Eye on the Markets - 2017

Diversification is Key to Investment Portfolio

By Ketu Desai

Diversification is an important aspect to building your investment portfolio. Diversification is the idea that you should not put all your eggs in one basket, but rather spread them across various asset classes. I will provide an overview of diversification, and then use real-life examples as a benefit of diversification. Lastly, we will speak about the risks of diversification.

Simply, diversification allows you to reduce your risk. More specifically, the concept of diversification is that investors can improve their return relative to the amount of risk they are taking by investing in multiple investments versus concentrating the balance in a single investment. Diversification can simply mean adding stocks spread across many different sectors to a portfolio. I will use the portfolio in the context of diversifying across asset classes and overall financial life.

A good place to start to think about diversifying is of your earnings stream. Many people earn income in industries that are subject to certain economic or business cycles. A thought exercise might be, what can cause my industry to face hard times and thus affect my earnings stream? Further, during those hard times what are other sectors that could do well, and how do you gain exposure to them? This could help stabilize your earnings stream throughout the economic cycle, as well as reduce risk from the economic cycle.

The concept is similar in managing your portfolio. The portfolio should consist of various asset classes that can fit together in a way that helps reach your financial goals. Luckily, with exchange-traded funds (ETFs), you can gain exposure to various sectors, asset classes, and geographies at very little cost. An S&P 500 index tracker is a good starting point for your equity portfolio, it will give you exposure to 500 of the top U.S. traded companies. You can mix that with exposure to some bond products, and you are on your way!

The year 2008 is the prime example of the benefit of diversification. In 2008, the equity markets were down approximately 40%. A simply diversified portfolio as described above, would have saved you more than half of that loss! As a reminder, it takes a 33% gain to make up a 25% loss.

Of course, 2008 may be an extreme example, so let's focus on this year. To start the year after the inauguration of the new President Trump, the “Trump trade" was the key theme in financial markets. To summarize, the “Trump trade" means to focus on asset classes and sectors that will do well with higher growth, inflation, and interest rates.

Let's fast forward a couple of months to March, the month highlighted how quickly market dynamics and the narrative can change. At the end of February, President Trump delivered a speech that many investors considered his most “Presidential." On March 1, the day after, saw a significant market rally, with most domestic equity indices hitting all-time highs. The days following, the market lost steam, as the market was concerned about the Federal Reserve raising interest rates perhaps four times this year. When the market got a more dovish after the Fed press conference, it was off to the races again. The market quickly brushed off the Fed, and focused on healthcare. This caused an eight-day losing streak for the Dow, the longest streak since 2011.

Months like March highlight the importance of diversification. Nearly all aspects of the “Trump trade" lost money or underperformed. A portfolio positioned with that single theme, and undiversified, would have suffered meaningful losses. Meanwhile, seemingly all market participants were expecting interest rates to go higher this year, and that just has not been the case so far. Further, most people expected that oil prices would increase to north of $60/barrel, instead fell into the $40s during March. While a short period, running a diversified portfolio would have stabilized your portfolio. If done right, it can not only reduce the risk in your portfolio, but can also increase the return.

The legendary investor Warren Buffett said, “diversification is protection against ignorance. It makes little sense if you know what you are doing." In Buffett's view, one should study in detail each investment, and make a concentrated bet. Diversification will have an array of investments, often times off-setting each other, which can result in limited gains. That is one of the biggest risks to diversification. It is important to note that timeframe is an important consideration. Warren Buffett has a holding period or a timeframe of decades, therefore, he has time to wait if his investments suffer losses. Most of us do not have this luxury, and diversification helps prevent large losses in a time-period where you may need that capital.

Diversification, like most things, has its pros and cons, and there is certainly such a thing as over-diversification. However, when done right, it can reduce the risk of your portfolio, while allowing you to participate in market gains.