Static diversification
Many investors know about diversification. But few understand the difference between dynamic diversification and static diversification.
Diversification means putting one's money into several investments. This can achieve a better performance because even if one of the investments decreases in value, the others might increase, resulting in a portfolio that is more stable than any individual investment.
There are several mistakes that people commonly make when diversifying their portfolio. First, simply putting one's money into several investments does not constitute diversification. This is because many investments have similar returns. More precisely, many investments are highly correlated with each other. This means that when one of them gains, the others gain as well; and when one of them loses, the others lose as well. Putting one's money in several such investments is similar to just putting it into one of them. If two investments are highly correlated, then investing in both of them will not improve portfolio risk.
Another pitfall is called static diversification. This means following a simplistic allocation rule that is based on very long-term data. An example of such a rule might be "70% stocks / 30% bonds". Such rules of thumb might sound good at first. After all, more data might appear to mean more precision.
One problem with static diversification is that it does not respond to changing market conditions. In the above example, an investor would keep 70% of his money in stocks, ever during the times when stocks severely underperform bonds.
Another issue is that static diversification recommendations are often too vague. Even if we buy the idea that we should always keep 70% of the money in stocks and 30% in bonds, the obvious questions becomes: Which stocks and which bonds? In a sense, the recommendation is a non-recommendation because there are so many indices, sectors, and industries to choose from.
The proper approach to diversification, the approach that we take, is asset allocation that responds to changing market conditions. When stocks are doing well, we can have all or most of our money in stocks. But when stocks are doing poorly, we do not need to keep any of our money in them.
Also, of course, our newsletters make very specific recommendations. You will never find us recommending that you put some money into "stocks". We give you the specific name and symbol of the investment and the specific percent of your money that should go into that investment.