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The Truth About Diversification

Diversification is a method that reduces risk by allocating money in a portfolio among various types of investment categories.  Those categories are known as “asset classes”, and deciding how much to put in to each asset class is known as “asset allocation”.  The rationale behind diversification is that a portfolio of different kinds of investments will generate higher returns with lower risk than one with only a few investments.

Why You Should Diversify
Let's say you have a portfolio of only one investment, all in a large insurance company.  It grows nicely and pays a handsome dividend for years, but then, a series of tornados in the Midwest devastate thousands of homes.  A short time later, two major hurricanes hit Florida then the gulf region.  Potential claims are so substantial that the insurance company could go bankrupt, and its stock plummets.  Your portfolio is crushed.  But now let’s say that instead of putting all of your money in to owning one insurance company, you had split your money equally putting half in to the insurance company and the other half in to a home improvement and building materials company.  In this instance, while the storm damages would cause your insurance stock to lose value, at the same time, homes would have to be rebuilt or repaired and the demand for building materials would skyrocket, as would your investment in the building materials company.  A statistician would say that because these two stocks seem to counterbalance each other, they do not have a strong “correlation”, meaning that they do not act the same way.  In building a diversified portfolio then, we want to have asset classes that not only do not act the same way, but actually have some degree of “inverse correlation”, meaning that if some investments go down, others will go up to offset losses (stocks and bonds often move in opposite directions).  This is why diversification keeps your risk of losses in check.  Now as you might imagine, the more you diversify your portfolio with inversely correlated asset classes, the better chance you have to lower risk.

Diversification or Diworsification?
Diworsification is a play on the word diversification, coined by the famed fund manager Peter Lynch.   While diversification involves a selection of assets with inverse correlations, which reduces risk and can increase potential returns, “diworsification” occurs by investing in too many assets that may appear to be different, but in fact act the same way.  A common mistake for example, would be for an investor to split his money over the top five performing U.S. large company mutual funds, with the assumption that five different mutual funds would be five totally different “diversified” investments.  On closer inspection however, by drilling down and looking at the top 25 stocks that each of these different mutual funds owned, one would be surprised to see that they all owned almost the exact same individual stocks.   

Two Kinds of Risk
When we talk about managing risk in the investing process, it’s important to note that there are actually several types of risk we need to be concerned with.

Systematic Risk – These are risks that affect the entire market and cannot be completely diversified away. Interest rate increases, recessions, political instability, exchange rates and wars are examples of systematic risks.

Unsystematic Risk – These are risks that are specific to individual stocks or investments, and can be diversified away as you increase the number of stocks or investments in your portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the advantages of diversification will exist only if the securities in the portfolio are not perfectly correlated

What is Asset Allocation?
Asset allocation is the strategy of dividing your total investment portfolio among various asset classes (that are not perfectly correlated), such as equities (stocks), fixed income (bonds), real estate, commodities, precious metals, etc. Asset allocation is the method we use to achieve effective diversification.
Some common asset classes are as follows:

  • Large-cap stock – These are shares issued by large companies with a market capitalization generally greater than $10 billion.
  • Mid-cap stock – These are issued by mid-sized companies with a market cap generally between $2 billion and $10 billion.
  • Small-cap stocks – These represent smaller-sized companies with a market cap of less than $2 billion. These types of equities tend to have the highest risk due to lower liquidity.
  • International securities – These types of assets are issued by foreign companies in developed nations, and are listed on a foreign exchange.  International securities allow an investor to diversify outside of his or her country, but they also have exposure to country specific economic or political risk.
  • Emerging markets – This category represents securities from the financial markets of a developing country. While investments in emerging markets can offer a higher potential return, there is also higher risk, often due to political instability, country risk and lower liquidity.
  • Fixed income securities – The fixed-income asset class comprises bonds or other debt obligations that pay the owner a set amount of interest, periodically or at maturity, as well as the return of principal when the security matures.  Maturities can range from short term to intermediate or long term.  These securities are intended to have lower risk because of the steady income they provide.  In reality, bonds can fluctuate in value and be worth more or less than the price you originally paid, if you seek to sell them before maturity.  In addition, there is always a risk of default if the issuer cannot repay the principal when due. Fixed-income securities include corporate and government bonds.
  • Money market – Money market securities are debt securities that are extremely liquid investments with maturities of less than one year. Treasury bills (T-bills) and short term commercial paper make up the majority of these types of securities.
  • Real-estate investment trusts (REITs) – Real estate investment trusts (REITs) trade similarly to equities, except the underlying asset is a share of a pool of mortgages or properties, rather than ownership of a company.

There is no standard formula that can find the right asset allocation for every person.  A customized asset allocation plan should only come after a professional assessment of an investor’s age, level of risk tolerance (how much can he lose in the short term and still sleep at night), anticipated future additions to the portfolio during working years, investment objectives (such as how big does the portfolio need to be at retirement age to meet expected living expenses) and other pertinent financial planning issues.  Only then can his specific investment goals be properly understood, and a roadmap to get there be designed.

Strategic and Tactical Asset Allocation 
After an assessment is made and a suitable asset allocation plan is determined, a portfolio is divided in to various percentages of each asset class.  Over time, some classes will grow in value, and others will lose in value.  Using a strategic asset allocation method, those asset classes are periodically “rebalanced” back to their original starting percentages to keep risk management and diversification on track.  For example, an investor with a $200,000 portfolio may start with an asset allocation of 50% in stocks and 50% in fixed income.  After a year, when stocks have outperformed bonds, the portfolio now holds $130,000 in stocks and $110,000 in bonds.  Rebalancing would result in the sale of $10,000 worth of stocks from the portfolio, and the proceeds would be used to buy bonds, to get back to the original 50%/50% allocation.

On the other hand, if a tactical asset allocation method is used, a portfolio manager seeks to create extra value by modifying the percentages in each asset class to take advantage of certain economic or market conditions.  This is a more active strategy where a portfolio manager only returns to the portfolio's original strategic asset mix after desired short-term profits are achieved.

Diversification via asset allocation is a fundamental investing principle, because it helps investors maximize profits while minimizing risk. Choosing an appropriate asset allocation strategy and conducting periodic reviews will ensure you maintain your long-term investment goals and reach your desired return at the lowest amount of risk possible.