By Matt Kelley, Chief Investment Officer, ESL Investment Services
“Diversification is the only free lunch in investing” – Harry Markowitz
Diversification isn’t merely financial advice, it’s designed to ensure that when one sector of your portfolio struggles, the others hopefully remain standing. Let’s walk through the important aspects of diversification in greater detail, exploring how this fundamental principle can help position you for long-term success.
What is diversification?
Diversification is a strategy used to reduce portfolio risk by investing in a variety of securities across a portfolio. It is typically accomplished by investing in different asset classes (stocks, bonds, currencies, commodities, etc.). We can also diversify within asset classes by including different geographical locations, sectors, company sizes, maturities, and more. The goal of diversification is to help create a balance of risk and return that matches the investor’s investment goals.
What are the benefits of diversifying a portfolio?
Portfolio diversification is a common investing technique used to manage your chances of experiencing large losses. It is accomplished by taking advantage of the correlation, or lack thereof, across different investments. Correlation refers to the relationship between the return of two different investments. Ideally you want uncorrelated investments, so the assets move in different directions thus offsetting poor performance in one with better performance in another.
What are some examples of portfolio diversifications?
Research1 has shown that 20-30 stocks remove most of the company specific risk in a portfolio, however, these positions need to be diversified across sectors or industries, and even geographies. If an investor has a portfolio of 25 technology companies, they will likely have more long-term volatility than a portfolio of 25 companies diversified across different sectors.
Investors can also invest across different asset classes in order to pursue diversification. Most commonly, investors will invest in both stocks and bonds to diversify their portfolio, in addition to diversifying across securities, industries, and sectors within their stock and bond portfolios. Stocks prices tend to respond favorably to unexpected, positive economic growth, while bond prices tend to respond favorably to unexpected, negative economic growth. It is important to note that while bonds are a component to portfolio diversification in certain economic environments, investors may need to turn to other asset classes or strategies (ex. commodities, alternative investments) to fully diversify their portfolio. While stocks and bonds have different growth drivers, they can both respond negatively to inflationary shocks.
Is there a thing as too much diversification?
Yes, it is also possible to have too much diversification, or diversification in name only. Envision a portfolio with 40 different funds where many of the funds equal less than 3% of the total portfolio. Realistically, it is likely that these small allocations are not moving the needle and could instead be combined into a couple diversified investments that strive to achieve very similar exposure, often at a much lower cost.
Understanding risk tolerances
Investors have both an ability and a willingness to take risk. The investors’ ability to take on risk is typically determined by their time horizon and cash needs. In general, an investor with a longer time horizon (before cash is needed) may be able to endure more risk because they have more time to recover from market dips, and vice versa. Similarly, an investor with lower cash needs (as a percentage of the overall investment portfolio) would likely be able to take more risk. Compare a professional in their 30s who plans to continue saving for retirement for the next 35 years to a retiree in their 90s who pulls 10% off their investment portfolio annually for living expenses. The younger individual has a much greater ability to weather greater volatility and drawdowns in their portfolio.
Investors also have a willingness to take risk, which can be thought of as the investors ability to stomach greater drawdowns in the portfolio. Consider the 30-year-old investor mentioned above; they plan to continue to save for 35 more years until retirement and have no plans to pull from their portfolio before retirement. However, if their portfolio drops by more than an amount they are willing to risk, they may panic and sell their investments. This represents a mismatch in the investor’s ability and willingness to take risk. Together, these two characteristics make up an investor’s risk tolerance. Ideally, one would invest based off their ability to take risk. Often, an investor’s ability and willingness to take risk are aligned. When they are not, a conversation with an advisor can help an individual align their risk tolerance and financial goals.
If you don’t hate something in your portfolio, you may be doing it wrong.
Unfortunately, market returns over the last 15 years have not incentivized investors to diversify their portfolios. It can be difficult to rebalance away from what has been performing well (e.g. large technology stocks2 and growth3 at the end of 2024) to invest in something that has performed poorly (e.g. bonds4, international stocks5). It is more important than ever to reassess the portfolio for volatility and diversification as well as the alignment to ones’ ability to take on risk. This can be especially hard when all we hear from our neighbors is their recent success investing in today’s high-flying stock. However, nothing will be more meaningless to your success as an investor than the performance of someone else’s portfolio. Instead, investors should ask themselves this question: is there something in my portfolio that I hate? If the answer is no, then your portfolio may not be as diversified as you think it is.
