Maybe it is because of the time of year, but I keep finding myself thinking about eggs in baskets. Actually, I am not thinking of chocolate eggs or brightly colored eggs, though I love my share of those, maybe a bit too many of the former. I am thinking about the old adage about not keeping all of one’s eggs in one basket. In other words, I have been thinking a lot about diversification. It is a word that we use often in our profession but that doesn’t make it less relevant. In fact, it may be more relevant than it has been in years, given recent developments in the markets. First let’s get a little history lesson on how “diversification” gained its place in portfolio management.
A compressed history of diversification
I am not sure when, but somewhere way back in history a savvy business person decided that having more than one source of income was a sensible way to ensure a more stable stream of returns. Farmers attempted to plant different types of crops that delivered produce during different seasons. The strategy not only increased revenue potential, but also provided the opportunity for one business to thrive when the other might be in a rut, or out of season. If one were reliant on one single income stream, one’s livelihood would be highly dependent on that single source. A bad season for that one business line would guarantee a truly bad season for the business owner. Clearly, the best case scenario would be for all businesses to thrive simultaneously, but having multiple sources of income is the best way to increase your probability that at least one source will always remain healthy. That seems sensible, if not wise. Interestingly, diversification in financial investing is a relatively new concept, from a historical perspective.
Early in the 20th century when everyday folks began to get more involved in the stock market, investors focused on the value of individual stocks. Find a good stock and buy at the best price possible which would hopefully provide great returns. Though investors may have owned numerous stocks at the same time, their relationship to one and other as well as their influence on the overall portfolio was a foreign concept. Turn the clock forward a bit to the early 1950’s when an operations research graduate student named Harry Markowitz became motivated to learn more about stocks after he spent time in a waiting room with a stockbroker. Markowitz wondered why no one spent time pondering the risks of individual investments or their impacts on a larger portfolio. His research into the matter led him to publish an article entitled “Portfolio Selection” in the Journal of Finance in 1952. The crux of the article was a mathematical proof that the greater the risk the greater the potential return, and that it was possible to optimize a portfolio and spread out those risks to minimize the overall risk, while simultaneously maximizing the overall potential for return. This marked the birth of what is referred to as Modern Portfolio Theory in which investors focused more on the risk of their overall portfolio. It took a while to catch on, but soon investors realized that embracing the theory gave them the ability to tailor a portfolio’s risk to their particular risk appetite.
Different forms of diversification
Individual Company Diversification
There are two general types of risk on any given investment. The first is referred to as systemic risk, which is really like market risk. If the market goes up, down, or enters a period of intense volatility, all stocks are likely to be impacted in one way or another. The second type of risk is called idiosyncratic risk, which is a fancy term for individual company risk. This refers to a stock’s going up, down, or increasing volatility in response to the company’s performance or events specific to that company. This type of risk can be minimized by first diligently selecting healthy companies with good prospects, based on accurate fundamental data. However, there are always unknowns which cannot be accounted for such as natural disaster, a potential scandal, loss of business, etc. These are things that cannot be accounted for in the stock selection process and are usually the ones that have the greatest impact on a stock’s ultimate performance. The only way to minimize idiosyncratic risk is through basic diversification. Just by simply owning more stocks. Markowitz’s theory proved that a portfolio of equally risky stocks is less risky than any individual stock within it. So, though I don’t recommend it, even if you throw darts at the stock section of the Wall Street Journal in order to pick stocks, you are better off with more than less.
We all probably intuitively know that different sectors behave differently during different stages of the business cycle. When the economy is expanding, sectors which benefit from prosperity tend to perform better than ones that thrive during a contraction. For example, when the economy is struggling and unemployment is on the rise, stocks that would be considered consumer staples may outperform stocks in the consumer discretionary sector. A stark illustration may be a consumer choosing food over the purchase of a shiny new car or a fancy pair of shoes. Unfortunately it is not that simple to just move from one sector into another based on where you expect the economy is heading, which is why it is important to have investments across multiple sectors, though they may not all warrant equal weighting.
It is a small world, after all, and it does appear to be getting smaller, but there are certainly periods where different regions of the world perform in different ways. Though many countries can be self-reliant, there still exist differences in labor and resource efficiencies that can be exploited through international commerce. An example of regional differences might be soybean farming in the US and low-skill labor manufacturing in China. Another example is how France is known for its fine wines, amongst other things, and you might imagine that people are less likely to buy a fine… and expensive, bottle of wine when times are tough. So, it would seem that it may be sensible to spread your investments across multiple regions in order to diversify. Side note: liquor is considered a consumer staple, which means people buy it when things are going well as well as when times get tough… perhaps even in greater quantities. But you probably knew that.
Asset Class Diversification
Asset classes are groupings of financial instruments that have similar characteristics. The most common asset classes are:
- Stocks / Equities
- Bonds / Fixed Income
- Real Property / Real Estate
- Cash / Cash Equivalents
There are others, but these are the most commonly quoted and liquid. As you might guess, all of these asset classes behave differently during different economic conditions or market regimes. Stocks and commodities generally perform well during economic expansion and high inflation while bonds generally go up during times of low inflation and weaker economic conditions. Historically, stock and bond prices had an inverse relationship, so if stocks went down bonds would go up. Owning both would therefore minimize losses on stock positions as bonds gained in value. Additionally, bonds tend to display lower price volatility than stocks, so owning a blend of stocks and bonds enables investors to minimize and control portfolio risk. This type of diversification is perhaps the most common directed form. Investors who historically wanted less portfolio volatility would have a greater allocation in bonds and a smaller one in stocks.
Investments in each asset class can be further broken down into categories based on exposure to different factors. A common strategy would be style investing, which includes investments based on factors like market cap, credit quality, or company maturity (growth versus value). Historically, small cap stocks, value stocks, and lower credit quality stocks/bonds outperform large cap stocks in a recovering and expanding economy. Conversely, growth stocks typically perform well in all economic conditions, but tend to outshine during periods of muted economic growth. It would therefore seem reasonable to diversify across multiple strategies in order to minimize volatility and increase the probability that one or more strategy is performing well.
Too good to be true?
Based on what you now know about the history and benefits of a diversified portfolio, you might be thinking “are there any downsides to having a diversified portfolio?” Unfortunately the answer is “it depends”. Going back to the theory that started it all, Modern Portfolio Theory, you may recall from up above that Markowitz posited that the greater the risk, the greater the potential return. Therefore a portfolio with a lower risk can be expected to earn a lower return. Remember all of those forms of diversification. Imagine if you only owned one stock: Tesla (TSLA) in 2020. That would hardly be considered diversified, but you would have earned +743% return on your investment. If you invested in the S&P500, a diverse portfolio of large cap stocks, you would have only earned 16.3%. Not interested? If you held Tesla into the current year hoping to cash out on your investment, the stock might have disappointed you after it sold off in February and March while the S&P500 continued to climb. Now, that is an extreme example, but it does illustrate the point that Tesla has made significant returns in price, but it is also subject to extreme moves in both directions. That is to say, it is volatile. If you are investing for retirement you would not want the stock to be on a downswing when you need the money most. The point here is that every investor has a different risk profile based on their personal appetite and portfolio objective. Someone closer to retirement may wish to give up higher potential returns for less volatility. Their focus may be on return of capital versus return on capital, which might work better for someone who may be farther from retirement or not be reliant on the principal.
Could this be you? The current state of diversification.
I have no doubt that many of you started out with a diversified portfolio which included blue chip stocks and bonds. You may have added some investments in emerging markets, say an award-winning mutual fund or an ETF. You may have even added some gold along the way for good measure. You may have noticed above that I frequently used words like “should”, “historically”, or “typically”. That is because markets tend to behave differently in different situations and history doesn’t necessarily repeat itself. Since the end of the Great Recession and the Global Financial Crisis, bonds have been rising along with stocks, meaning that they have been highly correlated, which may have worked in your favor if you held both asset classes… until recently when bonds sold off in response to fears of mounting inflation. The rising yields prompted a selloff in growth stocks because higher yields diminish the current value of the future income that is so critical to a growth stock’s value. You may have found yourself losing money on your growth stocks and your bonds. Ah, but if you were diversified in real estate and commodities, any losses would have been offset by gains in those asset classes. After having such a strong run in the past several years, technology based growth stocks tend to dominate the allocations in most portfolios. It is not uncommon for us to see a portfolio with over 50% of assets allocated to just 1 technology growth stock with the remainder in… you guessed it, more technology growth stocks. Now, it is understandable based on the outperformance of growth and tech… until that all changed toward the end of 2020, where left-for-dead energy stocks, bank stocks, industrials, and materials stocks have handily outpaced those ever-lovable tech shares. Growth stocks, which outperformed for the past decade were shunned for value stocks. Since the end of November of 2020 value shares on the S&P500 outperformed growth shares almost 3 to 1. The strategy that seemed to be unstoppable seems to have lost its luster. Will this new theme continue? It is hard to say, but the best way to ensure that your portfolio will perform well in all economic and market conditions is through… diversification. Worried that you will be giving up potential return? Don’t, simply match the risk of your portfolio to your risk tolerance. If you can afford the risk, then by all means take it on, but do it carefully, thoughtfully, and be prepared to modify the strategy if market or economic conditions change.
The final word
Every portfolio can benefit from one, some, or all of the types of diversification discussed in this newsletter. An esteemed colleague of mine always starts his presentations by jokingly saying that diversification used to be easy. Clients would come to him and say “I am diversified. I have 1 CD in each of the 5 local banks of my town.” I am here to tell you that diversification is not that simple and that many of us are not as diversified as we think we are. If this past year has taught us anything about investing, it has taught us that we can expect the unexpected, there are no straight lines to success, the market rarely behaves in a manner that is convenient for us, and what once worked really well may not work well tomorrow. Diversification was important ten years ago, just as it was fifty years ago. Today, it is more important than ever.
Muriel Siebert & Co., Inc. is an affiliated broker/dealer of the public holding company, Siebert Financial Corporation, which also owns Siebert AdvisorNXT, Inc. Siebert AdvisorNXT, Inc. is a registered investments advisor (RIA) with the SEC and with state securities regulators. We may only transact business or render personal investment advice in states where we are registered, filed notice or otherwise excluded or exempted from registration requirements. Investment Advisor products are NOT insured by the FDIC, SIPC any federal government agency or Siebert’s parent company or affiliates.
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