Diversification has taken on many meanings within the past few decades depending on who you talk to, and in my opinion, I think on the way we lost its true meaning.  I believe the reason for losing the real meaning of the word is due to the financial services industry bending and flexing it to their benefit.  Putting the question of diversification to someone within the traditional financial services sector, is like asking someone in the oil business what is the best source of energy?  It would be a safe bet that both answers would be skewed in favor of what they could sell you.  So, what really is diversification?  The definition, according to Webster’s dictionary is, “To make diverse: give variety to.”  So, to translate Webster’s definition to real world purposes, let’s explore some opinions on what supposedly qualifies as diversification?  The large brokerage houses like Fidelity, Schwab, J.P. Morgan, and most others all pretty much say the same thing, “A basket of stocks that cover many sectors in a weighted fashion.”  Well, I think we have all heard that before and it sounds like good advice if stocks were the only thing we were able to invest in.  Fidelity outlines this approach on their website by stating one of the simplest, most common philosophies used in the traditional investment world when speaking about diversification, “By spreading your money out over different kinds of investments - stocks, bonds, mutual funds, and cash - you generally reduce risk without sacrificing potential returns.”  Though I think we can all agree that the aforementioned is true, I think we can also agree that the stock market and bond market tend to counter move each other thus affecting each other.  Also, consider that Fidelity only talks about what they can sell you, i.e. stocks, bonds, mutual funds, and money market cash accounts(what I like to call “The Traditional Four”).  Merrill Lynch’s website states a similar philosophy and their version of diversification is either small cap or large cap, value or growth, and domestic or international.  That still refers to publically traded financial markets, and again only offers products that they can sell you.  

Most of the people reading this know that the stock market or the financial markets as a whole are basically a place where companies in the world can present and solicit themselves publicly.  But one must consider that, due to globalization and advanced communication, all the exchanges in the world seem to operate as a single market place that have access to the same media and have the ability to influence each other.  If you had a basket of stocks that you thought was diversified because it was covering many industries, and because it traded on one or more of these global stock markets operating as part of the larger single market, isn’t there a fundamental diversification problem with this?  What I see is only one marketplace; hence, it is not diversified and a glaring example of this is the current credit and subprime crisis.  Ask yourself if you would invest all of your money in say, only the NASDAQ?  If you answered no, then your common sense is telling you that a single market is not diversified enough, and not safe enough.  Through reaction and counter reaction, all of these global markets are moving and functioning like a single global market and your own common sense will tell you whether or not it is safe enough for all your investment dollars.  
 
At this point I have every broker, advisor, and trader up in arms and ready to call in the firing squad, but before we do that, let’s dig a little deeper.  Ask yourself how many times the “basket of stocks” made it through a correction untouched?  Ask yourself how your portfolio fared during the dot.com bust in the early part of this century?  Ask yourself how it performed during the little correction back in July of 2007 or the first few months of 2008?
 
Now that I have used up all my shock value, let’s get practical.  Stocks, bonds, and mutual funds are all very important investment vehicles, but they are only three that are represented by the “single market.”  Now here is something that most financial advisors probably won’t ever talk to you about.  THERE ARE OTHER WAYS TO INVEST YOUR MONEY.  There are people out there that are making great returns in ways that are not directly related to the single “financial” market.  So let’s take a look at a few alternative investments that are not represented by the “single market” by using some examples from the below matrix:

As we can see, there are definitely some alternative investments available that are not offered by your typical financial advisor, but there is a reason most people would not invest in these alternative investments; they are not for the inexperienced nor are they passive investments like stocks, bonds, or mutual funds.  I am not using the IRS definition of passive, because in their eyes passive means you buy a rental property and you get to go to the bank and cash checks every month without any work, though this is rarely the reality.  I am however using passive in the sense that after an individual purchases the investment, there isn’t additional work or time that goes into it except for collecting a return.  This is sometimes called an “armchair investment.”  With this in mind, all of the above investments really don’t qualify.  Let’s face facts, it would be great to diversify into these alternative investments, but who has time to do the years of research it takes to be a numismatics expert and successfully trade rare coins at a profit, or manage and staff a car wash every day.  One could argue that if you hired a property manger for your rental property, it would make it passive; however I can tell you from my own experience that you still have to manage your manager.

So, what if the aforementioned alternative investments were offered as a private fund with the expertise needed to return double digit returns while the investor did nothing but collect a check every quarter?  Would that be a diversification from stocks, bonds and mutual funds?  My unsolicited answer to that is yes, and in the effort to offer up an alternative, it is what helped give birth to hedge funds and private equity funds with the former’s strategy mostly using the financial markets and the latter offering more private alternative investments.

Most of us know about REIT’s that allow us to have the benefit of property ownership without being involved in the management aspect.  However,  I can almost guarantee that 95% of the investors out there didn’t know that there are managed funds for alternatives like rare coins, art, lending, medical technology, etc that was packaged into an armchair investment.  The best part is that these private funds can often be a true diversification for an investor’s portfolio and also be an armchair investment.  Remember, investing in a private alternative investment not only gives diversification from traditional investment vehicles but it also gives another important diversification factor; many of these funds are not traded on a public exchange.  This is crucial as it helps shelter the investment from the day to day fluctuations of the financial markets.  Another important characteristic found in many of these investments is that they are backed by real tangible assets.  This goes back to an age old argument of what the real value of paper is in comparison to something tangible like real property.  There may also be internal diversification within many of these alternative investment funds, which adds another possible layer of security (As a managing partner of Regent Global Funds, we have always believed that diversification within the fund itself to be paramount to our strategy).   All together, this gives the investor diversification from traditional investments, traditional markets, and from the investments themselves in the portfolio.  They are basically structured as a private mutual fund based on an alternative investment strategy.  

The next time you hear someone advising or talking about diversification, ask them, ” What is your definition of diversification?”  If they hit you with the “Traditional Four”, make sure you tell them about the single market.  You may find yourself on a soap box lecturing to traditional people about alternative ideas.