Diversification is a term most investors understand as “Don’t put all your eggs in one basket.” While that phrase captures the essence of what not to do with your investments, it helps to understand why this is sage advice.
Let’s consider a portfolio comprising U.S. large-cap, mid-cap, and small-cap stocks. While most individual investors would consider this a diversified portfolio, it’s not. That’s because it’s vulnerable to various sources of risk that could lead to a less-than-desirable rate of return.
Macroeconomic Factors and Market Risk
First, there is the risk that comes from fluctuations tied to various aspects of the general economy, such as the business cycle, inflation, interest rates, and exchange rates. None of these macroeconomic factors can be predicted with certainty, and all affect the rate of return. This type of risk is referred to as market risk or non-diversifiable risk. No matter how many stocks you own, this type of risk remains even after extensive diversification. In other words, if someone invests in many stocks all exposed to one market (such as the U.S.), the portfolio is not diversified enough.
Marketplace Factors and Diversifiable Risk
In addition, various marketplace factors can affect a stock value. For example, if a company makes a change in management or loses market share to a competitor, its stock value could decline. Diversifying by investing in numerous stocks spread across various economic sectors minimizes the impact of any single stock. In other words, investing in stocks spread across many different countries and investment types will result in less exposure. This is called non-systematic risk or diversifiable risk.
But what happens if all stocks are affected by the business cycle and you have all your investments in that particular economy, e.g., the U.S. economy? During 2000, 2001, and 2002, the Standard and Poor 500 index’s annual returns were the following, respectively: -9 %, -12 %, and -24%. That means a portfolio invested only in the U.S. stock market – even if across large-, mid-, and small-cap companies – would have fared poorly. A diversified portfolio representing international stocks, large-cap growth stocks, large-cap value stocks, large-cap blend, small-/mid-cap stocks, bonds, and cash returned -3.69%,-8.06%, and -14.78% during that time period. While not an ideal rate of return, the declines were considerably less than that experienced by someone whose portfolio risk was not spread among many countries and alternative investments.
Making the Right Diversification Choices
Proper diversification can help buffer the declines from market risk or the non- diversifiable risk that remains even after extensive diversification. One way to diversify is by investing in a single diversified mutual fund that represents the basic asset classes of stocks, bonds, and cash. However, a host of alternative investments – such as hedge funds, real estate, commodities, currencies, and international stocks and bonds – provides the opportunity for further diversification. In times of market uncertainty it may be wise to hire an advisor who understands risk management, optimization techniques, and incorporates flexible strategies in her investing methodologies.