Have you ever been watching the news during a major event and wondered “how will this impact my investment portfolio?” This is a natural question and one that doesn’t need to cause as much panic if you have a diversified portfolio. So, what is diversification? What are its pros and cons, and is it possible to have too much of it?
Diversification is an approach to investing that spreads your investments across different exposures. There are many different exposures to spread your investments across, for example, there are four major asset classes: equities, fixed income, real assets, and cash. The asset classes can be broken down even further, for instance, within equities you can have diversification spread across domestic equities or foreign equities, or you can have a small capitalization company or large capitalization company, or you could have value stocks or growth stocks, etc. The purpose of diversification is to reduce the risk of any one exposure. Or simply, to not put all your eggs in one basket.
Pros of Diversifying Your Portfolio
While risk can’t be eliminated entirely, diversification can help minimize your chances of losing large sums of money over time. To illustrate this, we can look at the Great Financial Crisis period. The graph below shows one portfolio invested only in the S&P 500 TR (TR = total return, meaning including dividend reinvestment) and the other invested in a diversified portfolio of 60% stocks and 40% bonds that is rebalanced quarterly. The diversified portfolio is also diversified across domestic and international markets in both stocks and bonds whereas the portfolio invested fully in the S&P 500 is only exposed to the U.S market.
As the table notes the diversified portfolio suffered a much shallower drawdown than the S&P 500 TR portfolio. The diversified portfolio also recovered a year and four months sooner than the S&P 500 TR.
Cons of Diversifying Your Portfolio
Diversifying your portfolio could lead to lower returns than if you had an undiversified one. For example, had you invested solely in the S&P 500 over the past decade you could have realized approximately 6% higher return each year on average versus the diversified portfolio in this example. This is a result of spreading your funds among lower-risk investments that offered lower returns than those of the stock market. If you only have one position in your portfolio you could greatly increase your returns (or lose it all). However, most investors use their portfolios to achieve their goals, not to maximize returns. In a diversified portfolio, if one investment goes bad, you still have others that could significantly reduce the negative impact. In keeping with our previous comparison of the S&P 500 and a diversified portfolio, the graph below illustrates the difference in total returns between the two over the period from August 01, 2007, to August 1, 2022. The diversified portfolio had a total return of around 128%, whereas the S&P 500 portfolio had a total return of around 280%.
Constructing a diversified portfolio with individual stocks and bonds can also make rebalancing a more difficult task. Rebalancing is the process of selling investments that have gone up in value and buying ones that have gone down, to maintain your original investment mix. If you have a lot of different investments, it can be tough to keep track of them all and make sure they are properly balanced. However, using ETFs and mutual funds can help with this, as they are already diversified investments.
Can You Have Too Much Diversification?
The number of stocks needed to achieve diversification is often debated by experts. Some experts say twenty stocks are needed to fully diversify, some experts say ten to thirty, and others say fifty or more. So who is correct? In theory, they all could be correct but the more important question is why does it matter if the portfolio holds twenty stocks or one thousand stocks? The answer is the number of stocks doesn't matter so long as the portfolio is properly diversified. What the experts are really trying to distinguish is the number of stocks needed to minimize unsystematic risk. Unsystematic risk, or risk particular to a single business or industry, is a risk that can be diversified away so investors are not rewarded for taking this risk. Since systematic risk (market risk) cannot be eliminated through diversification, investors are rewarded for taking this risk. As shown in the graph below, at a certain number of stocks, unsystematic risk is reduced to a minimum, leaving only systematic or market risk. Since market risk cannot be eliminated, a portfolio is properly diversified when the unsystematic risk is minimized.
Whether it takes twenty stocks or a thousand is a moot point as long as the portfolio is well-diversified. If the portfolio has a variety of stock positions, it is critical that it be diverse across industries, market capitalization, geographies, and so on. Having twenty technological companies will not assist if the entire technology industry collapses. This is when using mutual funds and ETFs is advantageous. Mutual funds and ETFs can contain hundreds or thousands of different equities and bonds, allowing unsystematic risk to be easily reduced at a minimal cost.
While there are some cons to diversifying your portfolio (such as lower returns vs an undiversified portfolio), they should not outweigh the benefits for most investors. Diversification can help you in periods of market volatility and increase the likelihood of reaching your goal without taking unnecessary risks. Do you feel like your portfolio is under-diversified? Over-diversified? Or just right? We would be happy to help you answer that question. Let's chat!
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