In many ways diversification is like apple pie and motherhood â good for you and always taken at face value without any real introspection.
Investors throw out lots of platitudes about their portfolios being diversified.Â Financial literature often contains allusions to diversification but do Main Street people really understand this important concept?
Understanding the portfolio diversification concept is not an academic nicety. Proper diversification is crucial for growing your wealth and managing through the inevitable ups and downs of financial markets .
Think of portfolio diversification benefits in the same way you think about insurance on your house. When nothing bad happens you go on and maybe for a second you think about whether you really need this form of protection.
But when something bad happens like a stock market crash or a tree falls on your garage, you do not even think for a nano second as to what you paid for the protection.Â Whatever the price was, it was well worth it!
The portfolio diversification concept is, however, different from typical insurance in some important ways.Â When you buy insurance on your house you have a contract regarding the conditions under which the insurer will pay, how much, and importantly a maximum out of pocket deductible.
With portfolio diversification there is no such contract and especially there is no set deductible capping your losses.Â When somebody says âmy portfolio is diversifiedâ it can mean a million things .Â But does it mean what you think it does?
The devil is always in the details, right?Â You may think that your portfolio is diversified because nothing bad has happened yet. Or, you may think that your portfolio is diversified because your advisor said so. Who knows?
Or maybe you read a mutual fund advertisement stating that the fund you own has investments in a large number of industries.Â Sometimes people think sprinkling their money across a large number of funds with different names means that they are diversified .
Why the confusion? Without getting too technical, diversification can mean a whole lot of different things depending on the context.
Properly understanding the context and what diversification means is difficult for non-financial people to wrap their hands around.Â And that is a big problem and why investors often fail to capitalize on what Nobel Prize winner Harry Markowitz once called the only free lunch in financial markets .
When typical investors hear the word diversification they think protection against portfolio losses. If you are diversified, your losses will be less than if you are not diversified, right? During a stock market meltdown such as 2008 your diversified portfolio should do ok, right?
Probably not. Remember the old saying – assume makes an a** out of you and me!Â Better be safe than sorry when it comes to your financial health.
Letâs start with some basics. Very simply put, diversification means that you are not exposed to any one investment type determining the bulk of your portfolio returns.Â One investment will neither kill nor make your whole portfolio.
A diversified portfolio contains investments that behave differently. While some investments zig, others zag.Â When one investment is up big, you might have another one that is down.Â Your portfolio ends up in the middle somewhere.Â Never as high as your best performing investment and never as low as your worst nightmare investment.
Asset classes such as bonds and stocks have very different behavior patterns. Sometimes these differences get lost in jargon such as risk and return or the efficient frontier concept.You donât need a PhD from MIT or Chicago to understand the concept of diversification but pay attention as the details are important.
Why do you own stocks in your portfolio? Why do you own bonds and, say, real estate? Why do you have some money stashed away in an emergency fund at the local bank?
I know these questions may Â seem a bit sophomoric but knowing the âwhyâ for each of your investments is important to understanding how well prepared you are to withstand periods of financial market stress.Most people already know that when economic times are good, stocks will typically go up more than bonds but when there is a crisis the reverse will often occur.
The whole point of owning stocks, bonds and potentially other major asset classes as a mix is to protect your portfolio from bad things happening.
Sure we would all love to get the upside of stocks without any downside but in reality nobody has the foresight to tell us in advance (please avoid subscribing to that doom and gloom publication that just popped up in Facebook) when stocks will collapse and when they will thrive.Â Anybody up to buying some snake oil?
Diversification is not necessary if you have a direct line to the capital market gods. If you are a mere mortal proper diversification is absolutely necessary to ensuring you remain financially healthy.
Spreading your bets around, mixing a variety of asset classes, hedging your bets, not putting all your eggs in one basket â whatever your favorite phrase is you also need to live it. Diversification is one of those good habits that you should practice consistently!
Accumulating investments over time is a very common practice.Â People sometimes get enamored with a certain investment type such as tech in the late 90âs and when things donât pan out they are reluctant to sell the investment.
Not dissimilar to hanging on to that old dusty treadmill in the basement or that collection of Bennie Babies in the attic.Â Many individual investors are hoarders without admitting it.
Sometimes it is as simple as when people change jobs leaving behind a 401(K).
Solution: Research each one of your funds. For example if you own the Alger Large Cap Growth fund (ACAAX) use a free tool such as Morningstar to do some basic research.
But let me warn you â looking only at past returns will tell you much about the past but virtually nothing about the future.Â Ruthlessly eliminate funds that you donât understand, have high fees or simply do not fit the style that youâre looking for. Donât eliminate funds based solely on past performance.
Some people think that if you own a lot of different funds or investments you are automatically diversified. A bit of this and a bit of that. Some growth, some value, a sprinkling of emerging markets and a Lifestyle fund thrown in the mix.Â There is no rhyme or reason for any of this, but many people use this approach, right?
This is a very common mistake of investors.Â A lot of funds of the similar ilk does not make a diversified portfolio. It makes for keeping track of many more things, but not necessarily things that matter to your financial health.Owning a large number of investments does not mean that you are diversified.Â It probably means that you or your advisor are confused about how to construct a portfolio. You can actually be much more diversified with a small number of uncorrelated investments â the number of investments is immaterial.
Solution: Less is often better when it comes to your investments. Too many funds means extra confusion.Â Simplify to a small number of funds that will serve as your core portfolio holdings.Â Think of these funds as the pillars holding up your financial house.
Choose low cost funds that you will be comfortable holding for decades.Â Hint â focus on a small number of broad based index funds covering stocks and bonds.
Sounds like you have a fun portfolio when things go well but a nightmare when they donât.Â People fall in love with investment themes all the time.Â They ride the theme hard not properly understanding that market sentiment is often fickle and can change on a dime.
In the late 90âs it was all about the internet.Â Many people loaded up on the sector and lost their shirt soon after.We have had more biotech booms and busts than probably for any other sector over the last 30 years .Â Many of the biotech stars of old unfortunately were sold for cents on the dollar despite promising early findings.
Starting in mid-2017 the buzz was all about cryptocurrencies.Â Many investors especially those too young to have experienced a stock market meltdown went head first into the craze and now probably are licking their wounds.
Solution: Theme investing is risky. Identifying the next emerging technology or the next Amazon or Google has a very low probability of success. Even the most seasoned venture capital firms thread lightly when it comes to the ânew, newâ thing.Â You should too!
If you really understand a theme think about how long it will take for the mainstream to adopt it in mass.Â Â Invest only a small percentage of your portfolio. For the rest of us, best to keep our greed in check and just say, no!
This is a variation of the previous issue.Â Sometimes you hear people say, âI am just a bond guyâ. Or, maybe they say âI am a stock jockeyâ. People come to identify with their investments as a badge of honor without realizing the consequences to their financial health.Â As my mother would say, âdo things in moderationâ. I still think that this is great advice whether it is about eating or investing.
The problem with just owning investments in one asset class is that you do not get the main course of the free lunch. You get the appetizer, but then you are shooed out of the room.Diversification within an asset class such as stocks or bonds is not nearly as powerful as diversification across divergent asset classes
What do you mean?
Letâs take the case of stocks. In any given day, most stocks tend to move up or down together.Â When the overall equity market (say the S&P 500) is up big for the day, you only find a very small percentage of stocks down for the day.Â Similarly, when the broad equity market experiences a meltdown you will unfortunately only find a handful of stocks that went up for the day.
Same applies to bonds but the herding effect is even stronger.Â Take the case of US bonds of a similar maturity, say 10 years.Â This cohort of bonds moves in a pack all taking their lead from the 10 Year US Treasury.Â If the 10 Year Treasury moves up, the vast majority of bonds move up in lockstep.Â Same on the downside. Just like sheep.
Sure, some stocks or bonds will do better than others. Overall, securities within an asset class tend to move up or down together.Â Call it a sister or brotherhood, while major asset classes relate to each other more as distant cousins.
Solution: For most people it makes sense to hold investments in all the key asset classes.Â The three main asset classes that you should own are stocks, bonds and real estate.
Donât get too cute. If you own a home you probably already have enough real estate exposure.Why should you own stocks? For growing your nest egg over the long-term.Â Sure stocks can be incredibly volatile, but if you plan to hold your stock investments for say longer than 10 years, history tells us that you can potentially maximize the growth of your portfolio. For a good review of the long-term power of stock investing read our recent blog.
Why own bonds? Historically, people held bonds for the yield and stability. Â In the current low interest rate environment, focus on stability but keep an eye out for a more normal interest rate environment.Â In the US we are already moving in that direction as the Federal Reserve hikes rates and Europe is not that far behind.
But, why is the stability of bonds useful? Mainly as an anchor to your stock investments. Bonds tend to do well during period of stock market stress so they tend to offset some of your losses.
Because bonds tend to be less than 1/3 as volatile as stocks holding a combination of bonds and stocks in your portfolio will dampen valuation changes in your accounts.Â The value of your holdings will still be heavily influenced by movements in your stock holdings.Â Your account values will, however, not fluctuate as much.Â Is this worth it to you?
For many people holding bonds allows them to sleep better at night especially when equity markets go through the inevitable corrections. Â A good nightâs sleep is a prerequisite for a happy life.A diversified mix of stocks, bonds and real estate is usually a great starting point for building your long-term financial wealth while allowing you to sleep well at night. Donât overthink it.
Given the low level of capital market volatility that we have had in the last few years, I would not be at all surprised to see people who dismiss the need for diversification.Â After all if you just pick your investments wisely why should you worry?
Somebody that has been riding the FANG (Facebook, Amazon, Netflix and Google) stocks for a number of years probably does not see any need for bonds in their portfolio. Maybe they got a hint that they should diversify a bit during the February 2018 mini-correction but all seems to be forgotten three months later.
Go back to the late 90âs. Investors were riding AOL, Cisco, Dell, and Microsoft.Â Very few individual investors saw the implosion that was about to hit and obliterate equity portfolios.
For example, investors in the Technology SPDR ETF (XLK) were riding high on the hog until March 1, 2000 when the XLK hit $60.56.Â By July 1, 2002 the price had dropped to $14.32 â a horrific 76% decline from the peak.Â It took until late 2017 for the XLK to hit its March 1, 2000 peak. That is a long time to wait to breakeven!
You donât need diversification when things are going well. You only need it when the bottom is falling out from one of your investments.Â Every single investor in the world has gone through a rough performance patch and nobody is immune to the pain and agony of market crashes such as 1987, 2000-2002 and 2008-2009.
Solution: Stress test your portfolio or at a minimum ask yourself what would happen if certain events of the past repeated themselves.For most people it is far wiser to leave a bit of money on the table by diversifying across asset classes than go head first into a market crash.
Could you withstand a sudden 20% daily loss in the stock market? How about a couple of years of major losses such as over the 2000-2002 period? Would you have the stomach to weather these storms?
Many times the tension is between your rational side and your emotions.Â Behavioral research shows that most times the emotional side wins out.Â Most investors panic during corrections because they are not properly diversified.
Investing is fun when capital markets are going up and everybody is making money.Â Equity market corrections and, heaven forbid, crashes are extremely stressful for the vast majority of investors.
Having a little bit of a cushion can mean the difference between emotionally and financially staying with your investing plan and chucking it all at what may turn out the most painful time.
Recovering from painful events is especially difficult when your state of mind is poor and your pocket book is much lighter than before.
Making decisions under stress is never optimal.Â Self-improvement experts always talk about making decisions while in peak states, not when you are emotionally down.
Nobel Prize winner Harry Markowitz called portfolio diversification in finance its only free lunch.Â Most people agree with his statement and attempt to build diversification into their investment strategies.
But the devil is in the details.Â Many people remain confused by the term and its impact on their financial health.
But understanding portfolio diversification is not an academic nicety â it materially affects your financial health
For most investors the relevant context for diversification involves the key broad asset classes of stocks, bonds and real estate.
If you like smoother rather than bumpier rides, portfolio diversification is for you. You will sleep better at night especially when equity markets go haywire.
Investors can easily fall in the trap of thinking that their portfolios are diversified or that they do not need any diversification.
Making too many assumptions is not a good investment practice. Better to know in advance whether you have the mental fortitude and financial resources to weather the inevitable storms.
For technically oriented investors Portfolio Visualizer is a great free tool that allows you to estimate correlations among your list of funds.
For a more in-depth analysis of your portfolioâs true diversification consult a professional consultant experienced in portfolio construction issues.Â You will get a lot more than simple correlations among your funds. You will get a full picture of the risk profile of your investments but keep in mind that ultimately the portfolio you own must work for you.
Your ideal portfolio must be designed in relation to your goals and needs while allowing you to sleep at night.Â Only a comprehensive wealth management assessment can give you the level of detail required.
We are expert portfolio construction professionals and would glad help you assess the quality of your portfolio.Â Donât assume that you are diversified.Â Contact the team at Insight Financial StrategistsÂ for a free initial consultation.
At Insight Financial Strategists we are your fiduciaries. Our advice is focused solely on our view of your best interests. As fee only practitioners, our interests are aligned with yours.