The Elements of Investing: Part III

Working Windmills in the Netherlands

Chapter three of the Malkiel and Ellis book, The Elements of Investing, contains four parts, all related to diversification.  I’ve written about diversification of the family portfolio over on Seeking Alpha.  If interested in this argument, here is the link.

Malkiel and Ellis write about the more standard ways to diversify a portfolio and I’ll go into this below.

The four areas of diversification explained in detail in Chapter three are:

• Diversify across asset classes.
• Diversify across markets.
• Diversify over time.
• Rebalance

Diversification across asset classes is standard procedure for all the Relative Strength portfolios.  The Schrodinger and Bohr are built around this argument.  What this simply means is that a portfolio should include value, growth, large-cap, mid-cap, and small-cap stocks.  This is easily done with index ETFs.  Asset classes will also include precious metals, commodities, and bonds if one wishes to have these asset classes in the portfolio.

Diversification across markets is certainly handled by Dual Momentum portfolios where U.S. Equities and International Equities bridge different markets.  Every portfolio tracked here at ITA embodies this type of diversification.

Diversification over time is frequently referred to as dollar-cost-averaging.  In other words, don’t invest everything at the same time.  Spread out your investments over time.  This is quite easy for the young investor just starting out.  Invest the minimum amount to open up a broker account and then begin to save monthly.  Another option is to invest more if the market declines and less if the market is rising.  To be more specific, suppose you have a plan to invest a sum each payday.  If the market is below where it was when you last invested, then invest a larger sum of money.  If the market is higher than it was the last time you invested, then invest less and save the difference for the time when the market declines.  This takes more discipline than investing the same amount each month, but it may pay off in the long run.

Rebalance the portfolio is the last diversification point.  If you are following the Asset Allocation model for investing and you have target percentages for each asset class, as is the case with the Schrodinger and Bohr portfolios, it is necessary to rebalance about once every year to three years so as to keep the asset classes within the recommended percentage limits.

There you have the major points of Chapter three from The Elements of Investing.  I highly recommend this simple, yet basic investment book.

Part I

Part II

The Golden Rule of Investing