a great source of income. There are some great low cost ETFs to get started. Happy New Year. Tom

      Reply
  5. Simple Money Man says

    January 2, 2019 at 3:01 pm

    I’ve never really looked into this form of diversification. Apart from formal education, I truthfully do not have much knowledge about it; maybe that’s why. I do own a bond fund with a nice yield.

    Reply
    • Tom says

      January 2, 2019 at 3:12 pm

      You probably engage in it more than you might think without really knowing it. If you lend or invest in businesses SMM you are diversifying across their capital structur. Tom

      Reply
  6. GYM says

    January 3, 2019 at 3:02 am

    I got a bit burned with preferred shares, but still have them. Sold a lot of my position at a major loss at a few years back.
    Great post on diversification, Tom!

    Reply
    • Tom says

      January 3, 2019 at 6:23 am

      GYM, Preferred shares (like most everything) got hit really hard during the financial crisis. I got burned a little too back then, but made up for it by adding after the crisis before the share prices recovered. Tom

      Reply

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