Thoughts on Portfolio Diversification
Photo Credit: Ivan Bandura, Unsplash
If you have ever thought of investing, one of the terms you’ve probably heard is “diversification.” This article will explain what diversification is, the benefits of creating a diversified portfolio, and, coincidentally, its drawbacks (Yes, there are drawbacks).
Diversification is putting money into a broader range of investments to reduce your risk and create a more stable portfolio. Even simpler, it’s not putting all your eggs in one basket.
Benefits of Diversification
The two main benefits of diversifying your portfolio are increasing return and reducing risk. Recasting a wider net within your portfolio may allow you to identify an investment that generates higher returns and reduces the volatility of your portfolio.
Even the best financial analysts cannot tell you what will happen to a stock, a bond, or even the market at large. By researching these investments above, you can develop a more educated guess, but at the end of the day, it is still just a guess. On the upside, having a broader range of investments increases your number of guesses, which means more guesses can generate higher returns.
Generally, no one likes looking at their investment portfolio and seeing that they have lost money. By diversifying, you limit the potential impact of your wrong guesses. Suppose you have an equally-weighted portfolio of 20 different U.S. stocks. If one of those 20 stocks in your portfolio vanishes off the face of the earth (it is technically possible), your portfolio will only go down by 5%. By diversifying, you reduce the volatility in your portfolio; the more investments you have, the more stable your portfolio becomes. A more stable portfolio’s main benefit is how it fits into human psychology. If you checked your retirement portfolio of $1 million and it went down 10% in a day, any rational person would have difficulty going to bed knowing that their investment portfolio experienced a significant decline.
Drawbacks of Diversification
As a rule of thumb, the amount of diversification someone has should be correlated to the amount of financial expertise at their disposal. By reducing your number of investments, you are telling yourself and the market that you have found the best places to allocate money.
Diversification is a double-edged sword. By limiting the potential downside of your portfolio, you also limit the potential upside. For an equally weighted portfolio of 20 stocks, if any of your stocks double tomorrow, your portfolio only goes up 5%. Using the thinking of the previous paragraph, if you have gone to the lengths to find a great investment, you would like more than a 5% return on a stock that doubles. That said, for most people, limiting the downside of your portfolio (diversification) is more effective and tolerable than betting on the upside (concentration).
Diversifying Your Portfolio
Well, it depends. There is no one-size-fits-all answer to this question, as investors have unique personalities, goals, and situations. If you are asking yourself if you should diversify, you should also ask yourself these questions:
What is my risk tolerance? Am I comfortable with being down 5, 10, or 20% for periods of time?
What is my time horizon?
What are my investing goals? Should I be more defensive or offensive in my approach?
With these questions in mind, there are some guidelines to help find the optimal level of diversification for your situation. If you have a lower risk tolerance, a shorter time horizon, or a larger portfolio size, consider a diversification strategy. If you can assume risk, have a long runway for your investments, and seek to grow the size of your portfolio, consider concentrating your portfolio.
Diversification Strategies
There are thousands of ways to invest your money, so choosing the best is ultimately up to you. The most common ways to diversify your portfolio are through real estate, commodities, treasury bills, bonds, CDs, savings accounts, stocks, ETFs, and index funds. Each option has different levels of risk, cash flows, and expected returns.
At Optima Capital, we strive to build our investment strategies with stocks, bonds, treasury bills, and exchange-traded funds (ETFs), which include index funds.
Stocks
Other than the number of stocks you own, the type of companies that you invest in matter just as much. In the US stock market, there are 11 main sectors:
Energy
Materials
Industrials
Utilities
Healthcare
Financials
Consumer Discretionary
Consumer Staples
Information Technology
Communication Services
Real Estate
Each sector can be divided into subsectors, but these are the general sectors. At different phases of the overall market, you would shift your allocations toward other sectors; during a recession, you would likely shift your portfolio toward healthcare, utilities, and consumer staples, as they are considered “core” to society. When diversifying your stocks, you should look at the overall number and what sector you invest in.
Bonds
Bonds are often seen as safer investments than stocks. Bond values do not fluctuate as much as stocks, producing predictable annual income. The most common way to diversify your bond portfolio is by varying the qualities, lengths, and timing of your bonds.
Treasury Bills
Treasury bills have the lowest amount of risk: virtually zero. For treasury bills to default, the American Government would have to default, and at that point, treasury bills are the least of your problems. Because of the risk profile, treasury bills also generate the lowest returns. Diversifying your portfolio with T-bills is similar to bonds, but for most, it is investing in them in the first place.
Exchange-Traded-Funds (ETFs)
ETF stands for exchange-traded fund. An ETF holds a variety of securities in one category or class. Let’s say that you think the semiconductor industry will rapidly grow in the next 5 years, but you don’t know which individual stock to buy. Instead of researching each stock individually, you can buy a semiconductor ETF, which consists of different semiconductor companies. Instead of betting on one stock, you bet on them all. Other than index funds, ETFs are the easiest way to diversify your portfolio.
Index Funds
If Socrates is the father of philosophy, then the Standard & Poor’s 500 index of the largest US companies is the father of diversification. Since its inception, the S&P 500 has averaged annual returns of almost 12 percent. It’s so effective that in the last 10 years, less than 7 percent of US equity funds have outperformed it. The common indices in the stock market are the Dow, Nasdaq, S&P, and Russell 2000. You can diversify between the index funds or by holding at least one.
Working with a Financial Advisor
Financial advisors are a great way to access investment expertise.
Many people work with financial advisors for different parts of their investable assets. The main benefit of working with a financial advisor is that they can help with other investment and financial planning strategies, such as tax-loss harvesting and optimizing cash flow scenarios.
When choosing a financial advisor, we recommend choosing an advisor who serves as an investment fiduciary, as they are bound by law always to put your best interests first.
Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.
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