Why Should We Diversify?

After a year in which the S&P 500 rose over 30% and U.S. stocks continued to outperform their international counterparts, it can be tempting to focus on the best performing asset classes and it feels natural to want to invest more money into them.  However, it is important to maintain a diversified portfolio to reduce volatility and lower the risk of not being able to achieve your financial goals.

Asset Class Diversification

One of the biggest decisions that an investor makes when designing a portfolio is the stock versus bond allocation.  Whether that is 90% stocks/10% bonds for a younger investor that is saving at a high rate or 60% stocks/40% bonds for a retiree planning to live another 25 years, that breakdown is going to have a large impact on the return characteristics of the portfolio.  Am I able to weather a 30% stock market downturn, both financially and emotionally, without significantly affecting my financial plan?  What is my current income need from the portfolio?  Do I have additional savings (from employment earnings, etc.) that could be used to buy cheaper shares if the stock market tanks?  These questions that you ask yourself can help point you in the right direction when determining the proper mix of stocks and bonds.

After selecting an equity-fixed income breakdown of a portfolio, the investor should also diversify among different asset classes.  On the equity side, this could entail splitting investments between U.S. companies, international companies, real estate companies, and natural resources or commodity companies.  In fixed income, there are government bonds, corporate bonds, international government bonds, high yield bonds, inflation-indexed bonds, and more.  There are myriad asset classes to choose from, but the goal of diversification is to gain broad exposure to multiple markets that will not always perform in the same manner.  Then, when an asset class in your portfolio is not doing well, there should be other asset classes owned that do less poorly or even show gains.  The adage of not putting all your eggs in one basket holds true in investing.  For example, an investor with $100,000 invested in the S&P 500 at the market peak in October 2007 would have lost over half of that over the next 18 months and not regained the previous high-water mark until March of 2012.  A portfolio split 60% stocks and 40% bonds would have experienced a less severe loss and recovered more quickly (by October 2010 vs. March 2012in the all-S&P scenario)*.  Since stocks and bonds tend to perform differently in various market conditions, holding some of each can reduce the overall volatility of the portfolio.  Similarly, not all equity markets exhibit the same price movement, so investing in multiple equity index funds can lower the volatility within the stock portion of the portfolio.      

Diversification Within Asset Classes

Once your portfolio is diversified across asset classes, it can also make sense to diversify within asset classes to further reduce volatility and to make the rebalancing process more effective.  A lot of common market indices, such as the S&P 500 or NASDAQ Composite Index, are cap-weighted, meaning that the biggest companies—as measured by market capitalization—get the largest weightings in the index.  If the entire S&P 500 index (a proxy for U.S. large cap stocks) has a market value of $30 trillion and the value of Apple is $1.5 trillion, then Apple will make up 5% of the index.  This leads to an inherent “buy high” bias, as the companies which have had the biggest increase in stock price (and thus, market cap) will make up larger and larger proportions of the index.  It is possible to counter this momentum-leaning index style with a complementary investment in a fundamental index.  Instead of weighting the index by company size, a fundamental index analyzes the company’s economic footprint using economic measures such as revenue, dividend rates, earnings, share buybacks, or book value.  This type of index, which looks at the same basket of companies as the related cap-weighted one, is tilted toward value and away from companies whose share prices may have overshot their actual growth.  While cap-weighted indices have outperformed value-tilted indices in recent years, that is not always the case and there are times when the fundamental/value indices outperform.  Allocating a portion of your portfolio to each of these index styles can reduce portfolio volatility within an asset class, as momentum-based and value-based indices don’t always move in lockstep.  It is also helpful to have both types in order to facilitate more efficient rebalancing.

Rebalancing Efficacy

At the portfolio level, the rebalancing process is designed to take profits from asset classes that have done well and to reinvest those proceeds into asset classes that have performed relatively poorly.  If you invest in both cap-weighted and fundamental indices within an asset class, you can execute the same strategy when deciding which to sell or buy when a rebalance is triggered.  If international stocks have gotten overweight in your portfolio, you can make the rebalancing sale from the index fund within the international space that has done better (cap-weighted vs. fundamental).  Conversely, any buys triggered by the rebalancing could be directed toward the index style that has most underperformed recently.  This improves the efficiency of rebalancing by allow you to take profits from the best-performing index style within the best-performing asset class and reinvest it into the most downtrodden index style of an underperforming asset class.

Costs Of Diversification

One issue to note with maintaining a diversified portfolio is that you should never have the best or worst performing portfolio.  The best-returning asset class can potentially become the worst performer in a short time span, while the diversified portfolio should be constantly buoyed by its exposure to different index styles within different asset classes of the investment universe.  This should generate an average return among all the underlying asset classes with significantly reduced volatility in the overall portfolio, even while some of the indices owned could have big price swings.  It is also important to make sure that you are not diversifying into expensive investment products just for diversification’s sake, which can eat into your net returns.

Implementing Diversification

It can be tough to stick to your investment plan when utilizing a diversified portfolio of equities and fixed income index funds.  As the most well-known indices outperform recently, the natural desire is to chase those hot areas to bolster returns.  In the long run, though, it pays to maintain discipline and stick with diversification to bolster your portfolio when the tough times for the “hot” investments materialize.  The financial planners at Moller Financial Services would be happy to review your allocation with you and discuss why diversification makes sense in more detail.

*Source: J.P. Morgan Guide to the Markets, 1Q-2020

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