Markets, Financial Planning, Retirement

A Review Of Why Diversification Is So Important

12/15/16 8:00 AM

iStock_000018447826_Small-1.jpgThe recent run-up in the stock market has largely resulted from Donald Trump’s election victory and his intentions to lower taxes, reduce regulation, and increase infrastructure investment. However, these and other potential pro-growth policies will still take some time to make it through Congress, and perhaps even more time to fully take hold. Add to this the near-vertical move higher in equites over the past month, with every major stock index having climbed to a new record, and it is understandable why some investors are growing concerned that the rise in the market may prove to be too much, too soon. Even if a pullback does occur, the long- and even medium-term resiliency of the stock market is undeniable. However, it is still probably a good idea with equities currently at such lofty levels to once again review the purpose and effectiveness of portfolio diversification.

Indeed, diversification in its simplest form is akin to the old adage “don’t put all your eggs in one basket,” because it generally isn’t a good idea to invest all of your money into a single stock since your savings would therefore depend solely on the performance of that one asset. Doing this could provide excellent returns for a while if the stock happens to outperform the overall market. However, this would also expose you to the idiosyncratic risks associated with that particular company, e.g. industry-specific problems, new competition, currency fluctuations, bankruptcy, etc., all of which have the potential to more than wipe out any unrealized gains. Diversification therefore requires that a basket of uncorrelated investments is constructed so that one can still benefit from strong performance but limit the portfolio’s overall exposure to the risks associated with any single asset.

Most retirement investors likely understand this concept and will therefore try to invest in a handful of companies that they are familiar with. Too often, though, such asset mixes chosen by retail investors will still be inadequate for a “properly” diversified portfolio. For example, the total number of investments could still be too small or the portfolio weightings may be too high in one or more assets. For the former it’s important not to think that the goal should be to own as many different stocks as possible, because research has shown that the benefits of diversification start to diminish after only a few dozen stocks as a portfolio’s returns and risk profile start to converge to that of the entire market, e.g. the S&P 500.

Retirement investors must also understand that there are times when even a well-diversified stock portfolio won’t provide a lot of protection. A good example of this is the price action seen in the market this summer immediately after the shocking Brexit vote, where scared investors across the globe rushed for the exits and caused stock correlations to spike, i.e. equities that normally wouldn’t have traded similarly are suddenly moving in lockstep. Put simply, spreading your money across a wide variety of stocks can help reduce the risks associated with any particular company or industry but exposure to a broad market selloff won’t be eliminated.

To help protect against those scenarios, a retirement portfolio must therefore be diversified not just in stock allocations but also asset classes. More conservative instruments like bonds can act as such a hedge since this asset class often performs well when equities are underperforming. This is especially true for U.S. Treasury’s, the “global safe-haven,” when markets are in a “risk-off,” “flight-to-safety” mode. Of course if you don’t plan to hold everything all the way to maturity then even government bonds can be a risky investment, particularly during a rising interest rate environment like the one we may very well be entering. Real estate investment trusts (REITs) and other alternatives exist to help provide greater portfolio diversification but one shouldn’t forget about cash. Indeed, leaving some money on the sidelines, or in highly liquid cash-like instruments, can help one take advantage of market corrections by providing the means for picking up shares of great companies at a discount.

Of course it's also worth noting that diversification, like most investing issues, isn’t an exact science, meaning that there isn’t a single formula for constructing a “well-diversified” portfolio that everyone should follow. This is because what's right for one person may not be appropriate for another since factors like risk appetite and nearness to retirement must be taken into consideration. Ultimately, it’s nearly impossible to completely eliminate risk from a portfolio but it is possible to reduce one’s exposure. Doing so, though, may be intimidating for many retail investors but consulting with a financial advisor can often provide a lot of help. In fact, a recent report from Charles Schwab found that nearly three-quarters (74 percent) of surveyed 401(k) participants who said that they regularly work with a financial advisor reported being “extremely or very confident” in their ability to make the right investment decisions for their retirement plan, compared to just 44 percent for respondents who do not seek professional advice.



Sources: Yahoo Finance, Wells Fargo, Advisor Perspectives, J.P. Morgan, BofAML, Journal of Financial and Quantitative Analysis

Post author: Charles Couch