Diversification seems to be a buzzword that is thrown around by investment gurus way too often. It is a feel good word that advisors use to sound intelligent and sophisticated. That is fine and all, but most investment advisors and their clients do not even understand what true diversification in an investment portfolio really means.
What is Diversification?
Diversification is “A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.” 1
How do I know if I am fully diversified?
This is where the water gets a little muddy. This question will bring different answers from different advisors. Some people would tell you that you need between 5 and 10 individual stocks to be properly diversified. If you have only 10 stocks you are taking on extreme risk that is not necessary for you to have. Odds are those 10 stocks are all in a similar place in the market. Thus all 10 of them will be moving in a similar direction when a crash in the market comes.
Diversification is more than just the number of stocks that you are invested in, although that is very important. As a result of the funds that our firm, Preferred Retirement Options, recommends, clients are invested in about 12,000 individual stocks. The most important part about that is that we are invested in every sub category of the market in every free country in the world. Large companies, small companies, international companies, distressed companies, growth companies etc. We are investing in different economies and different technology. It would take an extinction level event for all of those stocks to lose their value. From the portfolios I have seen, most investors that work with an advisor are invested in only large US stocks in the amount of 500 to 1000 total stocks and call that well diversified.
Why is Diversification so important in your investment portfolio?
Take a look at this chart created by Matson Money. 2
This is a pretty technical chart so let me explain. This is real data from 1970-2016. If you were to invest in the S&P 500 you would have gotten a 10.3% return with standard deviation of 17.11. Sounds great right. But if you add bonds/fixed income, international stocks, small stocks and value stocks, you end up with a 10.49% return and a standard deviation of 11.59. That is a higher return with less risk and less volatility. That is what diversification can do for your portfolio.
When you hear some investment guy throw out the word diversification, now you can have an understanding of what it is, and maybe even teach them a little something about it. If you want true diversification that lowers your risk and increases expected return, then give us a call.
By Jimmy Hancock
1. “Diversification Definition | Investopedia.” Investopedia. Investopedia US, n.d. Web. 25 June 2014. <http://www.investopedia.com/terms/d/diversification.asp>.
2. Matson Money. Separating Myths From Truths, The Story of Investing. N.p.: n.p., n.d. PPT.