Demystifying Diversification - Three Characteristics of a Diversified Portfolio

The wide world of finance is abundant with terms that sound more complex than they really are. Diversification usually tops that list. Demystifying diversification is important for reasons that relate to mitigating risk. No investor wants a loss in their portfolio but like it or not, market fluctuations are an inevitable part of investing and cause anxiety. Therefore, it is important to have a strategy to deal with it. You’ve heard the expression, “Don’t put all your eggs in one basket?” That’s exactly what we’re talking about.

Diversification comes from the Latin diversus , meaning turned in different ways. If you have diversified something, you have made its parts dissimilar from each other.

The theory behind diversification does not only happen in finance. Let’s take retail as an example. Designers like Tory Burch® diversify their product lines to include not only handbags, but every must-have you can dream up like clothing, shoes, watches, sunglasses, perfume and cosmetics. Can you just imagine walking into your favorite store and finding only one style, color, and size of shoe? That would be ridiculous. So why do it with investments?

How about this. Do you think sales on wool coats affect sales on flip flops during a winter freeze? Probably not. In this instance the demand for outerwear and shoes are not correlated, meaning a spike in sales of wool coats has no effect on flip flops, neither negatively or positively. That’s good news for the company and protects owners and shareholders in choppy sales cycles – keep that in the back of your mind as we return to the concept of diversification in investing.

So what is it? Diversification is a risk management technique that mixes a wide variety of investments within a portfolio Source: Investopedia . Sounds pretty self-explanatory. You’ll own some stocks, bonds, exchange traded funds (ETFs), mutual funds, real estate, commodities, etc. If something bad happens in one type of investment you may not necessarily lose your shirt and everything you own. So why all of the confusion? Because each investment professional does it a little differently. I know what you’re thinking? Is there one universal generic rule that is applicable to all portfolios? Not really. As Investment Reporter John Heinzl points out: “The academics disagree over how many separate stocks are required to secure the benefits of diversification, but most professionally managed equity portfolios have at least 30 or so individual securities in them,” U.S. fund manager Daniel Peris wrote in his 2011 book, The Strategic Dividend Investor.

So what about the demystifying part? I’m glad you asked. Let’s identify three characteristics of a diversified portfolio:

A mix and a variety of asset classes. Diversified portfolios use a blend of equities (stocks), fixed income (bonds), cash and cash equivalents (U.S. Government Treasury Bills), real estate and commodities (metals and energy). The main idea is to spread out risk across asset classes that behave differently under similar market conditions. For example, U.S. stocks and International stocks may not rise and fall together in the same fashion. Similar to our flip flop example above.

Combine assets that behave differently. Diversified portfolios are balanced between both stocks and bonds. Historically, bonds fluctuate less than stocks but stocks usually generate larger returns (gains and dividends) and carry more risk of market fluctuations than bonds. Studies show that a portfolio balanced between both stocks and bonds tend to achieve returns almost as good as one solely invested in just stocks alone Source: Fidelity . With proper diversification you may not achieve the largest gains in any year but you may manage to avoid the biggest losses.

Diversified within each type of investment. Diversified portfolios avoid overconcentration in one stock or sector. Investments like ETFs Related Four Benefits of ETF Investing and mutual funds increases diversification because they may invest in a large number of underlying securities of all different types. Furthermore, each asset class has its own unique risk and returns characteristics, for example U.S. Large Cap vs U.S. Small Cap. What’s the difference? Small cap companies are focused more on the domestic economy and have an advantage over bigger multinational firms who rely more on overseas sales. Generally speaking when the dollar is strong, small cap companies benefit more.

CONCLUSION:

Remember, the main goal of diversification is to reduce risk in a portfolio. It cannot and will not completely eliminate the risk of losses. Success in investing comes down to many different factors, diversification being one of them. At SheCapital, we believe a global, broadly diversified portfolio is the best way to go. It’s about limiting the downside while still providing an appropriate level of growth.

Are You Diversified?

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Are you diverisified? Get a free online analysis of your investment portfolio and find out.