We’ve been preaching the merits of wide stock market diversification for many years, and the advantages should be painfully obvious these days after the bear market of 2000-2002.

Any investor who loaded up on growth stocks or technology funds in 1999 or 2000 has long since learned the advantage of owning some other kinds of assets as well.

Proper diversification is not hard for investors who have enough money. However, we have been asked time after time how a small or beginning investor can achieve proper diversification with a relatively small amount of money.

It’s a good question, and there’s no perfect solution. But the benefits of diversification are worth achieving – even if they are achieved imperfectly.

IMPERFECT DIVERSIFICATION IS BETTER THAN NONE AT ALL

As our regular readers know, we believe strongly in diversifying well beyond the popular U.S. large-cap growth stocks that still dominate so many portfolios. We believe investors who diversify heavily into small-cap stocks, value stocks and international stocks will have better performance over the long run than those who invest mainly in U.S. large-cap growth stocks.

We recommend 10 equity asset classes: in the U.S., large growth companies, large value companies, small growth companies, small value companies and real-estate companies; internationally, large growth companies, large value companies, small growth companies, small value companies and companies in emerging markets.

The best way to get this diversification is through the institutional asset class funds of Dimensional Fund Advisors. However, these funds are available only through investment advisors.

For investors who don’t want to buy through an advisor, Vanguard’s low-cost index funds do a very good job with nine of those asset classes (although Vanguard’s international small-cap fund is closed to new investors). Our Vanguard Suggested Portfolios are based on eight equity funds: 500 Index (VFINX), Value Index (VIVAX), Small Cap Index (NAESX), Small Cap Value Index (VISVX), REITS (VGSIX), Developed Markets Index (VDMIX), International Value (VTRIX) and Emerging Markets Index (VEIEX).

However, buying all those funds requires more money than most beginning investors have available. In regular accounts, Vanguard’s minimum initial investment requirements mean it would take $24,000.

Still, there is no question in my mind that proper diversification away from large-cap U.S. stocks is worthwhile. Here are three things that we know from history:

•    Small-cap stocks have outperformed large-cap stocks. From 1927 through 2007, U.S. small-cap stocks compounded at 12.2 percent. The S&P 500 Index over that time compounded at 10.3 percent. A small difference, you think? Over 30 years, $10,000 invested at 12.2 percent grows to $316,072; at 10.3 percent, it grows to only $189,350.
•    Value stocks have outperformed growth stocks. From 1927 through 2007, U.S. large-cap value stocks compounded at 11.3 percent. Large-cap growth stocks compounded at 9.7 percent. Over 30 years, that’s the difference (on a $10,000 investment) between $248,230 (large value) and $148,088 (large growth).
•    Small-cap value stocks have been particularly productive. From 1927 through 2007, small-cap value stocks compounded at 14.1 percent. Compared with the S&P 500 Index, that’s the difference over 30 years (on a $10,000 investment) between $523,081 and $189,350.

And while international stock markets don’t necessarily outperform the U.S. market, we know that the risk of an equity portfolio is reduced by including non-correlated assets. In the great majority of the last 38 calendar years, the returns of international stocks have been significantly different from the returns of U.S. stocks.

In nine of those years, international stocks (measured by the Morgan Stanley Europe Australia Far East Index known as EAFE) beat the Standard & Poor's 500 Index by 10 or more percentage points. Here are three examples:

•    In 1977, the S&P 500 Index lost 7.2 percent; EAFE gained 18.0 percent.
•    In 1986, the S&P 500 Index rose 18.5 percent; EAFE was up 69.4 percent.
•    In 1993, the S&P 500 Index gained 9.6 percent; EAFE was up 25.9 percent.
Even the smallest investors can gain from such diversification. But unfortunately there is no single mutual fund that provides it.

So what is a beginning investor to do?

I’m about to give my best advice to an investor who’s just getting started. If you are fortunate enough to have enough money so you can diversify properly without this advice, I hope you’ll give this article to somebody who could use it.

Assuming that you’re working, your first investment dollars should go into your 401(k) (SEP IRA, Simple IRA, 403b, etc) account. Almost every 401(k) plan has multiple options, and you can start getting some diversification even with your very first $100. Even if all you can do is diversify into two equity funds and a bond fund, imperfect diversification is better than none. (However, beware of funds with different names yet similar portfolios. An “equity income” fund may be extremely similar to a “growth and income” fund.)

Particularly if you receive matching contributions from your employer, fund the 401(k) fully and regularly. To the extent you can make automatic savings a lifelong habit, you will not be sorry.

For guidance in maximizing your plan, I recommend you go to FundAdvice.com and check out our article “Successful 401(k) Investing in 12 Easy Steps” as well as our other 401(k) resources. 

Unfortunately, relatively few 401(k) plans have good investment options that fully and inexpensively cover small-cap, value and international stocks. Therefore, you will probably need to rely on other investments to give you the asset classes you can’t get in your 401(k).

You should think of all your long-term investments as making up a single portfolio – and strive for having the right overall balance. For example, your 401(k) may contain an excellent U.S. small-cap offering but not an international small-cap fund. In this case, use your IRA or a taxable account to invest in an international small-cap fund.

Incidentally, if you and your spouse each have a 401(k) plan, you can treat the two of them as one for allocation purposes. His may be strong in one asset class, hers in another. As simple as this is, in all my years of working with investors, I have met only one couple who studied their two plans and figured out the best way to build them together using the strongest options in each plan. If you can do that, I hope you will.

Aside from 401(k) accounts, the most common vehicle for retirement savings is the IRA. Even though contributions are limited to $5,000 per year for most people starting in 2008, an IRA gives investors almost unlimited flexibility in choosing asset classes.

I’m often asked how I would obtain proper diversification in an IRA. I recommend a 10-year program for diversifying gradually by adding money every year, and I’m about to tell you exactly how to do it using low-cost Vanguard no-load funds in eight cases and exchange traded funds (ETFs) in the other two.

But first: Some young people may be able to make only a single one-time investment. They don’t have the luxury of following the program I am about to outline for diversifying gradually by adding money every year. For people who are in this situation and who can accept the risks of being 100 percent in equities, I am pleased to recommend a single fund: Vanguard Global Equity (VHGEX).

This fund requires $3,000 for an initial investment and charges expenses of 0.64 percent. While that expense ratio is higher than I would like it to be, I think it is a reasonable price to pay for owning a portfolio with about 60 percent of its assets in international companies. About 21 percent of the fund’s portfolio is in mid-cap and small-cap stocks, according to Morningstar, and the portfolio has an overall tilt toward value.

However, I don’t know of any fund that gives investors all the diversification they need in a single package. If you want to make your money work hard for  you, there’s simply no great substitute for owning multiple funds.

I believe the majority of young people have the ability (and I believe they owe it to themselves and their families) to make annual contributions toward retirement.  By definition, long-term investors have plenty of time to achieve their goals. You don’t have to have an optimally diversified portfolio on Day 1. I recommend a patient, methodical approach, starting with the asset classes that have in the past been most likely to produce high long-term returns. That means value stocks and small-cap stocks.

To keep expenses low and efficiency high, I suggest investing in a single asset class each year.

In a Roth IRA with $5,000 annual contributions, here’s how I would do it, step by step:

Year 1: Invest $5,000 in a U.S. small-cap value fund. My choice is Vanguard Small-Cap Value Index. Result: Even in this very first year, an investor has representation in both the value and small-cap areas.

Year 2: Invest $5,000 in an international small-cap value fund. Since Vanguard doesn’t have such a fund, I would use WisdomTree International SmallCap Dividend (DLS). Result: By the second year, the investor has representation in small, value and international.

Year 3: Invest $5,000 in a U.S. large-cap value fund. My choice is Vanguard Value Index. Result: This adds representation into the most popular part of the market, U.S. large-cap stocks.

Year 4: Invest $5,000 in an international large-cap value fund. My choice is Vanguard International Value.

Year 5: Invest $5,000 in an emerging markets fund. My choice is Vanguard Emerging Markets Index fund. Result: The investor has now reached deeper in search of companies that have lots of future potential.

Year 6: Invest $5,000 in a U.S. small-cap blend fund. My choice is Vanguard Small-Cap Index.

This plan requires at least 10 full years to implement until full diversification is achieved. During this build-up time, the portfolio won’t have an ideal balance of assets. But to a young person, 10 years of imperfect balance is not likely to be fatal. And at the end of this time, a fully diversified portfolio will be the reward.

An investor who starts this plan on his 25th birthday will achieve full diversification by his 34th birthday. With a projected retirement age of 60, that leaves 26 years for the portfolio to grow with its proper balance. An investor who’s now in his mid-20s has a high chance of living to age 80 or beyond, giving this properly balanced portfolio the potential for half a century to reward its owner.

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Editor’s note: Historical returns of asset classes are based on Fama/French CRSP securities data.