Everyone’s heard the old chestnut about putting all your eggs in one basket. It’s just common sense. If you have two baskets and drop one, you’ve still got some eggs. You’ve reduced the risk of having no eggs at all.
Correlation is Key
Roughly the same idea applies to investment portfolios. Diversification means investing in securities that are subject to different types of risk and have low to negative correlation. The correlation coefficient measures the relationship between two variables and is expressed on a scale of +1 to 0 to -1. When the coefficient is positive, the variables, in this case investment returns, are moving in the same direction. If it’s 1, they’re moving perfectly in tandem. Zero means there is no relationship between the variables, and a negative coefficient means they move in opposite directions. Choosing individual securities that offer low to negative correlation with each other is the key to constructing a diversified portfolio.
Diversification is a Method to Mitigate Risk
It’s important to understand that diversification isn’t intended to maximize returns; it’s a strategy to mitigate portfolio risk. There’s no guarantee that an investor with a diversified portfolio will outperform an investor with a concentrated portfolio. For example, if you invested in all tech stocks during a boom, you could significantly outperform a diversified portfolio. But the eggs, in this case tech stocks, are all in one basket. The diversified portfolio will be insulated from large losses when the bubble bursts, while the concentrated portfolio will take a big hit. Over time, diversified portfolios tend to outperform concentrated portfolios.
The First Step in Diversification
The first step in diversification is including different asset classes in your portfolio. It starts with choosing how much to invest in stocks versus bonds. Stocks and bonds, as asset classes, tend to move in different directions. When stock prices rise, the bond market tends to head south. The converse is also true; when the stock market is doing poorly, the bond market performs well. The stock market is volatile and bears more risk, so it offers more potential for growth than fixed income does. While bonds may generate lower returns, those returns are more stable. It’s a rule of thumb that younger investors with a longer time horizon will allocate more capital to stocks. As an investor ages, the equity allocation decreases while the amount invested in fixed income grows.
It’s Not Just About Stocks and Bonds
Diversification entails more than just deciding on how much to allocate between stocks and bonds. Other asset classes offer diversification benefits as well. For example, commodities tend to have a low correlation with both stocks and bonds, as does real estate. Many alternative investments like hedge funds offer a low correlation to equity while increasing potential portfolio returns but may be much more difficult for the average investor to access.
Other Ways to Diversify
You can also diversify within asset classes. Let’s take stocks, for example. You might diversify by industry: there are 11 recognized sectors comprising the S&P 500. Assume an inflationary environment, which has a negative impact on the stock market since spending, especially consumer spending, declines. Some sectors react more strongly than others. Consumer discretionary declines, but the consumer staples sector is less affected because companies in this sector make staple products people can’t easily go without. Healthcare is also less likely to take a big hit because there is little consumer discretion involved in its consumption.
There are plenty of other ways to diversify too. Choosing large cap and small cap companies is an option as small caps tend to bear higher risk but offer more return. Growth and value strategies tend to be negatively correlated, and when one does well the other languishes. Geography is another source of diversification; choose between emerging and developed markets, or US and Europe, for example. Within the fixed income portion of your portfolio, you can balance your holdings between different levels of credit risk (as measured by agency ratings) and different levels of interest rate risk, which is a function of a bond’s time to maturity. Longer bonds have higher interest rates since there is greater uncertainty about rates over the longer period.
The Takeaway
Diversification offers risk mitigation benefits that can’t be ignored. It should be clear by now that it’s wise to include a range of investments in your portfolio and pay close attention to asset allocation. This can be complicated with all the choices available.
