Diversification: A Pillar of Sound Investment Selection
- Christopher Devlin, CFA
- Mar 8, 2023
- 5 min read
Updated: Apr 8, 2024
Diversification is a fundamental principle of investing that involves spreading your investments across different assets and asset classes to reduce risk and potentially enhance returns. By diversifying your portfolio, you can mitigate the impact of any single investment and minimize the impacts of market volatility and unexpected events. Diversification allows you to create a mix of investments that align with your risk tolerance, core values, and financial goals, while also providing exposure to a range of industries and sectors.
Summary
Diversification reduces risk and potentially enhances returns by spreading investments across different assets, sectors, and regions.
Key drivers for diversification are asset class and geographic diversification.
A diversified portfolio can generate retirement income, manage market volatility, and provide protection against unforeseen events.
Ongoing monitoring is essential for making well-informed decisions about investment strategy.
Building a diversified portfolio
To build a well-rounded investment portfolio there are key drivers that must be adhered to, and those that are less important.
The Key Drivers
Diversification by Asset Class
Asset class diversification is a strategy of investing in a variety of different asset classes, such as stocks, bonds, commodities, and real estate. By investing across different asset classes, investors can spread their risk and potentially enhance their returns. This is because different asset classes often perform differently in various market conditions. For example, stocks may perform well during a period of economic growth, while bonds may perform better during an economic downturn. Real estate can provide a hedge against inflation, while commodities may benefit from global economic trends. By diversifying across asset classes, investors can potentially improve their overall investment performance while minimizing the impact of any single investment.
Diversification by Geography
Geographic diversification is a strategy of investing in different countries and regions across the world to spread the risk of an investment portfolio. By investing in multiple countries, investors can mitigate the impact of localized risks, such as political instability, natural disasters, or economic downturns. Geographic diversification also provides exposure to a broader range of industries and sectors, which can potentially offer higher returns than a single market or region. Additionally, it allows investors to take advantage of varying economic cycles, as some countries or regions may be experiencing growth while others are slowing down.
Historically, achieving geographical diversification was slightly challenging and relatively expensive. Investors had to purchase emerging market funds with higher expense ratios to gain exposure to emerging markets, but in today's hyper connected world, the global economy is increasingly interconnected, and companies are no longer limited by geographical borders.
As a result, many companies from developed markets, such as the US, earn a significant portion of their profits overseas, particularly in emerging markets. For instance, the S&P 500 companies earn a large portion of their profits from emerging markets such as China, India, and Brazil. This means purchasing an S&P 500 index funds provides outstanding emerging market exposure. Conversely, many emerging market companies earn a large portion of their profits serving US companies, which implies that purchase an "emerging market fund" actually may not provide the as much geographical diversification as an investor might suspect, and the fund likely will carry a much higher fee.
Secondary Considerations
Diversification by Market Capitalization
Diversifying across market capitalizations, or the size of a company, is a commonly recommended strategy for investors. This involves investing in companies of varying sizes, including large-cap, mid-cap, and small-cap stocks, to spread risk and potentially increase returns. While diversification is generally a good practice, some argue that diversifying across market capitalizations is not as important as other types of diversification, such as asset class diversification or geographic diversification. This is because studies have shown that the returns of different market capitalizations tend to be highly correlated, meaning they move in the same direction at the same time. Therefore, while diversifying across market capitalizations may offer some benefits, it may not be as crucial as other types of diversification for building a well-rounded investment portfolio. Ultimately, the most effective strategy for an investor will depend on their individual risk tolerance, financial goals, and investment preferences.
Generating Income for Retirement
A well-diversified portfolio can also help generate income in retirement. By including a mix of income-producing assets, such as bonds, dividend-paying stocks, and real estate investment trusts (REITs), retirees can create a steady stream of income to supplement their Social Security or pension benefits. Diversification ensures that retirees are not overly reliant on any single source of income, providing a safety net in case any particular investment underperforms.
Managing Market Volatility
Market volatility is an inevitable part of investing, and it can be particularly concerning for retirees who have a shorter time horizon and may not have the luxury of waiting for markets to recover. A diversified portfolio can help manage market volatility by spreading risk across different investments that are less likely to be affected by the same economic events. This can lead to smoother investment returns and reduce the impact of market fluctuations on a retiree's portfolio, providing them with more peace of mind during their golden years.
Future global events are inherently unknowable and unpredictable, making it challenging to accurately forecast their impact on the financial markets. Geo-political events, such as wars, conflicts, and political crises, can have a significant impact on the markets, as they can lead to increased volatility and uncertainty. For example, the terrorist attacks of September 11, 2001, led to a sharp drop in the stock market, as investors reacted to the uncertainty surrounding the event. Similarly, the Arab Spring in 2011 and the subsequent conflict in Syria caused oil prices to spike, impacting markets globally. The ongoing COVID-19 pandemic is another example of an unforeseen event that has had a significant impact on the markets, leading to unprecedented volatility and uncertainty. While investors can use diversification to help mitigate the impact of these unforeseen events, they can never completely eliminate the risks associated with investing in the markets.
Ongoing Monitoring
After constructing a diversified investment portfolio that aligns with one's financial goals and risk tolerance, it becomes crucial to consistently monitor the performance of the investments. By keeping track of the portfolio's progress, an investor can stay updated on any changes in market conditions or individual investments, enabling them to make well-informed decisions about their investment strategy. Continuous monitoring also assists in identifying potential risks or opportunities that may warrant action. For instance, if a specific investment is underperforming, reassessing its position in the portfolio or considering a replacement with a more promising investment might be necessary. Furthermore, keeping an eye on the portfolio helps maintain accountability to long-term financial goals and allows for adjustments as required. In essence, regular monitoring of an investment portfolio is a vital practice for anyone seeking long-term financial success.
Conclusion
In summary, diversification is an essential principle of investing that enables investors to minimize risk, manage market volatility, and potentially enhance returns by allocating investments across different assets, sectors, and geographical regions. For retirees, a well-diversified portfolio can provide income generation, stability during uncertain times, and protection against unforeseen events. It is crucial for investors to build a diversified portfolio by focusing on key drivers, such as asset class and geographic diversification, while also considering secondary factors like market capitalization.