What’s the Big Deal about Diversification?

Originally published in North Bay Business Journal

basketball going into netDiversification. Financial Advisors use this word a lot when describing how the best portfolios are constructed, and it’s one of the keys to a successful investment strategy. The big idea here is that a properly diversified portfolio will mitigate losses because investments react to the same event in different ways. 

A well-constructed portfolio is comprised of many distinct parts – or in financial speak, they are allocated to specific asset classes. Each asset class has its own focus but adds benefits in a composite way over the long term.

The broad asset classes fall into two categories: stocks and bonds, and most of them operate differently from each other over time. They have particular risk and return characteristics: for instance, at the highest level, stocks are riskier than bonds, but they are expected to earn more. And each asset class has its own risk profile. For example, US Small Company stocks are generally riskier than US Large Company stocks; Emerging Market stocks are riskier than US Small Company stocks; intermediate-term bonds are riskier than short-term bonds. The riskier the asset class, the greater the expected return.

When all these elements are combined, we have a diversified portfolio. Or, to put it another way, instead of committing to a single, concentrated position (like tech stocks, for example), we are dividing the investment into a variety of categories. This reduces the extremes in a portfolio and softens the blows of significant market downturns.

Let’s use a basketball analogy to illustrate the point. For the Golden State Warriors to have won their most recent championship, they relied on much more than just the shooting prowess of Stephen Curry. There were indeed days he made all the difference – in one game alone he scored 43 points (40% of the total points scored by the team that night). But in the next game he was barely a factor. Instead, his teammate Andrew Wiggins, who had not made any notable previous contributions, became the dominant player.

Investing with a diversified portfolio is a lot like that – at times one player is hot and the others are cold. To rely solely on one player all the time would invite disaster and would not build the foundation for a repeatedly excellent team. And just like in basketball you do not have to win every game or be ahead on every point to have a winning year. It is a long season and those who pace themselves well are likely to come out near the top.

Why, then, do we continue to hold one asset class when it might impair the portfolio’s overall performance? The short answer is that only hindsight is 20/20. Why would the Warriors keep playing Damion Lee, even when he routinely underperformed? In finance speak, why hold bonds when stocks are going up?

The simple answer is one of timing and the unpredictability of the markets. If we could know beforehand when one asset class would surge and another would decline, we would always trade for the better option. But that timing is impossible to consistently get right. Despite our superstitions about professional sports, we could never guess if Steph Curry is going to have a 40-point game or be sidelined with an injury.

Just look at the performance of stocks and bonds over the past year. In the six months from July 1 to December 31, 2021, the best performing major asset class was US Large Company Stocks, which gained 10.3%, while short-term bonds were essentially flat (down 0.4%); in the subsequent six months from January 1, 2022, to June 30, 2022, the US market lost 18.2% while short-term bonds declined only 3.3%. They flip-flopped.

And this is not just a short-term phenomenon. If you look at the decade between 2000 and 2009, bonds, emerging markets, and international stocks far outperformed US stocks; from 2010 to 2019, the opposite was true: US stocks far outperformed bonds, emerging markets, and international stocks.

But here is the crazy thing: if you held a simple diversified portfolio of 60% stocks and 40% bonds over this whole twenty-year period, you would have far outperformed both. Replace your diversified portfolio with the Golden State Warriors and you’ve got yourself a 7th championship ring on your finger.

The best portfolios are based on time-proven, evidence-based practices. They are meant to avoid investment fads like cryptocurrencies, “meme stocks,” or whatever is trending in the financial press (or social media) at any given time. Although allocations can have subtle adjustments, a solid investment philosophy would never include changing allocations due to current market sentiment, flashy news headlines, or the latest trendy get-rich-quick idea.

This might seem contrary to what many people expect their financial advisor to do, but it is a time-proven approach adopted by the world’s largest pension funds and academic endowments – stay the course.

It is the nature of a diversified portfolio that you will always wish you had more of one thing and less of another. But, like a basketball team over a long season, we know we will not win every game, and the star player will not score every night. But a team with consistency and a solid foundation will have the best record at the end of a long season.