Introduction

You’re probably familiar with one of the investing world’s most popular buzzwords: diversification. Even those without a clue about investing have heard it and know how exceedingly important it is. But why is that the case, and what does it actually mean?

The term is most often associated with the stock market – the network of exchanges where investors buy and sell fractional ownership in real companies, hoping to come out with more money than they started with. It’s commonly known that stocks are volatile; there are constant swings up and down. But, although past performance does not guarantee future results, the stock market has tended to reward investors who stay the course over the long term.

Today, we’ll explore diversification in stock investing: how it works, its application to portfolios, its limitations, and common mistakes people make in pursuit of it.

What is diversification?

Diversification involves combining groups of assets with different characteristics that move together imperfectly in response to economic conditions and risks. This is measured by correlation, a statistical representation of exactly how closely two assets move together. Asset classes are groups of similar assets, with investments within each class typically exhibiting high correlation.

A diversified portfolio will likely have both winners and losers in the short term, and that’s by design. That’s right: If you don’t have any positions in your portfolio that you’re unhappy with in a given period, you’re likely not sufficiently diversified. The rationale behind this is that predicting which assets will underperform is uncertain, and today’s poor performers could become tomorrow’s winners.

Let’s say you’re a stock picker and you’ve been beating the market return using an investment strategy that you’re certain will work forever. (Side note: this is rare, if not impossible.) Why would you bother with diversification? You’re unbeatable! Well, that additional return isn’t free. It comes at the cost of high risk and potential loss that is much greater than you may be able to afford, especially if you’re using money that will materially affect your ability to retire. Instead, consider forgoing the potential for higher short term returns and opt for a diversified portfolio of many stocks. This will narrow the breadth of outcomes and ultimately provide a higher risk-adjusted return over time. Remember, the purpose of diversification is to minimize risk, not maximize returns. Risk-adjusted returns are the key to staying invested for the long haul.

How to diversify

Now let’s talk about how to implement a diversified portfolio of stocks using asset classes. The broad asset classes include cash, stocks, fixed income (bonds), real estate, commodities and alternative investments. There are also sub-asset classes; for stocks, these include market capitalization, sector, style, and geographic location. Companies that fall within these classifications will usually share some of the same risks. Let’s say you invest in Apple, for example, which is a US-based, large-blend company in the information technology sector. Microsoft may not be the greatest diversifier, as it shares a similar sub-class profile with Apple.

The decision as to how much of each asset class to include in your portfolio is the most important. This is known as your “asset allocation,” and it’s said to have the single largest effect on your portfolio’s long-term performance. Should your portfolio include all US companies, or should you include international companies too? What ratio of growth vs. value companies should you use? Maybe you think you should just buy everything as it’s weighted in the market as a whole, or perhaps you’d prefer to tilt certain characteristics that you are convinced will outperform. These decisions can be extremely complicated and overwhelming, but it is imperative to have a well-thought-out investment philosophy that you can stick to in good times and bad. For many, an investment advisor can be invaluable in providing this for you.

Once you have decided on your allocation, you still need to decide which investments to buy. Rather than purchasing hundreds of individual stocks, which most people have neither the time nor the ability to do, you should opt for funds. Usually in the form of mutual funds or exchange-traded funds (ETFs). There are index funds, passive funds, and active funds, which differ in the manner they’re managed. You can strategically choose funds that target specific asset classes.

Once you’ve made your choices and have a diversified, multi-asset-class portfolio of several funds, you have diversified out all the risk, right? Wrong. Investment theory says there are two categories of risk: (1) diversifiable risk and (2) undiversifiable risk, also known as market risk. The market risk is unavoidable in stock investing, but it can be tempered by including other, less volatile asset classes like bonds.

Diversification done wrong

A common pitfall with investing, even when using funds instead of individual stocks, is choosing funds that are materially the same or overlap significantly. For instance, what is the difference between the SPY, IVV, and FXAIX funds? Not much. All three of those funds are S&P 500 index funds. They’re operated by different companies: Two are ETFs, and one is a mutual fund. Their expenses differ slightly, but they’re all essentially the same thing. Diversifying by buying different funds is not really diversifying if the funds hold the same underlying companies in the same amounts.

While that is a somewhat extreme example, it’s certainly not uncommon to find someone investing in a large growth fund, a mega cap fund, and an S&P 500 fund. All these funds may track different indices, but because of the types of stocks that make up those indices, there is likely significant overlap of the individual stocks that make up those funds. This can lead to a situation where someone thinks they are diversified but are really more concentrated than it may appear. It’s important to check the underlying holdings of your investments to ensure you don’t have significant overlap.

On another note, you should never invest in something based on its diversification benefits alone. There are many suboptimal investment options out there that have low correlation with other assets. One example is Bitcoin, which most people have an opinion on one way or the other. Whether you believe it to be a worthwhile investment or not, never hold any investment simply because it diversifies. The investment should also have a positive future expected return. Each investment choice should be evaluated based on its own merit.

Conclusion

Diversification stands as one of the primary principals of prudent investing, helping to manage risk and increase portfolio resilience. While chasing higher returns might seem tempting, diversification offers steadier growth and protection against catastrophic loss.

If you feel like you could use assistance with your investment management, or if you’re seeking a deeper financial planning relationship, please reach out to our team.