History is filled with stories of successful stock pickers — figures who bet a large portion of their portfolios on…
History is filled with stories of successful stock pickers — figures who bet a large portion of their portfolios on a few stocks after thorough analysis and walked away with handsome gains.
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That being said, history is also filled with thousands of average investors who underperformed a simple index fund over the course of their investment career for a simple reason: a lack of diversification.
As Peter Eberele, president and chief investment officer of Castle Funds, puts it: “Diversification and having a long-term horizon are keys to long-term financial health.” In the face of volatile markets and unforeseen “black swan” events, diversification can minimize losses, smooth out fluctuations, and keep a portfolio chugging along smoothly.
Here are some main components of diversification to consider, including what the terms mean in an investing context and ways to check how diversified your portfolio is:
— What is diversification?
— The benefits of diversification.
— How to diversify your portfolio.
— How to tell if you’re diversified.
What Is Diversification?
A common explanation of diversification is the act of “not putting all your eggs in one basket.” This sentiment has been echoed by many famous investors, namely Warren Buffett. As Anessa Custovic, chief investment officer of Cardinal Retirement Planning, puts it: “diversification in investing means you have more baskets. If you have eggs in multiple baskets, you won’t break all of them.”
Academically, diversification is defined as the process of selecting and allocating a portfolio’s investment assets in a manner that reduces exposure to sources of risk.
“Every financial instrument is subject to certain risk factors, and a portfolio that is overly concentrated in a single instrument (or group of instruments with similar risk profiles) tends to be much more sensitive to those risk factors and more volatile as a result,” says Julia Spina, quantitative finance researcher at TastyTrade. “The more volatile the returns of a portfolio, the harder it is for investors to develop reliable profit expectations.”
Risk therefore comprises all the variables that could alter the trajectory of an investment’s return, whether positively or negatively. Examples include:
— Market risk: How the movements of the overall stock market affect your returns. This is also known as systemic risk and is unavoidable if you’re investing in assets other than cash.
— Interest rate risk: How changes in interest rates affect your returns and yields, especially for fixed-income assets (for example, how long-term Treasurys suffer when rates rise).
— Geographical risk: How changes in political or social regimes affect the equities and fixed-income assets of a particular market (for example, in the recent Russian stock market collapse).
— Idiosyncratic risk: How specific changes in the fundamentals of a particular company can affect the returns of its stock (for example, if you were invested in Enron before it declared bankruptcy).
In general, the more assets your portfolio holds, the more diversified and resilient to different types of risk it is. Jennifer Sireklove, managing director of investment strategy at Parametric Portfolio Associates, echoes this sentiment: “In the most extreme version, diversification means trying to own every possible kind of investment in the market.”
The Benefits of Diversification
At the heart of diversification are two academic concepts: correlation and variance/standard deviation.
— Correlation measures the direction and magnitude of the relationship between two assets’ returns. A correlation of 1.0 means both assets move perfectly in the same direction, while -1.0 means both assets move perfectly in opposite directions. A correlation of 0 means both assets move completely independently of each other.
— Standard deviation and variance measure the historical range that an asset fluctuates, on average, around its expected return. For example, if a stock has returned a compound average growth rate, or CAGR, of 7% annually, but it has a high variance (and therefore a high standard deviation, which is the square root of variance), this means that its return varies widely and 7% might not be a reasonable expectation in any given year.
A rule of thumb is that a diversified portfolio of volatile (high standard deviation) and uncorrelated (between 0.20 and 0.50) assets with positive expected returns will produce a better risk-return profile than an undiversified portfolio consisting of a single asset.
[See: 10 ETFs to Build a Diversified Portfolio]
To see this in play, consider how a balanced 60/40 portfolio of stocks and Treasurys has historically outperformed a 100% stock portfolio on a risk-adjusted basis, with a better Sharpe Ratio (a measure of risk-adjusted returns). Therefore, proper diversification allows investors to enjoy the following benefits:
— Obtain more returns for the same risk compared with an undiversified portfolio.
— Obtain the same returns for less risk compared with an undiversified portfolio.
— Reduce volatility (lower standard deviation) and portfolio fluctuations.
— Minimize portfolio drawdowns (peak-to-trough losses during a crash).
Another behavioral finance benefit of diversification is increased peace of mind and reduced stress. As Robert Johnson, professor of finance at Creighton University, puts it: “With diversification, you don’t need to pick winners.” Stock picking can be stressful and difficult for even professional investors to pull off successfully over long periods of time.
“I would suggest that someone just getting into the stock market concentrate on mutual funds and ETFs and not try to pick individual stocks,” says Johnson. “Most investors simply can’t afford to make oversized bets on individual securities. Trying to pick winners, for most, is a losing game. The solution is to invest in diversified funds,” where you don’t need to pick a single winner, he says.
How to Diversify Your Portfolio
Diversification is primarily achieved through proper asset allocation, which determines what categories of investments are held in your portfolio, and in what proportions relative to each other.
Cardinal Retirement’s Custovic recommends diversifying across asset classes, noting that “most are either uncorrelated [they do not move together] or negatively correlated [when one goes up, the other goes down and vice versa].” Portfolios should therefore have a balanced mix of different asset classes depending on the investor’s goals, risk tolerance and investment horizon.
“Traditionally a diversified portfolio was characterized as simply a portfolio with both stocks and bonds and the benchmark was a 60/40 mix of stocks and bonds [60% stocks],” says Johnson. “Today, many investors consider other alternative investments to be part of a diversified portfolio. These alternative investments include real estate, commodities, private equity, currencies and even cryptocurrencies,” he says.
When it comes to stocks, even the most conservative of investors will hold a decent allocation in their portfolio. Due to their higher risk, stocks tend to return the most, driving portfolio performance. Castle Funds’ Eberle suggests using exchange-traded funds, or ETFs, which allow investors to “have exposure to a broad range of stocks in one basket with very little fees.”
Multiple fund providers out there offer highly diversified ETFs that track global stock market indexes for a low price. “One of the easiest ways to do this would be to select an “all cap” or broad-cap index which spans companies with small market caps and large market caps and everything in between,” says Parametric Portfolio’s Sireklove.
Experts recommend diversifying your stock exposure over different market caps, sectors and geographies. Instead of betting solely on the returns of large-cap companies, investors can also buy mid- and small-cap stocks, which have different risk factors and thus varying returns.
Diversifying across sectors mitigates the risk of a long spell of underperformance, should a particular sector tank, like with the tech sector during the dot-com bubble. Finally, diversifying across geographies mitigates the possibility of a single country’s stock market performing poorly, such as the “lost decade” for U.S. stocks between 2000–2009 and the recent Russian stock market crash.
Finally, investors should diversify across time. This is the act of reducing your risk exposure as your investment time horizon shortens as retirement approaches. Commonly, this entails reducing equity allocations and increasing bond and cash holdings.
[See: 8 Best Bond Funds for Retirement.]
Custovic recommends the use of a target-date fund. “A target-date fund will have the target retirement date in the name for the buyer. For example, Vanguard Target Date Fund 2050 means I am planning on retiring in 2050. It will automatically shift the allocation from mostly equity to fixed income,” she says.
How to Tell if You’re Diversified
The following checklist can help you determine if your portfolio is sufficiently diversified:
— Do you hold more than 100 large-, mid-, and small-cap stocks according to their market cap weights?
— Are your stocks all concentrated in a single country, or are they allocated according to each country’s stock market weight by world market cap?
— Are your stocks evenly spread out among the 11 stock market sectors, or are they concentrated in just a few?
— Do you have an allocation to high-quality, investment-grade bonds that matches your risk tolerance and investment horizon?
— Does the effective duration of your bond holdings match your investment horizon?
— Do you keep a small allocation to alternatives like commodities, real estate and cash in the event that stocks and bonds fall in tandem?
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Why Diversification Is Important in Investing originally appeared on usnews.com
Update 05/26/22: This story was published at an earlier date and has been updated with new information.