29 May Here’s Why Diversification Matters
You hear it all the time: diversification is important. It even shows up in colloquialisms like “Don’t put all of your eggs in one basket.” The term is used so much it has almost lost much of its meaning or impact.
Diversification is referenced so frequently for a reason: it works! Here’s a simplified example to illustrate the math – obviously, real life is never this neat. Take two hypothetical stocks with the exact same annualized returns over a three-year period, but different timing of when those returns occurred. Then, we’ll also take a hypothetical portfolio where each of these stocks make up 50% of the holdings (and are kept exactly at 50%). See below:
|Year 1||Year 2||Year 3||Annualized Return|
Despite the exact same annualized return individually, the portfolio of the two stocks did better combined than on their own. Diversification is one of the only times where 1 + 1 can equal 3.
The secret to diversification’s success is in the way it can lower volatility. If you notice in the table above, the portfolio doesn’t have as large of swings from year to year when compared to the individual stocks. Stock A boosts returns in Year 1, and then Stock B returns the favor in Year 2.
Volatility is an investor’s enemy. If you lose 10% of your portfolio, you need to make just 12% to make your money back. If you lose 50% (like many all-stock portfolios in 2008), you need to make 100% just to make your money back.
The way to reduce volatility is through combining investments that are expected to behave differently from one another (non-correlation). Assets that have a negative correlation to each other will provide the most diversification and the greatest reduction in volatility. Adding asset classes with negative correlations gives you the most bang for your diversification buck! Historically, U.S. Treasury bonds have an inverse or negative correlation to U.S. stocks, which make them a great option to diversify a U.S. stock portfolio.
U.S. equities tend to have a positive correlation to other US equities, which means if your portfolio has 100 U.S. stocks, adding one more isn’t going to add much diversification. However, the correlation between U.S. stocks and Emerging Market stocks are lower so the diversification benefit from adding exposure to Emerging Markets would be higher.
Within stocks, focus on diversifying across market capitalization (company size), sectors (financials, industrials, technology, etc.), and geography.
Within bonds, different credit qualities, durations (a measure of interest rate risk), issuers (governments, municipalities, corporations, etc.) are all important.
With that said, don’t seek diversification simply for diversification’s sake, as a diversified portfolio doesn’t guarantee outsized returns. Once you have a target level of risk that is informed by your specific goals, time horizon, emotional tolerance, and financial capacity for risk, then the goal of diversification is to try to improve returns for that level of risk.
Diversification does have diminishing marginal returns, as the benefit of adding 1 stock to a 10-stock portfolio is much greater than adding 1 stock to a 1,000-stock portfolio. And adding a poorly performing investment strictly for diversification won’t necessarily result in a better outcome.
Still, diversification is particularly important when one believes, as we do at Highland, that there is no way of knowing which investments or asset classes will do well at a given time. Just remember: volatility is an investor’s enemy, diversification reduces volatility, and 1 + 1 can equal 3!