Everyone has heard the phrase “don’t put all your eggs in one basket”. This theory can (and should) be applied to your investment portfolio. Putting money into different “baskets” helps spread risk and keeps your portfolio positioned to withstand downturns in the market.
So what classifies different baskets in the investment world?
There are several ways to look at diversification. First, let’s look at allocating an investment portfolio across different asset classes, namely stocks vs bonds. Stocks tend to be more volatile than bonds because the investor is generally accepting an increased level of risk. By investing in stocks, investors are accepting the possibility of earning higher returns as well as the possibility of larger losses. While there are still inherent risks with bonds, bonds are generally known as a safer investment, partly due to the steady income they provide over the life of the bond. For example, the investor lends money to the issuer in return for periodic interest payments. At maturity, the issuer promises to repay the principal to the investor. A diversified portfolio may hold a mixture of stocks and bonds, depending on the investor’s risk tolerance. As investors near retirement, it is not uncommon to shift more money into the bond market in order to remove some of the risk of the stock market.
A second way to look at diversification is through market capitalization and investment style. Market capitalization refers to the size of a company and is determined by the total market value of a company’s outstanding shares of stock. More specifically, the total number of a company’s shares of stock is multiplied by the stock price to determine the total market capitalization. Market capitalization can be broken down into the categories of Large Cap, Mid Cap and Small Cap. Companies with a larger capitalization may be more mature companies, whereas companies categorized as smaller capitalization may be less established firms. In regards to investment styles, these include growth and value stocks. Growth stocks tend to be newer companies that may not pay a dividend because they reinvest their profits back into the business. As a result, these firms tend to have a greater increase in share price as their business grows. Value stocks tend to be companies that are undervalued and perhaps underpriced, especially compared to other companies in the same industry. Additionally, they may have fundamentals that do not warrant the current market price.
A final aspect to diversification entails adding an international component to a portfolio. By adding international companies, an investor becomes exposed to different economies and sometimes different currencies if unhedged. There are many external economic factors that may affect economies of different countries. This exposure provides another layer of spreading the risk in a portfolio.
Importance of Diversification
The Callan Periodic Table of Investment Returns conveys the importance of diversification. This chart looks at investment returns over the past 20 years and is broken down by some of the categories that have been discussed. The chart lists the highest returns to the lowest in a given year and is a colorful and concise summary that shows no two years are the same. To give a specific example, let’s look at two categories: the S&P 500, which is comprised of U.S. large cap stocks and the Bloomberg Aggregate Bond Market, which is a representation of the U.S. Investment Grade bond market. If we look at the returns provided on the Callan chart in the year 2002, the Bloomberg Bond Market returned 10.26%, which was the largest return in 2002. The S&P 500, however, was down 22.10%. Let’s look at a scenario where a portfolio maintained a 50% allocation to each of these categories.
The portfolio would have returned:
(.5)(10.26%) + (.5)(-22.10%) = -5.92%.
If the portfolio had only invested in the S&P 500, the portfolio would have lost over 20% of the portfolio value. By allocating investments into both stocks and bonds, this portfolio minimized the loss to just under 6%. While a diversified portfolio still carries risk and is subject to losses, this is just one example that shows how diversification could help in mitigating some of that risk.
In conclusion, as you build your own investment portfolio, remember the adage “don’t put all your eggs in one basket” and apply the concepts of diversification. It is one of the best tools you can use to reduce the risk in your overall portfolio.
All information herein has been prepared solely for informational purposes only and opinions are subject to change. Past performance is not indicative of future results and all investments involve the risk of loss of principle. For information on how these general principles apply to your situation, consult an investment professional.