Portfolio Diversification - How To Diversify Your Portfolio
Portfolio diversification is considered to be the only free lunch in investing. In this post, I'll show you why and how to diversify your portfolio.
What Is Portfolio Diversification?
Portfolio diversification simply means combining different assets in one's investment portfolio, effectively spreading out your risk. As the related adage says, "Don't put all your eggs in one basket," as it could be disastrous. This couldn't be more true in relation to investing and retirement planning.
By diversifying one's portfolio, the primary goals are to boost and maintain returns over time and also reduce the risk profile of the portfolio as a whole to avoid the permanent loss of capital and decrease the dispersion of possible outcomes. Specifically, we want to hold assets that don't move in the same direction at the same time. Portfolio diversification can describe holding:
Different asset classes - stocks, bonds, etc.
Different assets within those classes - Google, Amazon, Johnson & Johnson, Tesla, treasury bonds, corporate bonds, municipal bonds, etc.
Different cap sizes - small stocks, large stocks, etc.
Different styles - value stocks and growth stocks.
Different sectors - technology, financials, industrials, etc.
Different geographies - stocks and bonds from different developed countries and developing countries around the world.
Different exposure through time, aka temporal diversification.
Different, independent sources of systematic portfolio risk, known colloquially as factors.
Let's talk about why portfolio diversification is important in the first place.
Why Is Portfolio Diversification Important?
To illustrate why portfolio diversification is important, we can use a simple example. As is usually done, we'll use stocks for the example, as stocks are typically treated as the basis for an investment portfolio due to their greater expected returns compared to other asset classes.
While it may have paid off in cases like Apple and Amazon (survivorship bias!), it should be pretty obvious that it would be extremely risky - and a bad idea - to put your life savings in a single stock for 30+ years. Had you done this with Lehman Brothers or Pier 1 Imports, for example, it would have been a very different story - you'd be left with next to nothing. So we want to hold more stocks.
But we also know stock picking doesn't work. So extending our example to its logical conclusion, we want to go broader with more types and sizes of stocks, and then going even broader, more asset classes outside of stocks.
Consistency is perhaps the most important thing in investing. Do whatever allows you to stay the course. Portfolio diversification "stabilizes" returns and trims peaks and valleys for a smoother ride. It is the best defense against uncertainty and black swan events. Generally speaking, the shorter your time horizon, the more important diversification becomes. Similarly, once you reach your financial objective (your dollar amount at which you can retire), there's no real reason to not maximize diversification. That is, after you win the game, stop playing. The exception would be if for some reason you want to continue to attempt to aggressively grow your portfolio after retirement in order to grow the legacy to leave to someone as an inheritance, but this tactic may very well result in you losing the money you need to live in retirement.
At a certain level of diversification on the sliding scale from none to maximum, one's desire to keep diversifying will depend on their risk tolerance, time horizon, and subsequent asset allocation. That is, how much volatility (fluctuation in value) and drawdown (drop in value) can they stomach psychologically? And how much capital can they realistically afford to lose based on the time until their financial objective? But we can pretty reliably conclude that even the young investor who wants to go 100% stocks for a while should still probably be fully diversified within stocks.
We must also acknowledge the fact that most investors, especially novices, tend to severely overestimate their tolerance for risk and also succumb to recency bias. If you maximize risk by investing 100% in stocks but then you panic sell during the next market crash when your portfolio's value drops by 40%, you have overestimated your risk tolerance, and your asset allocation should be adjusted to be more conservative. Recency bias refers to the erroneous belief that the recent past will continue into the future. Investors in the late 1970's just assumed that high inflation had become a normal part of the economic landscape forever. Investors over the decade 2010-2019 flocked to large cap growth stocks and specifically Big Tech based on their stellar performance during the period, though their valuations now indicate that they have lower future expected returns. The future is unknowable. Trust that you will encounter different economic and market regimes - and likely several crashes - that will test your ability to stay the course. Thus, the sensible investor should prepare accordingly by diversifying.
The annual Callan Periodic Table of Investment Returns is probably the best illustration of why broadly diversifying one's portfolio is important:
Source: Callan.com
In short, this quilt tells us that different asset classes in different geographies outperform at different times, and this is impossible to predict ahead of time, so it's likely wise to have some exposure to all of them. Let's look at how to do that.
How To Diversify Your Portfolio
We can talk about how to diversify your portfolio by going through just a couple asset classes. Remember, based on the beautiful quilt above, a low- to medium-risk-tolerance investor should probably want to diversify across different asset classes.
Stocks
My website analytics tell me the majority of my audience are males in the United States age 18-45. Stocks, also called equities, probably form the basis of the portfolios of this audience (and they probably should). Again, stocks have greater expected returns than any other asset class because they are considered the riskiest, so this makes sense. On average, securities markets tend to reward investors for taking on more risk.
Once again, we know picking individual stocks is not the best idea. Here are some quick facts that illustrate this point:
The evidence has shown that even most professional investors can’t pick winners that beat the market over 10+ years, much less the average retail investor like you and me.
On the 50th birthday of the S&P 500 index, only 86 of the original 500 companies remained.
Blindfolded monkeys randomly throwing darts for stock picks have beaten top hedge fund managers not just once, but consistently.
Most stocks underperform the market; only a select few drive massive returns. Specifically, for U.S. stocks from 1926 through 2017, in terms of lifetime dollar wealth creation, only 4% of stocks accounted for the net gain above T-bills. Looking at global stock returns from 1990 through 2018, only 1.3% of stocks accounted for the positive wealth creation in excess of T-bills.
We can solve these issues in U.S. stocks by using broad index funds.
These index funds also provide immediate diversification across all stock sectors - technology, industrials, financials, etc. Just like we can't predict the performance of individual stocks, we can't predict the performance of sectors either:
Source: IFA.com
A broad index fund is self-cleansing in this sense; well-performing stocks and sectors rise within the fund and poor-performing stocks and sectors decrease in weight.
But the U.S. is just one single country of many around the world, and like the Callan periodic table tells us, we wouldn't expect one country to consistently outperform. If one did, that outperformance would also lead to relative overvaluation and a subsequent reversal.
At global market weights, U.S. stocks only comprise about half of the global stock market. International stocks don’t move in perfect lockstep with U.S. stocks, offering a diversification benefit. If U.S. stocks are declining, international stocks may be doing well, and vice versa.
If you're reading this, chances are you're in the U.S. You also probably overweight - or only have exposure to - U.S. stocks. This is called home country bias. The U.S. is one single country out of many in the world. By solely investing in one country's stocks, the portfolio becomes dangerously exposed to the potential detrimental impact of that country's cultural, political, and economic risks. If you are employed in the U.S., it's likely that your human capital is highly correlated with the latter. Holding stocks globally diversifies these risks and thus mitigates their potential impact.
Excluding stocks outside the U.S. means you're missing out on leading companies that happen to be based elsewhere. Similarly, there have been periods where a global portfolio outperformed a U.S. portfolio. During the period 1970 to 2008, an equity portfolio of 80% U.S. stocks and 20% international stocks had higher general and risk-adjusted returns than a 100% U.S. stock portfolio.
U.S. or international outperformance tends to be cyclical.
If I were writing this in 2010 (or 1990, or 1980), we'd be talking about how a global portfolio beat a U.S. portfolio the previous decade. Consider the famous "lost decade" of 2000-2009, for example, during which the S&P 500 was down 10% but Emerging Markets were up 155% and international Developed Markets were up 13%. The important takeaway is that it's impossible to know when the performance pendulum will swing and for how long, much less how those time periods would match up with your personal time horizon and retirement date.
Moreover, U.S. stocks' outperformance on average over the past half-century or so has simply been due to increasing price multiples, not an improvement in business fundamentals. That is, U.S. companies did not generate more profit than international companies; their stocks just got more expensive. And remember what we know about expensiveness: cheap stocks have greater expected returns and expensive stocks have lower expected returns.
For U.S. investors, diversifying globally in stocks is also a way to diversify currency risk and to hedge against a weakening U.S. dollar, which has been gradually declining for decades. International stocks tend to outperform U.S. stocks during periods when the value of the U.S. dollar declines sharply, and U.S. stocks tend to outperform international stocks during periods when the value of the U.S. dollar rises. Just like with the stock market, it is impossible to predict which way a particular currency will move next.
Dalio and Bridgewater maintain that global diversification in equities is going to become increasingly important given the geopolitical climate, trade and capital dynamics, and differences in monetary policy. They suggest that it is now even less prudent to assume a preconceived bet that any single country will be the clear winner in terms of stock market returns.
In summary, geographic diversification in equities has huge potential upside and little downside for investors.
I went into the merits of international diversification in even more detail in a separate post here if you're interested.
Bonds
Bonds are also called fixed income.
Of interest to us here is the fact that stocks and bonds are uncorrelated with each other, meaning when stocks zig, bonds tend to zag. Bonds offer the lowest correlation to stocks of any asset class, and are thus the best diversifier to use alongside stocks. I'll be referring to this concept of asset correlations a lot from here to the end of this post; it's the primary concern in considering adding diversifiers to the portfolio.
On average, bonds are less risky than stocks. Because of that, they also have lower expected returns than stocks, especially at low interest rates. But here again, there have been extended periods where bonds outperformed stocks, so it would be foolish to ignore them completely, especially for risk-averse investors and/or retirees. Bonds are particularly useful for retirees who may desire to simply live off the interest payments.
You've maybe heard of the classic 60/40 portfolio. It is composed of 60% stocks and 40% bonds, considered a near-perfect balance of risk and expected return. Bonds mitigate the impact of the risks of holding stocks. Stocks mitigate the impact of the risks of holding bonds. Such is the beauty of diversification.
Adding bonds alongside stocks tends to smooth out the ride (less volatility, measured by st. deviation, and smaller max drawdown) by making stock downturns less impactful, but typically sacrifices some performance in doing so. Specifically, historically the 60/40 portfolio's volatility has been about 1/3 lower - and its max drawdown roughly cut in half - compared to a 100% stocks portfolio, leading to its higher risk-adjusted return (e.g. Sharpe ratio).
In the Dotcom crash of 2000 and the Global Financial Crisis of 2008, for example, the 60/40 portfolio fell much less than the 100% stocks portfolio. This is particularly significant for a risk-averse investor. Again, I can't stress enough that most investors severely overestimate their tolerance for risk and do not have the stomach for a 100% stocks position, only realizing it during a market crash and panic selling, which is precisely what you shouldn't do. The asset allocation that's right for you is the one that allows you to stay the course, invest regularly, ignore the short-term noise, and avoid panic selling during a market crash.
Conclusion
Portfolio diversification seems to be the only free lunch with investing, with the purpose being an attempt to both maintain consistent returns and reduce risk. There are many different types of diversification, and for the most part, it's likely beneficial to utilize them all.
Luckily, we’re pros at diversification here at Exian. Contact us today to see if your portfolio is properly diversified.