If you’ve ever asked an experienced investor or your financial advisor for advice on improving the risk-adjusted returns of your investment portfolio, there’s a good chance you’ve heard of the term “diversification”. As one of the fundamental rules of investing, diversification is the idea of allocating an investor’s money across multiple investment categories such as stocks, bonds, and money market instruments spread over different industries and sectors. A comparison of this strategy can be made to the age-old adage of not putting all your eggs in one basket. Where the former is equivalent to an undiversified portfolio, putting your eggs in several baskets for added safety is equivalent to a diversified portfolio.
The core rationale behind diversification is to minimize an investor’s risk exposure in the financial markets by making investments into assets that have little correlation in their price movements. By doing so, this strategy allows the investor to spread out the downside risk in the event that a company, industry, or market experiences a particularly strong downtrend. Say, for example, an investor puts all their money into ABC stock. After a short period of strong performance, ABC company surprisingly runs into financial troubles, and the stock price drops dramatically, losing a majority of its value. It would be an unfortunate case for that investor since he would have subsequently lost the majority of the value in his investment. On the other hand, if instead, the investor put his money into ABC company as well as several other stocks in different industries, he could have likely minimized his loss from that one isolated event in ABC company and have the other stronger performing stocks compensate for the decline of ABC stock. Diversification is a risk management practice that should be implemented by all investors who want to achieve long-term success in the performance of their portfolio.
The above example of diversification can be applied across different securities within the same asset class. However, true portfolio diversification is not limited to just within a particular asset class, but instead, should additionally be applied across several asset classes. The most popular portfolio allocation for most fund managers over the past few decades has been 60% in stocks, and 40% in bonds. While stocks have a higher potential for return, they also carry a proportionally higher degree of risk when compared to bonds. By averaging out the risk and return of a portfolio over different stocks and bonds, an investor is able to greatly reduce their risk exposure while still being able to maintain modest returns. To further illustrate the purpose of diversification, while many public companies have gone bankrupt over the years, and their stocks rendered worthless, the overall stock market is still able to achieve an average return of roughly 7% annually.
Take for example an investor interested in investing in Sears (SHLD). Without knowing the downfall of Sears as we know now, it would have been reckless to invest solely into the SHLD stock.
This is where diversification comes into play. By investing in a range of stocks across different sectors, an investor can minimize the loss by having the other stocks compensate for the decline of SHLD.
Using the CRM2Plus software to illustrate the Fair Market Value of SHLD compared to a diversified portfolio (which includes SHLD). Having other stocks in your portfolio has compensated for the downfall of Sears.
You can see at the end of 2017 the value of the portfolio. A well-diversified portfolio clearly gave a higher return and reduced the risk of a single stock’s downfall.
Overall, diversification will yield higher returns for an investment portfolio by lowering the risk of severe loss in any individual investment. Although diversification cannot reduce the systematic risk found within the overall market, it can greatly reduce the unsystematic risk associated with each individual investment. Historically, the return from stocks have typically outperformed the return from bonds, and as a portfolio becomes more concentrated with the appreciating value in stocks, another best-practice used by portfolio managers alongside diversification is rebalancing – which is discussed here.
As individuals embark on their journey of investing, they should carefully consider their risk appetite and their long-term investment goals. Always be sure to consult your financial advisor on what the best allocation is for you!