We often speak with clients about the importance of diversification in their investment holdings. But what is diversification, exactly, and how does it affect your portfolio? If diversification is so great, how do you achieve it, and how do you maintain it?
We all know the old saying, “Don’t put all your eggs in one basket.” This is the classic concept of diversification, but in some ways, proper diversification can be more difficult to achieve than the average investor might think. In other words, there is such a thing as “false diversification”: believing your investments are well diversified when, actually, they aren’t.
The reason that false diversification can exist goes back to a basic principle of diversified investments: non-correlation. This means that a properly diversified portfolio will contain assets with characteristics that are dissimilar enough that different market conditions will tend to affect them differently. The classic example is a portfolio that holds both stocks and bonds. Because stocks represent a share of ownership in the underlying company, they will tend to react most strongly to perceptions of a company’s underlying value or future prospects. Because bonds represent money loaned to the company (or, perhaps, a government), they will tend to react most strongly to changes in interest rates or the bond issuer’s creditworthiness. Because they are affected by different conditions, stocks and bonds are said to be non-correlated. And that is why most well diversified portfolios hold a mixture of equities (stocks) and fixed-income (bonds).
Now we return to the idea of false diversification. Suppose an investor subscribes to the market adage, “Buy your straw hats in the winter.” In other words, she is a value investor who purchases equities of companies that she believes are selling at a low price relative to the company’s underlying value. She owns shares of 100 different value stocks. That’s a lot of different companies, so she must be well diversified, right?
Not really. Because all her holdings are of a similar type—value stocks—they are highly correlated. That means that the market conditions affecting one of her stocks is likely to affect them all in similar ways. This is false diversification—all the eggs in one basket.
Here’s another example. An investor has his funds distributed across six different mutual funds. As we know, each mutual fund holds dozens, or maybe hundreds of different assets. So, if he has six mutual funds, and each mutual fund has lots of different holdings, he must be well diversified, correct?
Not necessarily. What matters most is what each fund is actually holding and what the fund’s investment objective is. If he has six different funds, but they are all focused on high-growth companies, or emerging markets, or blue chips, or any other single sector, that is still false diversification.
The benefit of true diversification, of course, is that it helps to limit a portfolio’s exposure to volatility—the stomach-churning ups and downs that can occur in the financial markets. When a portfolio is properly diversified, the investor should see that when one asset class is down, another may be little changed, or even up slightly. That is the great benefit of true diversification. It permits the investor to benefit—or be at least somewhat protected—from a number of different market and economic conditions.
A qualified financial advisor can help you look at the assets in your portfolio and determine what they really are and which other assets they would be correlated with. At Shone Wealth Management, we specialize in helping you achieve broad diversification within the parameters established for your unique risk tolerance and long-term strategy. It all starts with a conversation, and if you have questions about diversification in your portfolio, we would love to hear from you.