How to Understand Why Mutual Funds Aren't Diversified

In light of the recent stock market crash, I’d like to discuss something that’s very fundamental to modern portfolio theory. And that’s something is diversification. And the idea of diversification basically says that if you have a portfolio that has assets in it, that do not all move in the same direction, then you can decrease risk and increase overall investment performance. And so the idea is that the assets in that diversified portfolio will have what’s known as the low correlation and if one of them has a significant loss of value then whatever created that loss of value will not carry over into the other assets and so instead of having your entire portfolio crash just that one asset has crashed and maybe another one will have done well at the same point and overall the entire portfolios is going to be okay and have very low risk.

Now, the theory of diversification makes a lot of sense but let’s take a look at how you can apply it. I think one of the biggest lessons from the stock market crash of 2008 is that the entire stock market can act like an asset class. The entire stock market went down in 2008, that’s unquestionable. But what nobody is talking about is what that means to diversification. What that means to diversification is that it is impossible to diversify only within the stock market. It absolutely requires that you’ll get into another asset class as well. And so people who have truly diversified portfolios that include direct to ownership or real estate, precious meadows, private equity, private debt had only the publicly traders securities portion of their portfolio lose significant value in 2008 while the person who wasn’t really diversified had all of their money in the stock market. They thought they were diversified because they had a little bit of everything in the market but we’ve learned that the market can move all as it so in asset class, everything in one direction downward or upward.

If you’d like to learn more about how to own alternative assets inside your IRA or your 401k, visit my blog at jeffnabers.com or subscribe to my video channel.


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