Diversification is simple to understand. In the context of managing your portfolio, it is (simply) about investing in diverse securities so as to lower the risk of the portfolio. Ever since Nobel Prize winner Harry Markowitz wrote his seminal paper "Portfolio Selection" in 1952, finance professionals (and increasingly lay people) have understood that the true risk of an asset is its contribution to the risk of a portfolio.
In a recent survey run by my firm, Insight Financial Strategists, 41% of investors reported that they believe having their net worth in a single mutual fund is sufficient diversification. After all, even the most concentrated mutual fund typically has several dozen stocks. However, many mutual funds diversify within a single asset class in a single country, such as, large-company stocks in the U.S.
Others will concentrate their portfolio on a few securities, sometimes with very unfortunate results. For instance, between September 1, 2015, until November 17, 2015, the Sequoia fund (symbol SEQUX) lost 26.3% of its value largely due to its high concentration in a single stock, Valeant (VRX). Looking at the price evolution of VRX below, and knowing that SEQUX had more than 30% invested in VRX, it is not surprising that the mutual fund tumbled.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
In practice, diversification is hard to implement. There are many levels of diversification. Some of them are:
- by individual securities;
- by asset manager;
- by asset class; and
- by geography.
Ideally, an investor will want to diversify so that the various investments are not correlated with one another, have low correlation or even have negative correlation. For instance, according to data from portfolio analytics firm Kwanti, Goldman Sachs (GS) and JP Morgan (JPM) have an 89% correlation based on monthly returns. In other words, buying GS and JPM in the same portfolio only provides a low diversification value.
In another example, JPM and Walmart (WMT) have a negative correlation of -0.14%, based on monthly returns, according to data from Kwanti. I don't know that I would necessarily want to buy either JPM or WMT. However, this pair provides good diversification from one another.
Most of us end up investing in mutual funds and exchange-traded funds, not in individual securities. The same principle applies there. Having a single large cap mutual fund that tracks Standard & Poor's 500-stock index may not be sufficient diversification.
Sure, the S&P 500 ETF provides more than one security and is, therefore, diversified. But in general, most of the securities within a single asset class will be highly correlated with one another (such as with JPM and GS). With that, you would be protecting yourself against the risk inherent in any given company in the portfolio, but not against risks inherent to the asset class or other factors.
Ideally, you would want to be diversified across asset classes, across regions of the world and across asset managers. The following jelly bean chart from Schwab demonstrates the benefits of a wide diversification program: the ranking of the assets by performance changes seemingly randomly from year to year. A fully diversified portfolio is intended to avoid the peaks and valleys of individuals asset classes while providing a more middle-of-the-road return experience.
Is your portfolio diversified? A detailed analysis from a fee-only Certified Financial Planner can give you the full scoop on your portfolio and provide suggestions to mitigate the risks that you are exposed to. Like any other sound advice, apply it now, not later.
Chris Chen CFP® CDFA is the founder of Insight Financial Strategists LLC, a fee-only investment advisory firm in Waltham, MA. He specializes in retirement planning and divorce financial planning for professionals and business owners.
-
Eight Key Steps to Take When Investing in the Stock MarketThe stock market can be a confusing place for beginners, but it doesn't have to be.
-
Confused by Annuities? Making Sense of the Different TypesMany investors aren't sure if annuities are a good option for meeting financial goals. Let's look at the different categories, along with their pros and cons.
-
Confused by Annuities? Making Sense of the Different Types
Many investors aren't sure if annuities are a good option for meeting financial goals. Let's look at the different categories, along with their pros and cons.
-
Talkin' 'Bout My Generational Wealth: Baby BoomersWith retirement, each generation has different priorities and challenges. For Baby Boomers, it's a matter of ready or not, here it comes.
-
How to Avoid a Big Hassle if Your Financed Car Gets WreckedHow an insurance check is made out for repairs can cause a world of problems if the lienholder is left out.
-
Estate Planning Strategies to Consider as Election NearsAre big changes in tax laws coming soon? Not likely, but you might want to take advantage of higher estate and gift tax exemptions well before the end of 2025.
-
How to Get Your Money's Worth From Your Financial AdviserA good financial adviser will focus on how your financial planning and investment strategy align with your lifestyle and aspirations.
-
Think of Prenups and Postnups as Financial Planning ToolsThese contracts provide a clear framework for asset management and protection and are especially useful if you get married later in life.
-
Congratulations on Your Raise: Three Things to Do With ItWe're not saying you shouldn't spend it on a new car, but there are some considerations to guard against lifestyle creep and to help ensure a comfy retirement.
-
Check Off These Four Financial Tasks to Finish 2024 StrongThe new year is a popular time to set financial goals, but now is the ideal time to check how you're doing. Four tweaks could make a big difference.
