“You have to understand what market history looks like. What market history tells you is that the very, very best investments are made when things look the worst.”
—William J. Bernstein
Diversification of an investment portfolio is a best practice for long-term investors. You may think of it as “not putting all your eggs in one basket,” although it involves a bit more than that. Diversification is a risk management practice that mixes a wide variety of non-correlated investments within a portfolio.
Correlation, as it relates to your portfolio, measures the degree in which two securities move in relation to each other. The correlation, which ranges from -1 to +1, will tell you when one asset goes up (or down) in price whether another asset will go up (or down) in price. Assets that move together are said to be positively correlated and those that move in different directions are negatively correlated. For example, large-cap mutual funds generally have a high positive correlation to the S&P 500 Index, nearly 1. If the S&P 500 is up 3%, then large-cap funds will be up nearly 3% as well. Small-cap stocks have a positive correlation to the S&P 500 too, but it is not as high—generally around 0.8.
Diversification addresses two types of risk affecting your portfolio—systematic risk and unsystematic risk. Systematic risk is market risk that every investor is exposed to. Systematic risk cannot be diversified away by holding different assets and sectors in your portfolio. Examples of systematic risk that are extremely difficult to diversify away are wars, recessions, and interest rates.
Unsystematic risks are those that individual companies or sectors possess. Some examples of unsystematic risk are drug companies getting sued, a company CEO under investigation or summoned to testify before congress, massive data breeches, etc. Unsystematic risks can be reduced by holding non-correlated stocks, such as U. S. stocks of the S&P 500 and developed international stocks from countries such as Germany, Japan, and the U.K. Historically, U. S. stocks and developed international stocks have not moved in complete lockstep, so this is negative correlation. At times, U. S. stocks go up when international stocks are down.
The problem many investors have, however, is they want to own only the best performing stocks, so they end up chasing after whatever has been working lately. Unfortunately, no one can predict the future of market moves. Regardless, investors affected by hindsight bias often assume they know exactly what is happening and then decide to make a change in their portfolio to chase past winners. This rarely works out well.
As we have said several times before, the hardest part of long-term investing is inoculating yourself against reactions to short-term movements in the market.
Our overall strategy is to invest across multiple assets such as U. S. stocks, international stocks, real estate, bonds, and cash. We think global broad diversification offers three advantages. First, as we said earlier, no one knows the future. Diversification confirms a lack of foresight about a tremendously uncertain future. Second, given that some assets are up while others are down, you almost always have something underperforming in your portfolio. However, over the long-term, diversification only works if you have the commitment to let it work. Keep in mind that all assets are volatile, yet all assets behave differently over your investment horizon. Third, diversification is the closest thing in investing to a “free lunch,” (although we know there is actually no such thing as a free lunch), but diversification is straightforward to implement and reduces volatility in the portfolio, at relatively low transaction and ongoing costs.
We remain committed to utilizing diversification as a portfolio risk management tool. By diversifying away unsystematic risks, you are able to design your portfolio to take the amount and type of risk you are confrontable with.
We hope you’ve found this review to be educational and helpful. If you have any questions or concerns about your financial plan, goals, and objectives or your portfolio allocation and how diversification helps to support those goals and objectives, let’s talk. That’s what we’re here for.
As always, we are honored and humbled you have given us the opportunity to serve as your financial adviser.