No matter which style of investor you are, diversified investments will be the foundation of your success. Low-risk investors can still put all their eggs in the wrong basket and end up with snail’s pace interest – or, worse yet, negative inflation. High-risk investors may have a chance at earning huge dividends, even if one of their investments totally tanks, so long as their portfolio is a healthy blend of opportunities. Rather than just setting up a diversified portfolio and letting it run itself, you will need to re-check your asset allocation at least once a year to consider whether or not your investments remain balanced and representative of your financial goals.
What is Diversification and Why Diversify?
“Diversification is the only free lunch in investing,” said Nobel Prize Laureate Harry Markowitz in 1952. Putting together a variety of different investments – mixes of different stocks, bonds, or mutual funds, for instance – is one of the best ways you can reduce risk and enhance performance over the long term.
There is no “sure thing,” and there is no guarantee against losses in the market, but a diversified portfolio is less risky than a concentrated portfolio. If you own stocks in multiple companies across multiple industries, it won’t be such a big deal if one of them performs poorly. You’ll also be able to make a partial investment in asset classes where you wouldn’t want to put 100% of your savings.How Does Diversification Work?
Say, for instance, you have invested in airline stocks. If airline pilots go on strike, the share prices of airline stocks will drop and your portfolio will feel the pain of it. If you have also invested in railway stock, your shares might pick up as more people turn to trains for transportation. If there is a disturbance to the travel industry in general, you’ll be glad you invested in that new tech startup. You’ll also want to diversify among asset classes with a mix of stocks, bonds, and equity. Choose some stocks for growth, and others for value. Invest in bonds with varying maturities and time frames.
Diversification Offers Long-Term Value
Over a 20-year period from 1996-2016, globally invested indexed portfolios achieved 6% returns, while US stock/bond portfolios fared slightly better at 7.6% annually. With typical spending rates of 5% and 2.1% inflation, most of these investors would be in a rough patch. By contrast, investors with highly diversified portfolios saw 8.6% annual returns, even after accounting for investment management fees. Researchers conclude that long-term investors have more money today because they stayed with the long-term, highly-diversified approach.
A 20-year study found a simple mix of 55% US stocks, 30% US bonds, 10% foreign shares, and 5% emerging market stocks gained an annualized 8.7%, and lost 27% in the 2008 market crash. Had you added international bonds, REITs, commodities, and hedge funds, you would’ve done slightly worse with 8.6% annualized gains, and a 25% loss in 2008. So, you will find some experts who believe as little as 10 is enough diversification, while others will tell you going much beyond 30 securities is just superfluous water over the dam. Other advisors believe “the more the merrier” and recommend juggling more than 100 stocks. In fact, there are major studies to back up all of these beliefs.
To diversify your portfolio:
· Create your own “mutual fund” by investing in companies you know and trust.
· Align your stocks, bonds, and short-term investments to your financial needs and volatility comfort level.
· Add index funds or fixed-income funds to hedge against market uncertainty.
· Use dollar-cost averaging into a specified portfolio of stocks or funds on a regular basis to weather volatility.
· Buying and holding might work, but it pays to keep an eye on market conditions and know when to get out.
Financial advisors will help you strike a balance of investing and risk tolerance through a diverse portfolio. For instance, a conservative investor who is more risk-averse might invest 50% in bonds, 30% in short-term investments, 14% in US stock, and 6% in foreign stock. The average annual return is just shy of 6%. At best, the conservative investor might lose 17% or gain 30%. Over two decades, the worst annualized return might be about 3%, and the best 11%.
On the opposite end of the spectrum, an aggressive investor with a flair for taking big gambles to go after big returns might put 60% in the US stock market, 25% in foreign stocks, and 15% in bonds for an average annual return close to 10%. At best, his returns top 137% over the course of the year. At worst, he loses 60%. Yet, even for this high-risk investor, a diversified portfolio results in a minimum of 2.66% annualized returns or maximum of 16.49% over 20 years.
Financial advisors will help you strike a balance of investing and risk tolerance through a diverse portfolio. For instance, a conservative investor who is more risk-averse might invest 50% in bonds, 30% in short-term investments, 14% in US stock, and 6% in foreign stock. The average annual return is just shy of 6%. At best, the conservative investor might lose 17% or gain 30%. Over two decades, the worst annualized return might be about 3%, and the best 11%.
On the opposite end of the spectrum, an aggressive investor with a flair for taking big gambles to go after big returns might put 60% in the US stock market, 25% in foreign stocks, and 15% in bonds for an average annual return close to 10%. At best, his returns top 137% over the course of the year. At worst, he loses 60%. Yet, even for this high-risk investor, a diversified portfolio results in a minimum of 2.66% annualized returns or maximum of 16.49% over 20 years.
A good target mix today may not necessarily be a balanced portfolio tomorrow. Past performance is no guarantee. Re-balancing not only reduces risks, but aligns with your risk tolerance in a way that’s comfortable for YOU. The team at Sixth Avenue can assist with your investment management needs, including diversification to mitigate loss.
Additional Resources:
Investopedia – Importance of Diversification, https://www.investopedia.com/investing/importance-diversification/
2. Motley Fool – Advantages of Diversification Strategies, https://www.fool.com/knowledge-center/advantages-of-diversification-strategies.aspx
3. EVLI Blog – Diversification is the only Free Lunch in Investing, https://blog.evli.com/funds-hub/factor-investing/diversification-is-the-only-free-lunch-in-investing
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