Diversification: What It Is and Why It Matters to Your Portfolio—and Financial Future
September 10, 2021
Diversification: What It Is and Why It Matters to Your Portfolio—and Financial Future
September 10, 2021
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The stock market and investing, in general, can come with high highs and stomach-churning lows. Knowing where to invest your money and how much to invest is a complicated interplay of many factors—investing most or all of your money in one security or stock means you’re fully exposed to the risks associated with that company. If the company has a bad year financially, you could lose a lot—sometimes all—of your investment. While there’s no way to completely prevent the peaks and valleys—or the emotions that come with them—there is one commonly accepted mitigation approach that plays off the old adage, “Don’t put all your eggs in one basket”: diversification.
What Is Diversification?
Diversification is a fundamental concept in finance and investing. According to Fidelity, “One of the keys to successful investing is learning how to balance your comfort level with risk against your time horizon. Invest your retirement nest egg too conservatively at a young age, and you run the risk that the growth rate of your investments won’t keep pace with inflation. Conversely, if you invest too aggressively when you’re older, you could leave your savings exposed to market volatility, which could erode the value of your assets at an age when you have fewer opportunities to recoup your losses.”
Diversification is a way to mitigate risk in your portfolio by spreading investments out into various asset classes and other investment vehicles (like stocks, bonds, real estate, commodities, and so on) in an effort to reduce long-term portfolio volatility. According to Investor.gov, “A diversified portfolio should be diversified at two levels: between asset categories and within asset categories. So, in addition to allocating your investments among stocks, bonds, cash equivalents, and possibly other asset categories, you’ll also need to spread out your investments within each asset category. The key is to identify investments in segments of each asset category that may perform differently under different market conditions.”
Hopefully, the end result is that any negative performance in one investment is countered by the positive performance of another. Diversification is a way to potentially limit the exposure risks associated with specific asset classes or when investments experience drops in value. As with all investments, diversification does not guarantee gains or protect against losses, and investments that performed one way during a market downturn or upturn may perform differently in another.
Morningstar offers a look into the 2021 diversification landscape here, in which they break down asset class performance and more. (Note: You must provide your email address, first name, and country to receive the report.)
A Diversified Portfolio’s Main Components
Owning a wide variety of stocks is a key component to a diversified portfolio; these stocks can—and in general should be—across various industries, like tech, pharma, and energy. You don’t necessarily need to own stocks in every sector; more important is to hold stocks from high-quality companies. Large and small-cap, dividend, growth, value, and international stocks may be essential to diversifying a portfolio further, although these often come with higher risks. In addition to stocks, consider including other investment vehicles such as bonds and CDs, which aren’t necessarily tied to the ebbs and flows of the stock market.
Exchange-traded or mutual funds are another way to incorporate a variety of stocks from different companies across one industry or across different industries in one fund more affordably than trying to buy a few shares across hundreds of companies as an individual investor. This is one of the main reasons these funds are popular with individual investors (which the industry refers to as “retail investors”). Read more about investment vehicles, retirement savings accounts, and other asset classes here.
While many financial and investment advisors recommend a 60/40 portfolio allocation—60% of capital to stocks and 40% to fixed-income investments like bonds, there are a near-endless variety of ways to build a tailored and diversified investment portfolio that considers factors like your age, risk tolerance, risk capacity, income, and financial goals.
Diversification and Correlation
Correlation, an essential concept in diversification, is a method that more often than not, only works if investment holdings are not perfectly positively correlated. Holdings must move in different directions with different responses in conjunction with market fluctuations (e.g., they can’t both be so perfectly correlated that they drop/rise together/in relation to each other). Individual investors who often do not have the computing capabilities to assess the overall correlation present in their portfolio accurately will tend to use a strategy called “naïve diversification.” This technique can be beneficial with careful research and examining each asset and security in a portfolio. Conversely, financial professionals and institutions will often use more sophisticated and advanced calculation methods, often by computers, called “optimal diversification,” to assess correlation and determine what they deem to be the proper allocations for portfolios and funds.
It’s rare for investments to have a perfect correlation, but it’s relatively common for them to have no, low, or high correlation. A negative correlation would indicate that the investments move in opposite directions concurrently. Generally speaking, the more investments with no or low correlation, the more diversified the portfolio.
Why Diversification Is Important
Diversification’s primary goal is to reduce volatility and risk in a portfolio. While overall investment goals likely include—or may center on—gaining returns, this goal is a secondary benefit that may happen with diversified portfolios.
Take a look at the charts below from Fidelity. The returns are based on hypothetical portfolios with asset allocations aligned with conservative, balanced, growth, and aggressive growth. Average annual returns are calculated using market data from 1926–2015 and include reinvested dividends and other earnings. As you can see, the average return increases as the portfolio progresses through the risk spectrum – and the span between the best and worst 12-month return increases in conjunction. A portfolio invested for aggressive growth spans from the growth of 136.07% and losses up to -60.78%. Many investors would run the other way at the thought of losing up 60% of their portfolio value. This becomes truer as investors age and approach retirement, generally making them more risk-averse as they work to protect their retirement nest egg.
Downsides of Diversification
While the upsides of diversification are important, we must discuss the potential disadvantages of building a diversified portfolio. It can be time-consuming and more expensive to manage a well-diversified portfolio. Especially for a retail investor, holding and managing a variety of stocks, assets, and other investments may be too time-prohibitive to do on their own. Not to mention that this variety also comes with transaction and brokerage fees when buying and selling. As demonstrated from the chart above, a diversified portfolio may also lessen both the risk—and the reward—at least over the short term.
Knowing that diversification’s primary goal is to mitigate market volatility and risk perhaps also lessens people’s expectations for greater returns. But as with all investments, enlisting professional help, managing risk and expectations, and making well-researched, educated decisions may pay dividends in the long term. Of course, diversification may not be well suited to everyone’s situation; some may prefer the higher growth potential (and greater risk of loss) with a more aggressive portfolio allocation, have a short-term time horizon focused on quick returns, or have more disposable income to throw into the ring. Contact your investment professional with any questions about this topic and a complete explanation of the matter.
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This blog expresses the author’s views as of the date indicated, are subject to change without notice, and may not be updated. The information contained within is believed to be from reliable sources. However, its accurateness, completeness, and the opinions based thereon by the author are not guaranteed – no responsibility is assumed for omissions or errors. This blog aims to expose you to ideas and financial vehicles that may help you work towards your financial goals. No promises or guarantees are made that you will accomplish such goals. Past performance is no guarantee of future results, and any expected returns or hypothetical projections may not reflect actual future performance or outcomes. All investments involve risk and may lose money. Nothing in this document should be construed as investment, tax, financial, accounting, or legal advice. Each prospective investor must evaluate and investigate any investments considered or any investment strategies or recommendations described herein (including the risks and merits thereof), seek professional advice for their particular circumstances, and inform themselves about the tax or other consequences of any investments or services considered. Investment advisory services are offered through Liberty Wealth Management, LLC (“LWM”), an SEC-registered investment adviser. For additional information on LWM or its investment professionals, please visit www.adviserinfo.sec.gov or contact us directly at 411 30th Street, 2nd Floor, Oakland, CA 94609, T: 510-658-1880, F: 510-658-1886, www.libertygroupllc.com.
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Fidelity. (n.d.). Why diversification matters. https://www.fidelity.com/learning-center/investment-products/mutual-funds/diversification
Investor.gov. (n.d.) Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing. https://www.investor.gov/additional-resources/general-resources/publications-research/info-sheets/beginners-guide-asset
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