Explaining the Benefits of Investment Diversification

Advisers can help their clients understand the importance of asset allocation and diversification.
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Financial advisers and their clients often talk about asset allocation and the benefits of investment diversification. A year like we’ve had so far in 2020 can really drive these benefits home. For advisers who are reviewing portfolio strategies with their client, here are some key discussion points about diversification.

Diversification is the investment equivalent of the saying don’t put all your eggs in one basket. A diversified portfolio contains some components that are not highly correlated to each other. Investments that have a low correlation will generally react differently to the same set of economic or market factors.

In discussing the performance of portfolios over the period of market volatility, advisers can show their clients how some of their portfolio holdings that are not highly correlated to stocks held up when the markets fell earlier in the year.

There are two types of investment risk: systematic risk and unsystematic risk. Systematic risk refers to risk inherent in the entire market or in an entire market segment. Systematic risk is also sometimes referred to as market risk. This type of risk is undiversifiable.

The other type of risk is unsystematic risk. This risk is attributable to a specific company, industry, market segment, asset class or country. Unsystematic risk is diversifiable risk. You can diversify by using investments that are not impacted in the same way by similar market and economic factors.

In having this discussion with your client, you of course will want to put it in terms that will be meaningful to them. Terms like systematic and unsystematic risk may be meaningful to you and fellow stock market geeks, you may run the risk of losing your clients with this type of financial jargon.

Diversification and Patience

An important message for your clients is the value of patience as an investor.

Patience means that an investor puts an investment strategy in place and allows the strategy sufficient time to work. They don’t react to every blip in the markets by panic selling or otherwise abandoning their strategy. Doing so can sabotage their ability to reach their financial goals over time.

This doesn’t mean that periodic reviews of their investment strategy aren’t done and that adjustments aren’t made over time. Things change and it’s important to monitor and adjust any investing strategy.

Your client’s asset allocation and portfolio diversification go hand-in-hand. Diversification is a process that balances out the portfolio’s potential for return with the level of downside risk the investor assumes.

Benefits of Diversification

In discussing the benefits of diversification with your client, a few points to emphasize:

  • Diversification serves to reduce portfolio risk.
  • Diversification incorporating some low or non-correlated asset classes further reduces risk.
  • Portfolio diversification is a critical part of the investing process because nobody knows how different asset classes, market segments and individual companies will perform over time. For example, so far in 2020 growth stocks have handily outperformed value stocks. This hasn’t always been the case and may or may not hold true in the future.
  • Diversification is a key part of the asset allocation of the client’s portfolio. Diversification can be tailored to match your client’s risk tolerance and investing time horizon.

Proper diversification can keep your client from incurring the opportunity cost of not being diversified. Just as with the example of growth versus value mentioned above, this opportunity cost can arise from a portfolio being too focused on any asset class, individual company or any other region or market segment.

During the recent market rebound and over the prior decade, the S&P 500 index has provided very solid gains. For the 10 years ending July 31, 2020, the SPDR S&P 500 ETF  (SPY) - Get Report, an ETF that replicates the S&P 500, provided investors with an average annual return of 13.74%. During the period from 2000-2009, however, the S&P 500 index posted negative total returns for the decade. This was in large part due to the bursting of the dot-com bubble in the early part of the decade and the financial crisis towards the end of the decade.

Many investors who were diversified beyond the large-cap stocks represented by the S&P 500 fared better. This is the type of conversation you need to have with clients around the benefits of investment diversification.

While your clients certainly trust you and have confidence in your advice, it can be hard to watch the market go up and for them to see their portfolios trailing those returns. This is when a conversation about their desire to limit their downside risk comes in, providing a good context in which to discuss the benefits of diversification.