The Diversification Decision

Let’s say you’re hosting a holiday open house. Would you serve your guests roast beef sandwiches and coffee, or would you also offer a vegetarian dish, green salad, fruit and assorted beverages? It’s likely, of course, you’d choose a varied menu to ensure that guests with different tastes would all be satisfied. Just as a little variety adds up to a terrific buffet table, so, too, does diversification benefit your investment portfolio.

When I first mention diversification, most clients nod knowingly. Some even repeat the old investment adage, “Don’t put all your eggs in one basket.” To further illustrate the concept, look at an example from the Security Exchange Commission’s Web site of street vendors who sell seemingly unrelated products, such as both umbrellas and sunglasses. Surely, you wouldn’t buy these items at the same time, but that’s the point. Umbrellas sell when it’s raining and sunglasses when it’s sunny. However, by diversifying their product line, the vendors reduce the risk of having their profits greatly impacted by the weather, which, like the market, is a force nobody can accurately predict or control.

Even if it’s a new concept, most people quickly come to understand the wisdom of spreading their money between stocks and bonds—asset classes that historically have responded differently to market conditions. The obvious expectation is that although one investment might lose money, the others may make up for that loss. The bottom line is that combining asset classes that generally move in opposite directions tempers total portfolio risk.

However, this simple diversification, the “don’t put all your eggs in one basket” approach, only gets us halfway to creating a properly diversified portfolio. In fact, there is a second, equally important, type of diversification—what I call effective diversification. Effective diversification, also referred to in academic circles as dissimilar price movement, advances the notion that a diversified portfolio must be diversified at two levels: between asset categories and within asset categories.

Because wealth is most quickly lost by concentrating on only one or a few investments, effective diversification requires that we also diversify by sub-asset class, and even by investment style. For example, on the stock side you might select from domestic, international, and emerging markets stocks. You could also divide your stock allocation between large and small company stocks, as well as growth and value stocks.

Why is this beneficial? Just as stocks and bonds tend to respond differently to market conditions, domestic and international, large and small, and growth and value stocks rarely move in tandem. This non-correlated performance further decreases your portfolio risk.

Interestingly, new clients often arrive with portfolios containing a dozen or so stocks and mutual funds and believe they have a diversified portfolio. However, on closer review, I find that their stocks and mutual funds are mostly highly correlated or very similar in investment style. As you recall, holding 12 technology stocks and a technology fund during the technology bubble did not truly diversify your portfolio.

Just as there are numerous ways to diversify the equity side of the portfolio, the options are endless on the fixed-income side as well. However, because bonds serve to help dampen the volatility of the portfolio, I believe fixed-income exposure should be concentrated in short-term instruments, because they possess lower volatility than long-term bonds. What’s more, the expected rate of return for long-term and short-term bonds is not significantly different.

Of course, not everyone needs to own a domestic large company fund, an international small company fund, and everything in between. Instead, based on your goals, risk tolerance, and timeframe, we’ll work together to identify how the right combination of investments might effectively and efficiently diversify your portfolio.

While each portfolio is diversified differently depending on each client’s needs, the one constant that holds true for all portfolios and in any market is that diversification in any asset category is achieved more effectively through the ownership of low-cost, institutional, asset class mutual funds, rather than with individual stocks. As I like to say, diversification is the closest thing to a free lunch, so you might as well take a huge helping. In fact, combining simple and effective diversification to minimize risk and maximize returns forms the cornerstone of Modern Portfolio Theory, which was introduced in 1952 by Harry Markowitz. (1)

It was Markowitz who proved mathematically that if you have two portfolios with the same average return, the one with less volatility, or risk, will have a greater compound return. We’ve come to accept Markowitz’s work as common sense, and we tend to forget that investors once focused on assessing the risks and rewards of individual securities in constructing their portfolios, rather than focusing on the big picture of how each portfolio asset class relates to the other.

Just as creating the perfect buffet for your holiday gathering requires pairing the salad with the main course and the wine with the food, complete diversification is achieved when we consider the relationship of all of the assets in your portfolio. To add another cliché to the investment lexicon, if you guard against putting all your eggs in one basket by employing both simple and effective diversification, you construct your portfolio in such a way that the whole is greater than the sum of the parts.


Additional Resources
You can learn more about the Nobel Prize-winning Harry Markowitz and Modern Portfolio Theory at the following two Web sites:
http://nobelprize.org/nobel_prizes/economics/laureates/1990/markowitz-autobio.html
http://nobelprize.org/nobel_prizes/economics/laureates/1990/press.html

Endnotes
1) “Portfolio Selection,” The Journal of Finance, Volume 7, No. 1, March 1952, pages 77-91. (It can be found here: http://www.math.ust.hk/~maykwok/courses/ma362/07F/markowitz_JF.pdf.)

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