As Martha Stewart might say, diversification is “a good thing.” It’s the most effective, least expensive, and easiest-to-implement strategy in an investor’s toolbox to reduce the risk of loss, without sacrificing return. The theoretical and empirical proof of this small miracle is complicated, requiring an understanding of the Greek alphabet and statistics. Yet like all unimpeachable truths, diversification is readily grasped in a bit of homespun wisdom. When your mother advised “not putting all your eggs in one basket,” she was telling you to diversify.
But let’s unpack this wisdom for a moment. If you put all your egg-dollars in Apple stock, your wealth will inevitably fluctuate with the health of the U.S. economy, changing tax laws, and the vagaries of the stock market. However, you also incur the risks specific to Apple – such as a slowing Chinese economy that spoils the country’s appetite for iPhones, or a lawsuit brought by U.S. government against Apple over its privacy policies. Now you have some extra demons to keep you awake at night.
You can counteract Apple-only risk, by investing in companies in other industries, such as food or pharmaceuticals, or in other countries: in other words, companies that “zig” when Apple “zags.” Furthermore, because Apple-specific risk can be diversified away, you won’t get extra return by keeping it.
Consider this analogy: if a policeman refuses to wear a bullet-proof vest while responding to a hostage situation, will he be recognized as more “heroic” or paid more than his fellow officer who always wears his vest? Of course not – the foolish policeman won’t get paid for taking risks he didn’t have to, and may even get fired. Same goes for investors: they get nothing extra sticking to one basket, and instead may lose a lot of money. Moral: stay diversified.
But the “why” of diversification says nothing about the “how” and “what.” Here the questions get harder.
How diversified should I be?
It used to be that you could diversity holding three basic asset classes: stocks, bonds, and cash. Using mutual funds to invest in these classes further ensured that you were diversified within each type of asset.
Trends over the past forty years, however, have made this approach seem far too simplistic. With globalization and the creation of marketable securities for illiquid or directly-held assets, it’s become possible to expand one’s investment repertoire. Now investors invest in foreign countries, commodities, mortgages, and real estate, with a click on their hand-held devices. Furthermore, recent evidence has shown that value stocks offer different risks and returns from growth stocks, and likewise with large-company stocks versus small. As a result, diversification possibilities have become more diverse. Now there are ETFs, in addition to mutual funds, which open up yet another possibility for investors intent on covering the investment field.
So is it possible to do too much diversifying?
Yes, particularly when investors uncritically believe that more is better than less. It’s well known that 401(k) participants often diversify according to the 1/n rule, where “n” is the number of investment options in the plan. For example, if a plan sponsor offers four US stock funds, participants are likely to contribute 25 percent to each. With ten options, they divide their money into tenths.
It has been shown that sufficient diversification of a U.S. stock portfolio can be achieved with approximately 10 to 13 stocks. After that, nothing extra is gained: no further lowering of risk, no enhancement of return. Conversely, management and information costs – not to mention expense rations – may increase with the number of investments.
Most CFP® professionals would agree that holding a broad U.S. stock index, a broad international stock index, a U.S. and a foreign bond index, and a high quality money market fund provides adequate diversification. A commodity fund might be added to the mix, as might a real estate fund, as the investment amounts grow larger.
What other risks can be diversified?
Beyond asset classes, there are other areas in an individual’s financial life that benefit from diversification:
- Human Capital: the skills, education, training, and professional experiences that an individual offers to the workplace. In today’s fast-changing knowledge economy, having a wide array of these resources is becoming more essential to higher paying, more secure jobs. With just one skill, or experience in just one industry, comes a greater risk of lay-off, burn-out, and stagnant wages.
- Type of Investment Accounts: Many people invest solely in their homes and tax-deferred retirement accounts, both of which can be illiquid, difficult to tap, or carry significant tax costs. Diversifying some investment capital into taxable accounts, where withdrawals can be made without ordinary income taxes or early withdrawal penalties, can provide tax savings and cash flow flexibility in retirement.
- Acquisition Cost: For large investments, it makes sense to diversify the prices at which the investment is purchased, rather taking the risk of buying an entire position which then goes on to plummet in price. Dollar cost averaging is a commonly known method for this type of price diversification which lowers the average cost per share of the acquired position.
As a final point, there is no one diversification strategy that fits all. Personal circumstances matter. An individual expecting a sizeable Social Security benefit may not require the same allocation to bond holdings as would a retiree depending solely on his portfolio to provide income. An executive working for a major oil company does not necessarily need to diversify into a commodity fund. This is where holistic financial planning provided by a CFP® professional who focuses on individual needs and goals comes in. Pair financial planning and diversification, and you get two very “good things” working together. Not to mention a good nights’ sleep.