You’ve heard some of these before. Buy low, sell high! Use the Iron Condor! Sell in May, Go Away! Watch the Groundhog! (I made that last one up…) Except for the reference to Puxatawney Phil, these are all investment strategies people turn to in order to increase returns or reduce risk. Investment risk can be measured using standard deviation. Standard deviation quantifies how much a series of returns varies around the average. Investors tend to like using standard deviation because it provides an exact measure of how varied returns have been over a specific time frame both on the upside and the downside.
There is no shortage of these strategies, and some of them may actually work. One strategy, however, stands the test of time: diversification. If done properly, diversification may help reduce risk. The magic of this strategy is anyone can use it.
You’ve probably also heard “don’t put all your eggs in one basket”. This is a simple way to remember the basic premise of diversification. But remember that there are many kinds of eggs… and baskets! Let’s start with the broadest of categories, aptly named broad asset allocation.
Broad asset allocation – Simply put, this is diversification by broad category, such as stocks, bonds, cash, or even commodities and real estate. Which do you think is riskier, owning only stocks, or owning stocks, bonds and cash? Your guess is probably right. For example, assume an investor owned 50 stocks in their portfolio and the S&P 500 went down x%. This individual would likely also suffer a loss of around x%. But, if that same individual owned those same 50 stocks along with bonds and cash, the x% drop in the stock market should only significantly impact a portion of the portfolio. That’s not to say that owning a portfolio consisting purely of stocks is bad. It all depends on risk tolerance and time horizon.
Sub-allocation – Okay, so now you have diversified your eggs (goose, turkey, chicken… i.e. stocks, bonds, cash). Now the question is about what kind of stocks, bonds, cash, etc. You can sub-allocate in the following ways:
1. Globally: With stocks and bonds you can choose domestic or international. Or choose both! You can pick stocks or bonds in individual countries, or buy a mutual fund that covers a wide swath of the world, or just a certain region. Interestingly enough, U.S. investors tend to invest with a bias toward domestic stocks, allocating only 26% of their equity assets internationally. Yet international equities represent over 76% of the global equity market capitalization. This means U.S. investors could be a lot more diversified by tapping into that much wider pool of international stocks.
Figure 1: Top 5 Performing Countries
Figure 2: Bottom 5 Performing Countries
From 12.31.07 through 03.31.17. Data for 2017 represented YTD returns as of 03.31.17. Total returns denominated in USD. SOURCE: AFAM Capital using data from Bloomberg. Charts contain references to individual MSCI country indices. Each country index is designed to measure the performance of the large and mid cap segments of the country market indicated. More information can be found at https://www.msci.com/end-of-day-data-search under the “Country” tab. It is not possible to invest directly in an index.
As you can see in figures 1 and 2, the top and bottom performing countries are not consistent from year to year. This is yet another reason to diversify.
2. Industry/Sector: Diversification across the many U.S. industries/sectors is possible with both stocks and bonds as well. You may wonder why this makes a difference. To illustrate, let’s look at the relationship between the consumer discretionary sector and utilities sector of the stock market. Utilities are considered more defensive in nature, while consumer discretionary stocks are cyclical and favor a more robust economy. An easy example relates to budgeting. A rule of thumb is to list out wants versus needs, and when money is tight, your needs come before your wants. Same goes for the sectors. For example, you may be willing to forgo that $5 latte (consumer discretionary) but it is unlikely that you would go without water (utilities). This illustrates how the same event can have varying consequences for different sectors. Similar relationships exist within the bond markets as well.
3. Capitalization: This is a form of sub-allocation you may not be familiar with. Small-, mid- or large-sized companies may perform well at different times. Having your stock portfolio in different “market caps” can diversify the risk of one of the categories doing poorly. Large-cap companies are those with a market capitalization of over $10 billion, mid-cap are those between $2 billion and $10 billion, and small-cap companies have a market cap of under $2 billion. Market capitalization is found by multiplying the price of the stock by the number of shares outstanding. Or you can just find the market cap on a reputable financial website.
This is a good place to take a breath. So far, we have given a solid introduction to diversifying your portfolio, but truth be told, we could go on for days. Bond investors could also diversify further by credit quality, duration, type of entity, etc. Stock investors could diversify further by sub-industries (not just oil stocks, but refiners or oil service companies, etc.)
The bottom line is that diversification is an investment strategy that can be used in many ways to manage risk. Used wisely, it has the potential to help avoid catastrophes and expose your portfolio to more opportunities.
 Morningstar Global Flow of Funds Report, 2013 & World Bank
Investing involves risk, including risk of loss. Diversification does not ensure a profit or guarantee against loss. Past performance is no guarantee of future results.
The information provided herein is educational in nature, is not individualized, and is not intended to serve as the primary basis for your retirement, investment, or tax-planning decisions.
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