Most investors know that investing all your money in one or two stocks is the financial equivalent of putting all your eggs in one basket.
Owning a variety of investments—otherwise known as diversifying your portfolio—is an intelligent solution. But how diversified must a portfolio be to strike the best balance between growing and safety?
The answer is: Probably more than you think.
Before we go on, consider your definition of risk, which is, after all, one of the primary reasons investors diversify. Investment risk comes in three forms: security risk, industry risk and market risk.
Security-specific risks result from factors specific to a single security—such as the management or debt of the underlying company or even bad acts by the company. Industry risk is a sympathetic change in value resulting from a company in the same industry reporting results that are likely to translate across the entire industry. Market risk, meanwhile, arises from factors that impact an entire asset class—think rising interest rates or a financial crisis.
Properly diversified portfolios seek to reduce the first two forms of risk.. No risk can be eliminated completely, of course. Investors’ returns can be thought of as their reward for taking on risk in the first place. But diversification has been shown to successfully manage investors’ risk of loss and volatility.
Simply said, proper diversification can help ensure that your assets will not all perform in the same manner in a given situation. If one kind of asset is falling, another may be holding steady or rising. In technical terms, a healthy portfolio contains assets with low – or even negative – correlations to one another.
That brings us back to the question of how diversified a portfolio should be. The fact is that diversification is more involved than just owning several different companies and a few bonds. In order to manage the range of risks inherent in investing, we believe your portfolio should be diversified across four dimensions:
1. By Geography. Diversifying among different countries and regions will reduce risks from recessions, political upheavals and natural disasters. An investor should also consider owning investments in different kinds of economies; after all, one can have exposure to several developed countries, but no exposure to developing ones.
2. Among Sectors and Industries. Investors should diversify across industries and sectors. After all, companies in a single sector can all be affected by a single consumer trend, or by a recession. Industries are smaller subsets of sectors, so concentrating your holdings in one industry can be even riskier.
3. By Company Size. A properly diversified portfolio should consist of different-size companies, that is, large-cap, mid-cap and small-cap. Stocks with different market capitalizations can perform differently under the same circumstance, so it is essential to own all market caps.
4. Among Assets. By diversifying across asset classes—that is, stocks, bonds and cash, investors can reduce market risk. Because of differing economic situations in different countries, global diversification can reduce these risks even further.
Using only one or two of these forms of diversification will not provide investors with the greatest possible benefit. To maximize diversification benefits, investors should strive for global exposure to asset classes encompassing sectors, industries and company sizes. Implementing the methods above will reduce both security-specific risks and market risks to even lower levels.
Diversifying across four dimensions is not only important to manage risk, but also to tap into growth. As the chart above1 shows, different asset classes, market caps and sectors outperform in different years. Full diversification helps to ensure that you have exposure to this outperformance.
Rebalancing a few times per year serves to restore the full benefit of diversification. The key is to rebalance by selling high and buying low. As markets reset, a portfolio’s losers may become its next winners. Historically, assets have always regressed to their averages. Said differently, what goes up (fast) often comes down, and vice versa.
The diversification approach we’ve discussed serves to effectively lower a portfolio’s risk and volatility and create a smoother ride for returns over time. This smoother ride is a tradeoff: Investors generally will enjoy all of the upside in a rising market, but nor will they have to absorb the entire impact of a falling market. Remember that if you don’t have something in your portfolio that you hate, then you’re probably not properly diversified.
Diversification will not guarantee a profit or assure against losses during market downturns. But it should, at the very least, balance risk and return so that investors can achieve their long-term goals with less volatility. And that can translate into a great benefit: The ability to sleep well at night.