“That introduces a ‘size bias’ that increasingly overweights sectors that are already overvalued and getting more so,” writes Chevreau. “That occurred in 1999-2000, when TMT — telecom, media and technology — stocks inflated, drawing in investors at the worst possible time, then burst.”

One way to get better diversification is through fundamental indexing, says the writer. Picking stocks by earnings and revenue, rather than market-cap, would result in more variety. Equal weighting also works. “An equal-weighted portfolio with 100 stocks would each have a 1% weight no matter how large or small the company was,” says Chevreau.

My favourite option (at least it would be the most fun) is “throwing darts at the stock pages.” If you randomly choose enough of equities, market-cap won’t factor into the equation.

Choueifaty’s prefered investing method is to find stocks that do not correlate with each other. “Thus, his U.S. portfolio holds maybe 60 stocks — versus 600 for the MSCI US benchmark — but he insists those 60 stocks are more diversified than the 600. The resulting portfolio is 1.5 times as diversified as the index and less volatile.”

You can read the rest of the Financial Post story here.

The first thing you’ll notice is that no one asset class has done really well or extremely poorly. Everything is all over the place. The point they’re making is diversifying is key, and after seeing this chart, it’s hard to argue otherwise. It’s pretty cool and I may try to dig deeper into it soon. Feel free to comment if you make any observations.

Franklin Templeton’s “Why Diversify?” chart.

Junk bonds are issued by firms with shaky credit —the ones that have to pay extra to convince investors to lend them money. These bonds aren’t officially labelled as “junk,” of course. They’re more politely known as high-yield bonds.

As you can see from the accompanying graph, high-yield bonds now pay north of 18% a year. The yields have shot up in recent months as a sickening economy has increased worries that marginal firms may start defaulting on their bonds. To compensate for the extra risk, investors are demanding higher and higher yields.

The current yields look very tempting indeed. During the last two recessions the default rate for these bonds peaked near 12%, which suggests that at their current prices, highyield bonds offer a healthy margin of safety even in a nasty recession.

If you’re intrigued about the potential of this market, forget about buying individual bonds. The risk is high that you’ll guess wrong and pick a dud. Instead, buy a diversified selection of bonds. The iShares iBoxx $ High Yield Corporate Bond (HYG) is an exchange-traded fund that trades on the New York Stock Exchange. It gives you exposure to a wide range of high-yield bonds and charges only 0.5% per year in fees. If you prefer to rely on a manager’s expertise, Chou Bond fund is a good pick even if its management expense ratio is 1.34% per year. Just remember, high-yield bonds aren’t for the faint of heart and most people should only put a small fraction of their portfolio into them.

If you’re investing once a year, you should use exchange-traded funds or ETFs. These are index-fund-like investments that trade like stocks on major stock exchanges. Many ETFs charge ultra-low management fees (think 0.3% or less), but to buy or sell them you have to pay a brokerage fee just as if you were buying a stock. The fees aren’t huge in themselves — $30 is typical — and if you’re investing once a year, they are a minor annoyance when you consider the low management fees you’re paying.

On the other hand, if you want to contribute monthly, paying $30 a pop for each transaction can send your overall bill soaring. You’re better off to use index mutual funds. You’ll pay a bit more in management fees, but you won’t face brokerage fees on every contribution.

For purposes of illustration, we’ll assume you’re using our Global Couch Potato strategy (for other strategies, see Meet the potato family).

Once-a-year investors: Open a discount brokerage account. Deposit your money, then divide the total amount by five, and buy these ETFs:

The first pile

• (20% of your money) goes in the iShares Canadian Composite Index Fund [TSX: XIC]. (We’ve decided to replace the i60 Fund recommended in previous articles with this new, more diversified fund, but if you already have the i60, there’s no need to switch.)

The second pile

• (20%) goes in the iShares Canadian S&P 500 Index Fund [TSX: XSP].

A third pile

• (20%) goes to iShares Canadian MSCI EAFE Index Fund [TSX: XIN].

Both the fourth and fifth piles

• (A total of 40%) go in the iShares Canadian Bond Index Fund [TSX: XBB].

Once a year, buy and sell your ETFs (or add new money) to get your portfolio back to its 20%-20%-20%-40% split.

The net result of all this is a very low-cost portfolio that has 60% of its money invested in a wide range of stocks in Canada, the U.S. and around the world, and 40% invested in Canadian bonds.

Monthly contributors: For purposes of illustration, we’ll use TD eFunds, because they’re particularly cheap. As above, you start by transferring your money into the account and splitting it up into five piles:

One pile

• (20% of your money) goes in the TD Canadian Index Fund.

The second pile

• (20%) goes in the TD U.S. Index Fund.

The third pile

• (20%) goes in the TD International Index Fund.

Both the fourth and fifth piles

• (40%) go in the TD Canadian Bond Index Fund.

Once a year buy and sell your funds (or add new money) to get them back to their original split.

That’s it. Now sit back, put up your feet and enjoy life as a couch potato.

Past performance: Classic Couch Potato performance, Global Couch Potato performance.