The term ‘diversification’ is one that often crops up in topics and literature around investment. And for good reason. Diversification can improve the long term chances a portfolio will deliver positive returns.
The good news is that like most things, investment portfolio diversification can be made very complicated but really needn’t be. It’s based on principles that are actually very easy to understand.
Diversification In Investments and Types of Investment
Many investors who think they have built a ‘diversified portfolio’ have actually only diversified between investments rather than ‘types’ of investment. That’s important too but only half of the job. So first off, what’s the difference?
Diversification between investments simply means not having all of your money in a small number of assets. For example, splitting your entire stocks and shares ISA between 5 or 10 shares. The reason is simple – spreading your risk. As well as you may think you have researched the companies and as much faith as you have in their long term potential to give you a return on your investment, you might be wrong.
Even the top professional investors pick the occasional dud. If you only own 10 shares and 2 unexpectedly lose 50% of their value, you’ve just seen 10% of your portfolio’s value wiped out.
But if you have shares in 30 different companies, a few of them going wrong won’t have the same impact on your overall portfolio. And there’s also a chance a couple do better than you hoped.
Of course, investing in funds, either passive index trackers or actively managed funds, is the easiest way to get diversification if you lack the time or experience to pick stocks yourself. That’s the typical route for many investors. But even then, it is better to diversify holdings between several funds so you don’t completely rely on the performance of one.
Diversification Between Sectors and Regions
Diversification between investments should also mean making sure the funds or stocks you are invested in are not all in one sector or geography. The way stock markets work means that often all or many of the stocks in a sector or region of the world suddenly fall or gain in value. In the case of a fall, even if the sector goes on to recover in future years, like the tech sector after the ‘dot com’ crash of 2000, some individual companies never do and it can take several years for a full recovery.
The same can happen with world regions, such as when Asia had an economic crisis in the late 1990s. And the opposite. During the great recession of 2007-08, China’s economy remained relatively unaffected compared to much of the rest of the world.
So diversifying between regions and sectors as well as individual company stocks helps reduce a portfolio’s overall volatility.
Diversification Between Investment Types
But diversifying between investment ‘types’ is also important. During big stock market downturns, almost all stocks tend to suffer together. But if you’ve also invested in bonds, which offer fixed income which shouldn’t be affected. Your portfolio’s value would typically be expected to fall less and perhaps recover faster than one entirely dedicated to the stock market if pasts declines are any guide.
A model created by investment advisors Charles Schwab compared 2 portfolios with starting values of $100k from the year 2000 to 2017. One was 100% stocks and the other 60% stocks, 35% bonds and 5% cash. During the dot.com crash of 2000 the stocks-only portfolio dropped 44% and the diversified alternative 20%. During the great recession, ‘07/’08, it was a loss of 48% to 29%.
By 2017 the diversified portfolio was worth $267,245 and the stocks-only portfolio $257,885 – a difference of almost $10k. Not a huge difference but still a valuable one. And the owner of the diversified portfolio would certainly have suffered less stress during the two stock market crashes over the 17 years. And a smaller loss if forced to cash in investments during those periods!