By Eric Weigel
Diversification is one of the core concepts of investment management, yet it is also one of the least understood. In many ways, diversification is like apple pie and motherhood -- good for you and always taken at face value without much thought.
Investors throw out lots of platitudes about their portfolios being diversified. Financial literature often contains allusions to diversification.
Understanding portfolio diversification is not an academic nicety. Proper diversification is crucial for growing your wealth and managing through the inevitable ups and downs of financial markets.
Think of portfolio diversification in the same way you think about insurance on your house: When nothing bad happens, you go on and maybe for a second you think about whether you really need this form of protection.
But when something bad happens, like a stock market crash, or a tree falls on your garage, you do not even think for a nanosecond how much the protection cost you. Whatever the price was, it was well worth it.
Portfolio diversification is, however, different from typical insurance in some important ways. When you buy insurance, you have a contract defining under what conditions the company will pay, how much, and importantly, a maximum out-of-pocket deductible.
With portfolio diversification there is no such contract and, especially, there is no set deductible capping your losses. When somebody says, "my portfolio is diversified" it can mean a million things. But does it mean what you think it does?
The devil is always in the details, right? You may think that your portfolio is diversified because nothing bad has happened yet. Or, you may think that your portfolio is diversified because your sensei said so. Who knows?
Sometimes people think sprinkling their money across a large number of funds with different names means that they are diversified.
Why the confusion? Without getting too technical, diversification can mean a lot of different things depending on the context.
Properly understanding the context and what diversification means is difficult for non-financial people to wrap their heads around. And that is a big problem and why investors often fail to capitalize on what Nobel Prize winner Harry Markowitz once called the only free lunch in financial markets.
In my experience, when typical investors hear the word diversification, they think protection against portfolio losses. If you are diversified, your losses will be less than if you are not diversified, right?
Don't Assume You're Diversified
Should you just assume that you are diversified?
Probably not. It's better to be safe than sorry when it comes to your financial health.
Let's start with some basics. diversification means that you are not exposed to any one investment determining the bulk of your portfolio returns and risk. One investment will neither kill nor make your whole portfolio.
A diversified portfolio contains investments that behave differently. While some investments zig, others zag. When one investment is up big, you might have another one that is down. Your portfolio ends up in the middle somewhere. Never as high as your best performer and never as low as your worst nightmare.
Asset classes such as bonds and stocks have very different behavior patterns. Sometimes these differences get lost in jargon such as risk and return or the efficient frontier concept.
Most people already know that when economic times are good, stocks will typically go up more than bonds but when there is a crisis the reverse will occur.
The whole point of owning stocks, bonds, and potentially other major asset classes, is to protect your portfolio.
Sure, we would all love to get the upside of stocks without any downside. But in reality, nobody has the foresight to tell us in advance when stocks will collapse and when they will thrive.
Diversification is not necessary if you have a direct line to the capital market gods. If you are a mere mortal, proper diversification is absolutely necessary to ensuring you remain financially healthy.
Here are five symptoms of fake portfolio diversification:
Your Portfolio May Not Be as Diversified as You Think
Your portfolio is nothing more than a collection of funds and other investments that you have accumulated randomly over time
Accumulating investments over time is a very common practice. People sometimes get enamored with a certain investment type, such as tech in the late 1990s, and when things don't pan out, they are reluctant to sell the investment.
Not dissimilar to hanging on to that old dusty treadmill in the basement or that collection of Beanie Babies in the attic, many individual investors are hoarders without admitting it.
The More Funds and Strategies, the More Diversified
Some people think that if you own a lot of different funds or investments you are automatically diversified. Some growth, some value, a sprinkling of emerging markets and an asset allocation fund thrown in the mix. There is no rhyme or reason for any of this, but many people use this approach.
This is a very common mistake. Owning a large number of investments does not mean that you are diversified. It probably means that you or your financial adviser are confused about how to construct a portfolio.
You can actually be much more diversified with a small number of uncorrelated investments. The number of investments is immaterial.
Your Portfolio Contains Lots of Investments With the Same Theme
People fall in love with investment themes all the time. They ride the theme hard, not properly understanding that market sentiment is often fickle and can change on a dime.
In the late 1990s it was all about the Internet. Many people loaded up on the sector and lost their shirt soon after. We have had more biotech booms and busts than for any other sector over the past 30 years. Many of the biotech stars of old, unfortunately, were sold for cents on the dollar despite promising early findings.
Starting in mid-2017 the buzz was all about cryptocurrencies. Many investors, especially those too young to have experienced a market meltdown, went head first into the craze.
If you are going to build your portfolio based on your favorite themes, make sure that these themes do not have much in common. If everything is about innovation, for example, how will you feel when the market turns and favors old-line industries?
All Your Investments Are in One Asset Class
This is a variation of the previous issue. People come to identify with their investments as a badge of honor without realizing the consequences to their financial health. The problem with just owning investments in one asset class is that you do not get the main course at the free lunch event. You get the appetizer, but then you are impolitely shooed out the door.
Diversification within an asset class such as stocks or bonds is not nearly as powerful as diversification across different asset classes.
Let's take the case of stocks. In any given day, most stocks tend to move up or down together. When the overall equity market (say the Russell 3000) is up big for the day, you only find a very small percentage of stocks down for the day. Similarly, when the broad equity market experiences a meltdown you will unfortunately only find a handful of stocks that went up for the day.
Same applies to bonds but the herding effect is even stronger. Take the case of 10-year bonds of a similar maturity, say 10 years. This cohort of bonds moves in a pack, all taking their lead from the 10-year U.S. Treasury. If the 10-year Treasury moves up, the vast majority of bonds move up in lockstep. Same on the downside.
Your Portfolio has Not Gone Through a Tough Market
Given the low level of capital market volatility that we have had in the past few years, I would not be at all surprised to see people who dismiss the need for diversification. After all, if you just pick your investments wisely, why should you worry?
Somebody that has been riding the FANG (Facebook, Amazon, Netflix and Google) stocks for a number of years probably does not see any need for bonds in their portfolio. Maybe they got a hint that they should diversify a bit during the correction in the fourth quarter of 2018, but all seems to be forgotten by now.
Go back to the late 1990s. Investors were riding AOL, Cisco, Dell, and Microsoft. Very few individual investors saw the implosion that was about to hit and obliterate equity portfolios.
For example, investors in the technology SPDR ETF (XLK) were riding high-on-the-hog until March 1, 2000, when the XLK hit $60.56. By July 1, 2002, the price had dropped to $14.32 - a horrific 76% decline from the peak. It took until late 2017 for the XLK to hit its March 2000 peak. That is a long time to wait to break even.
You don't need diversification when things are going well. You only need it when the bottom is falling out. Every single investor in the world has gone through a rough performance patch and nobody is immune to the pain and agony of market crashes such as 1987, 2000-2002, and 2008-2009.
Don't tempt fate by hoping that your portfolio is special.
Don't Forget Your Free Lunch
As Markowitz said, portfolio diversification the only free lunch in finance. Most people agree with his statement and attempt to build diversification into their investment strategies.
But many people remain confused by the term and its impact on their financial health. But understanding portfolio diversification is not an academic nicety - it materially affects your financial health.
If you like smoother rather than bumpier rides, portfolio diversification is for you. You will sleep better at night especially when equity markets go haywire.
Investors can easily fall in the trap of thinking that their portfolios are diversified, or that they do not need any diversification. Diversification is one of those good habits that you should practice routinely.
About the author: Eric Weigel is the founder of Retire With Possibilities, a coaching and planning business focused on key retirement issues. He is also an investment adviser with Little House Capital, an SEC-registered firm based in Massachusetts with more than 30 years of experience. He is a certified professional retirement coach, and an MBA graduate from the Booth School of Business at the University of Chicago.