Is Diversification and Asset Allocation Important?

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I have read or heard some widely differing advice recently, some of it even silly, in the "mainstream" financial media regarding diversification and asset allocation.

Here are some examples:

1. Without providing any basis, a certified financial planner was quoted in a leading magazine: "You should have at least 50% of your money in stocks, 40% in bonds, and 10% in cash in order to fully diversify and protect your portfolio against downside risk. That mix has historically provided the best return."

2. Another "expert" writing for a financial publication: "The portion of your portfolio that stocks comprise should be less than your age subtracted from 100". 

3. A stock analyst on one of the cable TV channels stated "you should own one stock from each of the major sectors, don't buy another stock until all sectors are covered and that one of your investments should also be a high yielder". High yielder wasn't defined in any detail. 

I don't strive to achieve a certain mix of stocks, bonds and cash or a fixed number of stocks in a certain sector.

I do recognize that I don't want all my eggs in one basket and allocate my assets by looking at it from the perspective of risk. If something goes wrong (think Enron or the financial crisis of 2008) I do not want to lose money that I will need in the short term (1 to 5 years) or in the case of an emergency. Those funds should be kept in a bank account, CD, or a Treasury bond. Also, before picking stocks I made sure my 401k contribution was maxed out.

Anything left over can (and should) be invested in stocks. Determining which ones is more of an art than a science. 

Sometimes diversification happens when you are searching for one type of company and also find another in a different sector.

I'll provide an example. I was looking for businesses with solid earnings growth and balance sheets that consistently pay dividends.  

Two are Procter and Gamble (NYSE: PG) and McDonald’s (NYSE: MCD).

Most people go to the grocery store once or twice a week. Look down almost any aisle and you will see a P&G product. Tide laundry detergent, Gillette razors and Pampers are some of the things that they produce. Almost everyone needs those things. The stock pays a dividend of $0.56 per share and yields about 3% at the current price. 

After shopping drive down the interstate and pull off an exit. Any exit. Most likely you will find a McDonald's there. Order up a Big Mac for yourself and a Happy Meal for the kids. This has been happening for over a half century. Lots of cash being generated to keep paying and increasing the $0.77 per share dividend. 

Off that same exit ramp there will probably be a gas station or two. You might see a Chevron (NYSE: CVX) sign. Fill up your tank; most people do so every week. The cash flow drives a dividend payment of $0.90 a share. I've had my eye on the stock. It may be a good buy based upon many factors including low debt, a P/E ratio below its peers and past history and earnings growth averaging 12% per year over the last 5 years. 

So by looking at where a strong consumer product company operates its business I also found another strong company that happened to be in another industry. The end result might be diversification but that was not the intent at the beginning of the process.

Apple (NASDAQ: AAPL) produces the iconic iPod, iPhone, and iPad devices in addition to several types of computer and networking products. Millions of these items are sold all over the world. The company is the most valuable by market cap, which over the last 10 years has increased by over 100 times.

<img height="309" src="http://media.ycharts.com/charts/01a87b73f5b9322437b8177527b4315f.png" width="440" />

AAPL Market Cap data by YCharts

While researching Apple I came across several articles discussing suppliers for their products. Besides the many tech stocks that you would expect to be on the list one less traditional company stood out: Emerson Electric Co. (NYSE: EMR). Emerson is one of the Dividend Aristocrats; companies that have been paying and increasing their dividend for at least 25 consecutive years. Emerson stock yields 3.3% and the dividend has doubled over the last 10 years. Looking at one very strong growth stock, allowed me to find one from a different category, a dividend grower. Again the result is diversification, although that was not the intent at the start. 

<img height="304" src="http://media.ycharts.com/charts/e3c52c01f01bb1dd7eafb504da4a3a6f.png" width="426" />

EMR Dividend data by YCharts

In summary, my advice to you is to be careful regarding any advice you may hear on the subject of diversification and allocation. It may be better to allocate using a risk-based approach. Have your ducks lined up before diving into the market. And in the natural process of finding great companies you might also find another one in a different bracket that diversifies your portfolio anyway.

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Mathman6577 owns shares of Apple, The Procter & Gamble Company, and McDonald's. The Motley Fool owns shares of Apple and McDonald's. Motley Fool newsletter services recommend Apple, Chevron, Emerson Electric Co., McDonald's, and The Procter & Gamble Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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