Diversification and Market Envy

I’m not sure on which stone tablet the following statement is inscribed, but its relevance is a fixture in modern portfolio theory:

“Thou shalt not put all thy eggs in one basket.”

We all hear the term “diversification” in investing but what is it?

Diversification is a risk management technique involving the use of various investments to reduce exposure to risks associated with any single investment. It is more than just having some random assortment of stocks as true diversification has to do with crafting a portfolio of investments with varying correlations and risk exposures.

Is investing in an S&P 500 ETF considered diversified?

Though owning a S&P 500 index fund is a decent start to spreading risk between industries, it is not true diversification because the portfolio’s concentration is 100% in US Large and Mid Cap stocks. US Large and Mid Cap stocks are highly correlated with each other so their performance moves in generally the same direction. There are no US bonds, short term US treasuries, international stocks, small cap stocks, real estate, etc. to reduce some of the risks associated with S&P 500 companies. Investing in the index is like placing “eggs” in multiple, but very similar, baskets.

So how does an investor properly diversify a portfolio?

Correlation between investments is the underlying concept at work when diversifying a portfolio. Correlation is a value comparing the performance relationship between two investments. If two investments are too closely correlated, their value will increase or decrease together. Too much correlation between investments in a portfolio means the portfolio is not truly diversified. Understanding the performance interactions between your investments is vital in spreading your “eggs” across various, unrelated baskets.

We hope that by now diversification makes sense so let’s have a look at why it can also be a source for emotional pain and heartache for investors. Investors are human and humans tend to get caught up in the "would have, could have, should have" mindset. Because it is so readily available, investors naturally will use the market return to gauge their portfolio’s performance, often a dangerous move as it leads to something we like to call “market envy.” So let’s compare the returns of the S&P 500 to that of a diversified portfolio from 2000-2018 and see for ourselves how investors can develop a serious case of market envy.

Diversification is about reducing risk, not outperforming the market year in and year out. In other words, the idea is to lose less in down markets to preserve the portfolio’s value so there is more left to grow in up markets. The table below illustrates the importance of portfolio preservation in down markets:

Notice in Year 2 that instead of starting out with $70,000 if we invested in just an S&P 500 ETF, we preserve $85,000 by diversifying. If an investor is 100% invested in an S&P 500 index fund, they experience 100% of the market upside AND 100% of the downside. A properly diversified portfolio may only experience 50% of the gain in a positive market but more importantly, it may only experience 50% of the loss in a negative market, leaving less of a hole to climb out of in subsequent years.

It can take years just to get back to even after a negative market event. If the market experiences a negative shock close to your retirement, it could put a serious damper on retirement plans. Having an investment plan is important but accounting for the risks involved is too often overlooked, leaving too many eggs in the proverbial basket. Give us a call to work with financial planners who can educate and help guide sound investment decisions, backed by thousands of hours of training and by decades of Nobel-prize winning research.

The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. Securities offered through Securities America, Inc., member FINRA/SIPC, Betsy Merritt & Tyler Aubrey Representatives. Advisory services offered through Securities America Advisors, Inc. New Break Financial and Securities America are separate companies. Securities America and its representatives do not provide tax or legal advice. It is important to coordinate with your tax or legal advisor regarding your specific situation. Diversification seeks to reduce the volatility of a portfolio by investing in a variety of asset classes. Neither asset allocation nor diversification guarantee against market loss or greater or more consistent returns.