Why is Diversification Important?
Risk Management
Diversification is fundamental for two main reasons: managing risk and potentially improving returns. When investments are diversified, the poor performance of some assets can be offset by the better performance of others. This balancing act stabilizes your investment journey over time, making your financial goals more attainable.
Preventing the Pitfall of Chasing Returns
A diversified portfolio also discourages the risky practice of chasing returns, where investors move their money into asset classes or sectors that have recently performed well. Chasing returns can lead to overexposure in certain areas, increasing risk. Diversification advocates for a portfolio that is consistently balanced across an array of assets, reducing the temptation to make impulsive investment decisions based on short-term trends.
A Brief History of Diversification
The roots of diversification in finance go back centuries, but it gained significant prominence in the modern era with the development of Modern Portfolio Theory (MPT) by Harry Markowitz in the 1950s. MPT introduced the idea that a diversified portfolio can reduce investment risk without necessarily diminishing returns. Markowitz won the Nobel Prize in Economics in 1990 for his work on diversification.
Perspectives from Financial Authorities
If we look to the wisdom of government agencies whose job it is to protect consumers of financial services, they are clear about the value of diversification. The Federal Reserve Bank, whose charge is to maintain the stability of our country’s financial system, among other things, highlights diversification as a key tool for managing risk and achieving long-term financial goals. Their studies often demonstrate how diversified portfolios tend to be more resilient, especially in volatile markets. And the Consumer Financial Protection Bureau (CFPB), whose job it is to advocate for and protect consumers of financial products and services, advises diversification as a protective measure against the unpredictable nature of individual investments, emphasizing its role in weathering market fluctuations.
Common Misconceptions About Diversification
Diversification is not just having a large number of holdings. For example, having 30 large technology companies in a portfolio would not represent meaningful diversification. Diversification requires assets that will react differently to the same market event. That might be accomplished by owning investments from a wide array of industries across different countries, from both small and large, high and low valuation companies, and so on.
Diversification does not eliminate risk overall, but it greatly reduces concentration risk by not allowing for too many correlated assets. It can also reduce stock market risk through the inclusion of fixed income. But systemic risks—rising interest rates, for example—tend to affect all assets and cannot be eliminated. Fortunately, since risk is correlated with return, you can expect to get paid for systemic, unavoidable risks. However, if you make the choice to forgo diversification in your portfolio, you’re setting yourself up for market vulnerability that is technically avoidable, and the market does not pay you to take avoidable risks.
It’s important to remember that diversification does not necessarily guarantee returns. This strategy primarily focuses on reducing volatility.
Implementing Diversification
While the math can get complex, the core idea revolves around correlation: how different investments move in relation to one another. Ideally, you want investments that have “low” or “negative” correlations. This means when one investment goes down, another might go up or remain stable, reducing the overall volatility of your portfolio.
As discussed, effective diversification involves mixing asset classes, geographical regions, and sectors. Asset classes may include stocks, bonds and real estate. Within stocks, you might have “US” or “International” as a further diversification, And within geographies, spreading investments across diverse sectors like technology, healthcare, and financial services furthers one’s diversification.
Anecdote: The Entrepreneurial Path to Wealth
Consider the story of quite a few Abacus clients who amassed their fortune by founding a successful company. Their initial strategy was high-risk, concentrating all or most of their resources in one venture. While this approach was instrumental in creating their wealth in the beginning, they recognized—with their advisor’s guidance—that continued concentration was unnecessary and counterproductive for wealth preservation. They shifted to a diversified investment strategy to safeguard and grow their newly-acquired wealth, acknowledging that the principles of risk management differ significantly between wealth creation and wealth preservation.
Example of a Diversified Portfolio
An example of a diversified portfolio might include:
- 30% in domestic stocks across various sectors
- 25% in international stocks across various sectors
- 35% in government and corporate bonds
- 10% in real estate investment trusts (REITs) across various sectors
This is only for the purposes of illustration. The specific mix of investments that is right for you will be an outgrowth of your personal financial situation and objectives.
Historical Examples of Diversification
It is easy to see the benefits of diversification in action when you consider notable market upsets in our recent history. During the Dotcom Bubble (2000), those who had heavily invested in the tech sector suffered significant losses, while diversified portfolios were less affected. In the 2008 Financial Crisis, portfolios that included a mix of stocks and bonds navigated the crisis more effectively than those that were exclusively in stocks.
Playing the Long Game
The biggest “win” of a well diversified portfolio is that it empowers you to maintain a long-term vision with confidence, thereby reducing the risks associated with emotional decision making.
When you focus on chasing returns, or picking individual stocks, you’re emotionally tied to the market’s many ups and downs. It can take a lot of effort from even the most seasoned investors not to have a reaction—positive or negative—when the market is unpredictable, possibly derailing your long-term investment strategy.
Partnering With an Advisor
Not only can a financial advisor help you construct your diversified portfolio, but they will also act as a sounding board to keep you on track as you move toward your big-picture goals. If you want to learn more about how Abacus advisors partner with our clients to create durable, holistic investment strategies—and the role diversification plays in our investment philosophy—schedule a call today. We’d love to help you build toward a brighter future.
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Disclaimer:
Please remember that past performance is no guarantee of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product will be profitable.
