Markets, Financial Planning

A Review Of Why Diversification Is So Important

2/2/21 8:00 AM

Given a combination of the substantial rally in the stock market during the past few months, last week’s uptick in intraday volatility, and the potential for additional price swings going forward, this could be another opportune time for our periodic review of the importance of diversification, including when it works, and when it does not. Indeed, diversification in its simplest form is akin to the old adage “do not put all of your eggs in one basket,” because investing all of your money in a single stock means that your wealth will 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 the 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 exposure to the risks associated with any single holding. Many 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 again be too small, or the portfolio weightings may be too high in one or more assets (a problem even for some ETFs). For the former it is important not to think that the goal should be to own as many different equities 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 begin to converge to that of the entire market (index). Investors must also understand that there are times when even a well-diversified stock portfolio will not provide a lot of protection.

Such a situation can arise whenever uncertainty reaches extreme levels and scared investors rush for the exits all at once. This behavior can cause stock correlations to spike, i.e. equities that normally would not trade similarly suddenly move in lockstep, and such price action has arguably been exacerbated by the rise of automated, high-frequency trading systems. 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 will not always be eliminated. For additional protection a retirement portfolio must therefore be diversified not just in stock allocations but also asset classes.

More conservative instruments like bonds can sometimes act as such a hedge since this asset class often performs well when equities are under pressure. 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 do not 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. Real estate investment trusts (REITs) and other alternatives exist to help provide further portfolio diversification but one should not 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.

Like most investing issues, though, diversification is not an exact science, meaning that there is not a single formula for constructing a “well-diversified” portfolio that everyone should follow. This is because what is right for one person may not be appropriate for another since unique factors like risk appetite, tax situation, and nearness to retirement must be taken into consideration. Altogether, it is very difficult to completely eliminate risk from a portfolio, but it is possible to reduce one’s exposure to many “known unknowns.” Utilizing mutual, target-date, and target-risk funds, as well as other innovative financial products, can often help simplify the process, but for many regular investors even these selections can seem intimidating, which is why consulting with a professional advisor may also be worth considering.



Sources: JFQA, J.P. Morgan

Post author: Charles Couch