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Diversification is a requirement when spicing up your portfolio

Reprinted courtesy of MarketWatch.com.

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If you are a chef making what you hope will be a successful stew, you will know intuitively that your choice of ingredients — and the quantities — will have a profound effect on the final product.

Likewise, as an investor, you can’t put just anything into a portfolio and expect to be successful. In my first book, “Live It Up Without Outliving Your Money,” this topic took six chapters. Here, I’ll give you the basics along with some links for more information.

Gathering the ingredients

It’s easy to ignore all the details of diversification. But I hope you won’t.

When you’re making a stew, you can grab whatever ingredients are handy and throw something together. If the outcome is mediocre, tomorrow is always another day. When you wash your car, being lazy is not likely to produce any life-altering consequences.

But when you are managing your life savings, a mediocre outcome lasts a lot longer — possibly forever. The consequences can change your life.

Lazy investors often try to get by with only three mutual funds: one that owns U.S. stocks, one that owns international stocks and one that owns bonds. But you gain a huge advantage when you own small-company stocks and value stocks, as well as foreign stocks, which now make up more than half the world’s total market capitalization.

Over the long haul, stocks of small companies produce big returns. Research going back to 1926 shows a pronounced difference in the returns of stocks of small companies and those of large companies.

Where size and value fit in

Over many periods, small-company stocks — for example the MicrosoftMSFT, -1.87%  of 1987 — outperformed large-company stocks — for example the Microsoft of 2015.

Taken one at a time, small young companies are very risky. But if you buy enough of them, you’ll pick up those that grow to become the giants of tomorrow. As an asset class, these stocks often pay off handsomely for investors who can take the risks.

I’m not recommending you put all your money into small-company stocks. But if you use a mutual fund to put some of your money into hundreds or even thousands of small-company stocks, you’ll most likely benefit from what the academics call “the size effect.”

Another extremely important asset class, known as value stocks, focuses on companies that have low prices and are out of favor with investors. These stocks are risky, but owning them by the thousands is a good way to make money. In my book, I give some interesting examples that make worthwhile reading. The difference isn’t trivial.

The value effect works with small-company stocks too. In fact, small-cap valuestocks have been stunningly productive over long periods of time.

Putting the world to work for you

Once you accept the fact that diversification is good and you make the choice to include value stocks and small-company stocks, it takes almost no extra work to invest outside the United States as well. I call this putting the world to work for you.

I recommend that you have half your equity investments in stocks of international companies, including international value stocks, international small-cap stocks andinternational small-cap value stocks.

In addition, you will likely benefit from including emerging-markets stocks in your portfolio for their demonstrated ability to provide premium returns at reasonable levels of risk.

Even if international stocks don’t increase the long-term return of a portfolio, the additional stability they bring is especially valuable to retirees who are withdrawing money from their investments. In fact, international stocks can make the difference between a retirement portfolio that lasts a lifetime and one that runs out of money prematurely.

Where real estate fits in

There’s one more asset class I recommend: commercial real estate such as office buildings, parking lots, shopping malls, theaters, apartment complexes, hospitals and other real estate that makes money. It’s easy to do this through mutual funds that own real estate investment trusts known as REITs.

The main point of investing in commercial real estate isn’t to increase your returns, although sometimes it will do that. The point is to improve your portfolio’s diversification and decrease your overall volatility.

OK, I confess that in this short column we have covered is a lot of ground — and I’ve given you lots of additional reading material. You may be wondering: Is all this diversification really worth it?

I think the answer is yes, and you will find the details in one of my favorite articles,The Ultimate Equity Portfolio. You might think that massive diversification adds risk, but that article shows that just the opposite has been true.

Let me sum up the case this way:

When all is said and done, the evidence for diversification is so compelling that this should be an easy choice for you. Depending on how much money and how much time you have, proper diversification could be worth $1 million to you — perhaps even more.

Whether or not you take my advice, choosing your asset classes is certainly one of the most important decisions you will make as an investor. I hope you will take the time to make it carefully and thoughtfully.

To hear the audio version of the book chapter on which this article is based, check out my podcast “How Will You Diversify Your Investments?”

Richard Buck contributed to this article.