Meridian Blog

Harry Markowtiz, the Nobel-winning Pioneer of Modern Portfolio Theory, was quoted as saying that “diversification is the only free lunch in investing.” Properly diversifying may not always feel “free.” We tend to joke that in a diversified portfolio, there will always be something you are not happy with owning; however, diversification stands as one of the most fundamental principles for managing risk and optimizing returns in the ever-evolving world of investing.

These last few weeks in the markets have proven that diversification is hugely important to managing the uncertainties of the future. Below are the 1-month, 3-month, and 6-month performances of the major stock sectors.  While some sectors held steady, the majority of the sectors have rotated wildly over the last several months.

Source: https://www.sectorspdrs.com/sectortracker

Source: https://www.sectorspdrs.com/sectortracker

Source: https://www.sectorspdrs.com/sectortracker

Yet, despite the importance of diversification, many struggle with understanding and implementing it effectively.

What is Diversification?

At its core, diversification is about spreading your investments across various assets to minimize the impact of any single investment’s poor performance on your overall portfolio. The idea is to avoid putting all your eggs in one basket. By doing so, you can reduce the volatility and risk associated with investing in any one asset class.

Why is Diversification Important?

• Risk Reduction: Different assets often perform differently under various economic conditions. For example, when the stock market is down, bonds or real estate might be up. By holding a variety of asset types, you reduce the risk of a severe drop in your portfolio’s value.
• Smoothing Returns: Diversification can help smooth out returns over time. While individual investments may fluctuate widely, a diversified portfolio tends to experience more stable performance.
• Capture Different Market Opportunities: Different sectors and asset classes perform well at different times. Diversification allows you to benefit from a broader range of opportunities.

Key Principles of Proper Diversification

• Asset Classes: Invest across different asset classes, such as equities (stocks), fixed income (bonds), real estate, and commodities. Each asset class reacts differently to economic events, so combining them can balance your risk and reward.
• Geographic Diversification: Spread your investments across different regions and countries. Markets in various parts of the world may not move in tandem, so international investments can offer additional protection against domestic downturns.
• Sector Diversification: Within the stock portion of your portfolio, diversify across various sectors like technology, healthcare, finance, and consumer goods. Different sectors often react differently to economic and market conditions.
• Investment Styles: Incorporate different investment styles, such as growth vs. value investing. Growth stocks may offer high potential returns but come with higher risk, while value stocks are often more stable, tend to pay higher dividends but might have slower growth.
• Time Horizons and Risk Tolerance: Diversify based on your investment horizon and risk tolerance. Long-term investors can afford to take more risks with a higher proportion of stocks, while those closer to retirement might prefer a more conservative mix with a higher percentage of bonds and cash equivalents. Utilizing the “bucket approach” is a way investors can implement diversification

Common Misconceptions About Diversification

• Having lots of accounts at different custodians/brokerages is diversification: Holding accounts at several brokerages can increase fees and expenses as well as dilution of investment focus, which could lead to a lack of cohesive investment planning and diversification.
• Diversification Means Safety: While diversification reduces risk, it doesn’t eliminate it entirely. Diversified portfolios can still lose value, especially during severe market downturns.
• More Is Always Better: Over-diversifying can lead to diminished returns and unnecessary complexity. Some mutual funds or ETFs that have very different names can actually be quite similar with regard to their holdings and overall investment strategy.  We often see over-concentration in portfolios to the same 100 companies without the investor ever knowing.  The same goes for holding individual stocks.  Research has shown that holding anywhere from 18-30ish individual quality stocks covering multiple sectors without an over-concentration into one specific company could provide about 90% of the maximum benefit of diversification.  However, this is all does depend on the investor’s objectives, tolerance, and goals.
• Diversification Is a Cure-All: Diversification is a crucial part of a well-rounded investment strategy, but it should be complemented with other practices such as diligent research, regular monitoring, and understanding your investment goals.

Conclusion

Proper diversification is a powerful tool in the investor’s toolkit, but it requires careful planning and ongoing management. By spreading your investments across different asset classes, sectors, and geographic regions, you can manage risk more effectively and improve the stability of your returns. Remember, the goal of diversification is not just to avoid losses but to strategically position your portfolio to seize opportunities across various market conditions.

As always, consider consulting with your financial advisor at Meridian to tailor a diversification strategy that aligns with your personal financial goals and risk tolerance. Happy investing!