If you take your MRI to a dozen doctors, you may get several different opinions about the cause of your back pain. Likewise, if you take your financial picture to a dozen financial planners, you may get several different opinions about how you should invest your money. However, if there is one piece of investment guidance that the majority of financial planning professionals agree upon, it’s the need for portfolio diversification. The odds are high that they all would explain the strategy to you by using the cliche, “Don’t put all your eggs in one basket.”
Portfolio diversification means finding a variety of investments (e.g., stocks, bonds, mutual funds, etc.) and real estate, spreading your investment nest egg across those vehicles, and perhaps even diversifying funds within those vehicles. The underlying rationale for portfolio diversification is risk management. If you plow all your dough into Apple shares, only to see Samsung, Google or some new startup develop a revolutionary electronic device that does more and costs less than Apple’s, your retirement funds could take a huge hit, one from which you might not be able to recover.
Of course, no amount of diversification will eliminate all risk, but diversifying assets will help you rest easier, secure in the knowledge that a disruptive technology, like a revolutionary phone, or geopolitical event—like a terrorist attack on oil fields in the Middle East—will not wipe out your portfolio.
It’s also worth noting that portfolio diversification can be practiced to a fault. In 2014, a team of three New York University School of Business professors and one from Yale University School of Management published the ninth edition of “Modern Portfolio Theory and Investment Analysis.” Modern portfolio theory posits that you would come very close to achieving optimal diversity after adding the 20th different stock to your portfolio.
The authors conclude that the average standard deviation, a measure of volatility or risk, of a one-stock portfolio was 49.2 percent. Increasing the number of stocks in the average well-balanced portfolio to 20 could reduce the standard deviation to a maximum of 19.2 percent. After that, increasing diversity from the 21st to the thousandth stock would further reduce risk by only 0.8 percent.
“Many investors have the misguided view that risk is proportionately reduced with each additional stock in a portfolio, when in fact this couldn’t be farther from the truth,” according to “The Dangers Of Over-Diversifying Your Portfolio,” an article on financial investment website Investopedia. “There is strong evidence that you can only reduce your risk to a certain point beyond which there is no further benefit from diversification.”
In addition, it may be difficult for the average investor to keep track of more than 20 stocks.
“To do initial research on a given investment, to keep track of earnings and profit, company news or other news that might change the stock’s story, takes a considerable investment in time,” he said. “Anyone managing a job or a business, and perhaps raising a family, will tell you how little time they have left in the day for actively managing a large portfolio of stocks.”
At some point, transaction costs for a much larger group of stocks or other investments begin to adversely affect performance.
Of course, buying any 20 stocks does not necessarily qualify as diversification. True diversification requires buying stocks that are different from one another, whether it be by company size, industry, sector or country. Also, simply buying stocks is probably not enough diversification for most people who want to manage risk well.
What are you willing to risk?
Before considering how to diversify your portfolio, first determine risk tolerance and investment objectives. For most of us, retirement is a major life goal. It means the income of a job or business that you’ve counted on for decades dries up and you must depend on your life savings, Social Security, and retirement plan to support yourself and your preferred lifestyle. You have departed from the accumulation stage of financial life and entered the distribution stage.
Young investors can afford to be more aggressive in their investments because they have the luxury of time. If there is a broad market decline, not too many portfolios can escape serious damage. If you were to come of retirement age in 2008 and were counting on living off money thrown off by your investments, you were rudely awakened by the 2007–2008 financial crises. During the 17 months between October 2007 and March 2009, the Dow Jones Industrial Average dropped from over 14,000 to 6,600, the biggest decline since the Great Depression, and not many investors or investing professionals saw it coming. If you were 20 years old, not 60, you still had an investment lifetime for the market to fully recover lost ground. Those contemplating imminent retirement, however, were justifiably alarmed when they woke up to a market crash—caused by a confluence of unsound economic policies and practices—and to a significantly smaller nest egg.
Since their objectives and risk tolerance are different, the younger, aggressive investor might want a total asset portfolio with a mix of 80 percent stocks and 20 percent bonds, while an older, very conservative investor might choose just the opposite, 80 in bonds, and 20 percent in stocks. Younger investors should take stock of their financial positions as they get older and their life circumstances change. In the intervening years before retirement, they might buy a home, start a family, sell or buy a business, develop a serious health issue, or set their hearts on a plan to leave the workforce early and travel the world.
In the precipitous 2008–2009 market selloff, it might have seemed to the individual investor that a diversification strategy failed. A closer look will reveal that, while the diversified investor did lose real ground, he or she lost less than those who hadn’t taken that precaution.
Strategic Advisors Inc., Fidelity’s registered investment advisor, has studied how three hypothetical portfolios would have performed during the crisis. One portfolio was all cash, one was diversified, and one was an all-stock portfolio. The all-cash portfolio did best by far in the depths of the crisis, actually gaining, marginally, in value. The diversified portfolio fell 35 percent from January 2008 through the market bottom in February 2009. The all-stock portfolio fell 49.7 percent during the same period. In the five years from the bottom, the diversified portfolio rose 99.7 percent, while the all stock portfolio gained 162.3 percent. Measuring the five-year period between the bottom in 2008 and February 2014, the study found that the all-stock portfolio barely beat the diversified portfolio, 31.8 percent to 29.9 percent.
Despite the gut-wrenching volatility in the market, a diversified portfolio performed almost as well as the all-stock one and allowed the portfolio owner to sleep better, particularly in the first year or so of the drop, declining by a bit more than one-third, while the all-stock portfolio fell by nearly 50 percent. Furthermore, the all-cash folks, while they didn’t lose their shirts during the crisis, would probably lose their shirts over the long haul, according to famed investor Warren Buffet.
The ups and downs
Buffet warned in a 2015 letter to shareholders that investors should not mistake volatility for risk. During the decades from 1964–2014, the S&P 500 Index returned 11,196 percent, including reinvested dividends. During those years, the value of a dollar fell by 87 percent. Thus, if you owned U.S. bonds during those years, you earned a “safe” rate of return, but you ultimately lost 87 percent of the purchasing power of those invested dollars. The purpose of having some cash in a diversified portfolio is to smooth out the bumps in market behavior and to produce income when you need it.
In its guide to diversification on its website, Fidelity Investments recommends that, to build a diversified portfolio, the investor “should look for assets—stocks, bonds, cash or others—whose returns haven’t historically moved in the same direction, and, to the same degree, and, ideally, assets whose returns typically move in opposite directions. This way, even if a portion of your portfolio is declining, the rest of the portfolio is more likely to be growing, or at least not declining as much.”
Fidelity also recommends staying diversified within each type of investment.
“It’s smart to diversify across stocks by market capitalization (small, mid and large cap) sectors, and geography. Again, not all caps, sectors and regions have prospered at the same time or to the same degree … . You may want to consider a mix of styles, too, such as growth and value.”
Market capitalization is the total dollar market value of a company’s outstanding shares.
When considering diversifying a portfolio, you should examine the management fees for various investments. You don’t want high fees you might find in mutual funds or annuities, for instance, to offset the advantage of diversifying your investments. Experts say that exchange-traded funds are a good way of diversifying and keeping expenses under control.
One other thing that most investment professionals agree on is the need to give your asset allocation a periodic scan. Some professionals advocate having an annual asset allocation checkup at the same time that you get your annual physical. Others might advocate more frequent oversight, but the vast majority agree that, as your risk management and investment objectives shift, and as the investing landscape changes, failure to pay attention to your asset allocation can be dangerous and lead to missed opportunities and, ultimately, missed retirement goals.