Is Your Portfolio Really Diversified?
Diversification is simple to understand. In the context of managing your portfolio, diversification is (simply) about investing in diverse securities so as to lower the risk of the portfolio. Ever since Nobel Prize winner Harry Markowitz wrote his seminal paper “Portfolio Selection” in 1952, finance professionals (and increasingly lay people) have understood that the true risk of an asset is its contribution to the risk of a portfolio.
In a recent survey run by Insight Financial Strategists, according to 41% of respondents a single mutual fund is sufficient diversification . After all, even the most concentrated mutual fund typically has several dozen stocks. However, many mutual funds diversify within a single asset class in a single country, such as, large-company stocks in the U.S.
Others will concentrate their portfolio on a few securities, sometimes with very unfortunate results. For instance, between September 1, 2015, until November 17, 2015, the Sequoia fund (symbol SEQUX) lost 26.3% of its value largely due to its high concentration in a single stock, Valeant (VRX). Looking at the price evolution of VRX below (source: Google), and knowing that SEQUX had more than 30% invested in VRX, it is not surprising that the mutual fund tumbled.
Price of VRX from 9/1/2015 12/31/2015
In practice, diversification is hard to implement. There are many levels of diversification. Some of them are:
- by individual securities
- by asset manager;
- by asset class; and
- by geography.
Ideally, an investor will want to diversify so that the various investments are not correlated with one another, have low correlation or even have negative correlation. For instance, according to data from portfolio analytics firm Kwanti, Goldman Sachs (GS) and JP Morgan (JPM) have an 89% correlation based on monthly returns. In other words, buying GS and JPM in the same portfolio only provides a low diversification value.
diversification is about investing in diverse securities so as to lower the risk of the portfolio
In another example, based on monthly returns, JPM and Walmart have a negative correlation of -0.14%, according to data from Kwanti . I don’t know that I would necessarily want to buy either JPM or WMT. However, this pair provides good diversification from one another.
Most of us end up investing in mutual funds and exchange-traded funds, not in individual securities. The same principle applies there. Having a single large cap mutual fund that tracks Standard & Poor’s 500-stock index may not be sufficient diversification.
Sure, the S&P 500 ETF provides more than one security and is, therefore, diversified. But in general, most of the securities within a single asset class will be highly correlated with one another (such as with JPM and GS). With that, you would be protecting yourself against the risk inherent in any given company in the portfolio, but not against risks inherent to the asset class or other factors.
Ideally, you would want to be diversified across asset classes, across regions of the world and across asset managers. The following jelly bean chart from Schwab demonstrates the benefits of a wide diversification program: the ranking of the assets by performance changes seemingly randomly from year to year. A fully diversified portfolio (the orange boxes in the chart) is intended to avoid the peaks and valleys of individuals asset classes while providing a more middle-of-the-road return experience.
Is your portfolio diversified? A detailed analysis from a fee-only Certified Financial Planner can give you the full scoop on your portfolio and provide suggestions to mitigate the risks that you are exposed to. Like any other sound advice, apply it now, not later.
Check out some of our other blog posts on investing:
A previous version of this post was published in Kiplinger.