The term “diversification” is so widely used in the world of investing that we tend to take its meaning for granted. It has become something of a mantra, repeated over and over like a chant, yet with little time devoted to what it really is or how to achieve it. We just assume everyone knows what it’s all about.
Well, let’s put those assumptions aside for a moment and take a deeper look at what diversification really is – its purpose, its execution, and a little warning.
Investopedia defines diversification as “a risk management technique that mixes a wide variety of investments within a portfolio.” We all understand the concept of spreading your eggs across multiple baskets. But if we don’t focus on the purpose behind that spreading – risk management – we end up spreading our money about simply because we are told to spread it out, yet with little regard for how we are doing it.
Our diversification beam, then, is now focused more tightly on risk minimization. But there are two main types of investment risk out there, and diversification can’t help you with both.
Systemic risk: Also known as “market risk,” this is “the risk inherent to the entire market or entire market segment,” Investopedia explains.
This is the broader overall market risk affecting all stocks to one degree or another, such as the 2008-09 financial crisis, where a massive shortage of cash liquidity seized up the gears of capitalism. Recession, interest rates, wars, terrorist attacks, natural disasters, and political chaos are other examples of systemic risk that can hit your portfolio no matter how well diversified it is and are thus also called “un-diversifiable risk.”
This is what they mean by a “falling tide lowers all ships.” This is the risk you are exposed to simply by being long the market, and the only way to mitigate it is to be hedged – that is, holding an equal value in short positions or bear ETFs.
Unsystematic risk: Also known as “specific risk,” this “affects a very specific group of securities or an individual security,” Investopedia contrasts.
Specific risk on an individual company basis includes a company’s mismanagement, loss of market share to competitors, and bankruptcy; while specific risk on a sector basis includes a tax on medical devices, which hurts only medical equipment manufacturers, or cuts to defense spending, which hurt only defense contractors but not other sectors.
This is the only type of risk that diversification can help you with, and our beam of focus now narrows all the more.
Now that our focus has narrowed onto mitigating unsystematic or specific risk, let’s see how proper diversification does its job.
The objective of diversification, Investopedia clarifies, is “to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others.” Simple. We can now apply that basic principal to any tier of unsystematic risk out there. I see five such levels.
To mitigate company-specific risk, say in a gold miner such as Barrick Gold (NYSE: ABX), we would divert a certain amount into another gold miner, say Goldcorp (NYSE: GG). We are thus diversified between two companies.
To mitigate more risk, we could divert a certain amount into another precious metal, say platinum. We thus have two metals, or two different sub-sectors.
To mitigate still more risk, we could divert a certain amount into a completely different sector altogether – say energy. We thus have two commodities, or related sectors.
For the next level up, we could divert a certain amount into a something completely unrelated, such as financials. We here have two unrelated sectors.
The broadest level of unsystematic risk is between markets themselves, such as spreading your money between equities and bonds, or between domestic markets and foreign markets. We are thus diversified at the highest level possible, among multiple markets.
Ultimately, then, we have several levels of unsystematic or specific risk that diversification can help us with. Some would insist there are really only two levels: company specific and sector specific. But with so many new investment products in the marketplace these days, investors have more tools to choose from, which can help us slice and dice any category of stocks into smaller and smaller pieces and also group them together into larger and larger blocks.
We can slice and dice the categories as many times as we wish as long as we adhere to diversification’s primary rule: “the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated,” Investopedia cautions.
In other words, diversification works only if your investments do not move lock step with each other. Owning both the Select Sector SPDR-Financial ETF (NYSE: XLF) and the iShares U.S. Financials ETF (NYSE: IYF) isn’t diversified enough – in fact, it is actually “under-diversified.” Holding just one of them, however, is well diversified even if it is just one stock, since it is a mutual fund that contains multiple stocks across a sector.
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Don’t Overdo It
But there’s a warning to be heeded in diversification – and that is to not “over-diversify.” Some portfolios are so focused on limiting risk that they end up spreading their investments across too many opposite moving instruments, such that they end up limiting profit as well.
After all, what good is it to hold the SPDR S&P 500 ETF (NYSE: SPY) and an equal amount in the ProShares Short S&P 500 ETF (NYSE: SH)? Where the bull fund gains 1%, the bear fund loses 1%, so there is no net gain, ever.
That is an exaggerated example of over-diversification which only professional neutral hedge funds would ever use. But that similar type of self-defeating over-diversification does happen quite a bit in self-directed portfolios.
To avoid being so diversified that we lose out on market opportunities, we need to anticipate what general sectors of the economy will outperform in the foreseeable future, say over the next 5 years. Once we figure that out, we can divert the majority of our investment – perhaps as much as 60 to 80% – in those areas, while keeping the remainder in sectors that run opposite our five-year projection.
For example… Over the next short while, the U.S. Federal Reserve is expected to gradually reduce its monthly bond purchases to zero over a short order of time. After that, we can expect the Fed to gradually begin raising interest rates back up to normal levels, starting perhaps 2015-16 and ending around 2018-20.
This tells us that bonds and bond funds will lose some of their capital value, even though their interest and dividend yields will rise as a result of higher interest revenues and a lower stock price. It also tells us that banks and other financials are likely to outperform the other sectors.
A proper diversification plan, then, would put perhaps 60 to 80% into equities, with a slightly heavier weighting on the financial sector and lighter weightings on other sectors, while keeping the remaining 20 to 40% in fixed income instruments, with a heavier weighting on floating rate bond funds and lighter weighting on fixed rate funds.
Remember that even if you are thoroughly convinced that the market will do one thing over the next few years, proper diversification requires placing a little bet on it doing what you don’t expect – because that’s what happens in real life. Yet at the same time, we don’t want to be so evenly spread that we miss out on the market’s growth.
Just keep in mind what diversification is and what it is not. It is a means of reducing company- and sector-specific risk while still allowing your portfolio to grow with the market. It is not a means of eliminating all risk altogether – because in the end, the measure of reward is generally proportional to the measure of risk.
Reward requires risk. A properly structured plan of diversification can contribute a great deal toward reducing that risk and increasing that reward in whatever measure you are comfortable with.
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