What Is Portfolio Diversification?
I’m diversified. I have money in three different mattresses!
Diversification is a strategy whereby investors spread out their risk by investing in multiple asset classes. In other words, they don’t invest all of their money JUST in domestic stocks or JUST in municipal bonds. They spread it out over a variety of investment types that have different risk profiles. That way, if their domestic stocks are doing poorly (losing money), their investments in bonds may bring in enough of a return to make up for their stock losses.
THE THEORY (AND A SIMPLER WAY TO LOOK AT IT)
For many investors, diversification is not just a best practice, but a requirement to help grow and protect their future income as effectively as possible. Modern Portfolio Theory (MPT) states that for a given portfolio of assets, there is an optimized combination of stocks, bonds, and other assets, which provide the greatest return based on the level of risk assumed. First described by economist Harry Markowitz in the 1950’s, MPT has led to the development of what’s known as the “efficient frontier,” which is essentially the sweet spot in investment where your risk and your returns are in alignment and support the best possible return on your investments.
Let’s put diversification into a context most Vermonters can relate to—the garden! There is a very popular and effective strategy for maximizing the crop yields, called companion planting, which involves planting herbs, vegetables, etc. alongside mutually beneficial plants. For example, a plant that requires full sun may be planted alongside one that requires full shade or a plant that requires an excessive amount of water may be placed near one that requires very little. The point is that the plants have different and compatible needs, thus mitigating the risk to both plants that their resources will be used up and improving the performance of both.
IS YOUR PORTFOLIO DIVERSIFIED FOR YOUR RISK LEVEL?
MEMBERS Financial Services can help you update your holdings.
WHAT DOES DIVERSIFICATION LOOK LIKE?
Now think about the asset mix within your portfolio for a moment. If you own too much stock in one company, it exposes you to the full risk of that company. If that one company has a poor earnings year, you will be in a position to lose a lot. Owning several companies that respond to differing business environments differently can protect your portfolio during an economic downturn.
The most common way investors achieve diversification (though by no means the only) is with mutual funds. A mutual fund, by its very nature, represents diversification since it is a basket of securities, actively managed for a desired outcome. There are thousands of mutual funds offered by hundreds of investment companies so it’s important to select a fund that matches your risk tolerance and investment goals.
With an initial investment oftentimes as low as $250, an investor can purchase shares of a fund that could represent 300 different stocks. Purchasing shares in 300 different companies would take a lot of time and could cost tens of thousands of dollars. Mutual funds simplify diversification by pooling a diverse selection of stocks together for you and selling you a portion of the full portfolio.
Portfolio managers working for the mutual fund company handle all the trading decisions and ensure that the fund stays true to its purpose. If one of the companies owned inside the fund has a terrible quarter, it may represent only 1% or less of the total portfolio. Oftentimes a portion of the portfolio manager’s salary is paid based on the performance of the fund, so they are always working on maximizing the return while managing risk.
Mutual Funds are offered at a cost and are sold by prospectus only. The prospectus describes fees, charges, expenses and other features of the product. Always discuss investments, including mutual funds, with a financial professional. Ask for a prospectus and read it carefully before investing.
WHY WOULDN’T YOU WANT A BALANCED PORTFOLIO?
Well-balanced (diversified) portfolios aren’t for everyone. For example, the short-term investor who is focusing on increasing returns may quickly become frustrated by the slower returns offered by such investments. You can find mutual funds that offer higher risk and therefore higher returns, but in general, balance means safety, which in investing, means slower and lower returns.
Need a real-life example? I could drive home from work in about five minutes if I really wanted to, I would just need to ignore all stop lights while maintaining an average speed of about 100 miles per hour. What are the risks? I think they are obvious, which is why I follow the posted speed limit signs and obey all traffic lights. I would like to successfully drive to and from work for the next 25 years, not just tonight. In the same way, having $10,000 invested in stocks associated with a high-risk industry may earn quick and high returns. They could also drop to $0 in value. People who want the high returns may enjoy the thrill and potential of that type of investment. Others may not.
HOW CAN YOU MAKE SURE YOUR PORTFOLIO IS DIVERSIFIED?
Review your holdings. The simplest way to do this is by looking for the pie chart typically found on the first page of your statement. The pie should have several slices! Even if you are younger and have a pure growth objective, the pie, or asset allocation chart, should indicate ownership in small, medium, and large companies as well as foreign and domestic-based companies. More conservative investors will own bonds in addition, which also offer differing levels of risk and many sub-types.
It’s important to note that diversification reduces concentration risk (the risk that comes with having all your proverbial eggs in one basket), as well as non-systematic risks (risks that affect only one asset or industry). It doesn’t protect you from risks that affect the entire stock market and won’t maximize your short-term gains, but rather is designed to smooth out the journey to your financial goals.
Trimming back some of the euphoric highs and softening the gut-wrenching lows associated with a volatile stock market can reduce stress for the everyday investor and keep more risk-sensitive individuals invested when it matters most, which might be the most valuable function of diversification.
Not all of us enjoy roller coasters. In fact, I’ve never been on one in my life! Come to think of it, I’ve been managing risk in my own life long before I thought about helping others manage theirs. Remember to slice your pie into several sections and keep your eggs in more than one basket. This sounds like the beginning of a nice picnic!
OTHER ARTICLES YOU MAY ENJOY:
The views and opinions expressed in this blog are those of the authors and do not necessarily reflect those of VSECU.
Representatives are registered, securities sold, advisory services offered through CUNA Brokerage Services, Inc. (CBSI), member FINRA/SIPC, a registered broker/dealer and investment advisor, which is not an affiliate of the credit union. CBSI is under contract with the financial institution to make securities available to members. Not NCUA/NCUSIF/FDIC insured, May Lose Value, No Financial Institution Guarantee. Not a deposit of any financial institution. FR-3357203.1-1220-0123
About Blair Wolston
A native Vermonter and licensed financial advisor, Blair enjoys listening to the stories of his neighbors while helping them to make important financial decisions. A self-described "Solution Hunter-Gatherer" he starts with the basics and builds repeatable strategies that transport his clients incrementally and deliberately toward their goals.