The Importance of Portfolio Diversification
Even if you're new to investing, chances are high that you have heard about the importance of diversification within your investments. But hearing and understanding are two completely different animals, which is why it is important to address the subject head on. What is portfolio diversification and why is it important? Let's dig in.
When structuring a traditional investment portfolio, there are generally 4 different types (asset classes) of investments that you can buy within an account:
Stocks: Stocks (or equities) are ownership interests in companies. Stocks fluctuate in value depending on how well the particular companies perform in the marketplace, and some will also pay out a portion of their earnings to stock owners (in the form of dividends). Stocks are subject to a lot of price movement (volatility), but also have the potential for high growth.
Bonds: Bonds (or fixed income assets) are an ownership interest in debt products. Think of this as a mortgage, where you are the lender instead of the borrower. Bonds can fluctuate in value, but price movements are usually more stable and predictable than stocks. Their primary lure is the interest they pay to investors.
Cash: This category needs no description, as everyone should know how cash functions. Within a portfolio, cash is usually held in form of a money market fund. It is very liquid and stable, but pays very little interest to investors. This makes it most vulnerable to erosion of value due to inflation.
Alternatives: This category can be considered a catch-all for investments that don't fit neatly within the three categories listed above. Investments that can be considered alternatives are commodities (such as gold, coffee, etc.), real estate (in form of a REIT), and other investment products that might include creative investment strategies (options, short-selling, etc.).
Creating a mix of these different types of investment products would be a form of portfolio diversification. Creating a blended portfolio to specifically fit one's financial goals and risk tolerance would be considered a portfolio diversification strategy. We will take a deeper dive into strategic portfolio construction with a future post.
The Benefits of Diversification
Nearly every product available to investors will have it's own risk and return profile. If an investor holds only one type of investment, the entirety of their portfolio is subject to the pros and cons of that one particular investment. This can be considered a feast or famine type of investment strategy that can wreak havoc on one's emotional well-being, which is not a good recipe for investor success or health. This is where diversification can come to the rescue (think superhero cape and all!).
When blending a mix of investments that don't act the same in every economic environment (we call these non-correlated investments), both the price and emotional ride for an investor will become more tolerable. To demonstrate, let's look at the 20-year investment behavior of 2 very common holdings that have differing characteristics: U.S. stocks and 10-year U.S. Treasury notes/bonds.
It is pretty easy to see that the movements in both investments vary throughout this 20-year period (which designates a relative non-correlation). U.S. stocks (Portfolio 1) grew from a $10k starting point to $41,813, generating a 7.42% annualized return. In route, returns fluctuated an average of 15.36% (as measured by standard deviation) above or below that 7.42% return in any given year, which means it was one heck of a bumpy ride. By contrast, the 10-year U.S. Treasuries (Portfolio 2) grew from a $10k starting point to $27,082 over the 20 years, generating a 5.11% annualized return. Returns fluctuated an average of 7.43% above or below that return in any given year, meaning the path for Treasuries was much less volatile (which was to be expected).
Now let's look and see what happens when also chart a 3rd portfolio that combines both U.S. stocks and 10-year Treasuries (in a 50/50 split) over the same 20-year period.
The blended/diversified portfolio (Portfolio 3) gives us a combination of the risk and return profile of its two underlying assets. The major benefit of combining these non-correlated assets can be seen in the portfolio's ability to better weather the storm when one of the holdings face a nasty period of decline (U.S. stocks in 2008, for example). In addition to generating a smoother investment cycle, there are others statistical benefits which can be better understood by taking a dive into the underlying numbers.
The combined portfolio grew from a $10k starting point to $39,095 after 20 years, generating a 7.05% annualized return. During this time, returns fluctuated an average of 7.22% (the standard deviation) above or below that return in any given year. This means that the blended portfolio earned nearly all of the gains of U.S. stocks over the same 20 years (7.05% versus 7.42%) while actually experiencing an enhanced measure of safety relative to 10-year U.S. Treasuries (7.22% standard deviation versus 7.43%). From an investors point of view, this is about as close as you can get to having your cake and eating it too! Welcome to the mystical power of portfolio diversification.
This is a very basic, high-level view of the benefits of diversification within an investment portfolio. By combining additional holdings that possess other unique risk/return characteristics (even within each asset class), returns can usually be enhanced even further. We will dig into what that might look like in the next post within our series on portfolio investing, which will address how one can properly construct their own diversified portfolio. Stay tuned!