The old chicken farmer lived up on a hill, alone but for the company of his dog. At the end of each day he would go into the henhouse, gather the eggs, and load them into a basket to bring them to market in the morning. He was awakened one night by a commotion – the dog barking and growling, the hens screeching. When he made his way out to the henhouse to investigate, his fears were realized. As quick as his dog was to respond, the fox was quicker. The eggs meant to supply the village had been stolen or destroyed.
The old farmer learned a lesson that day, one I’m sure you’ve heard of before.
Putting a portfolio together can seem like a very intimidating thing to do, especially for new investors. There are so many principles to learn, ideas to understand, and ultimately decisions to make. Fortunately, some fundamentals are quite easy for any investor to grasp. One concept within investing that is almost universally understood is diversification. Simply speaking: don’t put all your eggs in one basket.
What is Diversification?
In investing, diversification is the act of investing a in a variety of different assets. Diversification aims to reduce the overall risk of an investment portfolio without diminishing the return potential. By spreading capital out into an assortment of different investments, the impact of a decrease in value to the portfolio in the event one investment suffers losses is greatly dampened.
Harry Markowitz, the economist and father of modern portfolio theory, famously called diversification “the only free lunch in finance” due to the benefits it brings without sacrificing much in the way of long-term returns.
In spite of this, many investors still unknowingly have overconcentration issues with their portfolios. The classic example is in real estate, it is not uncommon for someone to gather all of their life savings and put it towards purchasing a home. Should something happen to the structure or property, the investor would suffer steep losses.
Risk can be categorized into two categories: systematic and unsystematic risk. While no amount of diversification can reduce systematic risk, the day to day ups and downs of the market, there are many ways to diversify an investment portfolio to significantly reduce unsystematic risk.
Diversify: Market Sectors
Consider an investment portfolio containing, among other things, fifteen stocks. If one of the companies should falter the value of the portfolio would decrease but not catastrophically, there is some diversification. However, there are more steps that can be taken to reduce risk than simply having more securities. If all fifteen stocks are in the oil industry, a change in legislation or advancement in alternative energy could impact the entire portfolio. By spreading out capital across the 11 GICS (Global Industry Classification Standard) market sectors, we can greatly reduce the impact of market events that impact entire industries in our portfolio.
The 11 GICS Sectors
- Health Care
- Consumer Staples
- Consumer Discretionary
- Information Technology
- Communication Services
- Real Estate
Just as entire industries can be affected by major events, so too can entire countries. Consider again our portfolio containing fifteen securities spread across the 11 GICS market sectors. We are well positioned to survive an event affecting one of the companies or even a market event impacting an entire sector. If however, all fifteen portfolio companies are located in China, we are still exposed to the risk that geopolitical events could drag down our entire portfolio. For example, new tariffs introduced by the United States could negatively impact all Chinese companies and greatly damage our portfolio value.
Diversify: Types of Securities
In the above examples we have done a good job creating a diversified equity portfolio, but it is just that: an equity portfolio. We can do more to diversify by adding different types of securities into the mix. A truly diversified portfolio would not only contain stocks from varying sectors and geographies but additional asset classes apart from equity. Even with a mix of stocks from around the world, our portfolio is far from immune to losing money in stocks as global equity markets are increasingly interconnected. By adding in assets outside of equities or even outside public markets altogether, we can reduce the impact on our portfolio from a host of major market-wide events. Of course, these other types of securities each come with risks of their own.
Of course, your financial advisor will have taken all of this into account when putting together an investment plan and as much as we would like to, we cannot diversify away all the different kinds of risks. There will never be a way to bring your portfolio risk down to zero but if you don’t put all of your eggs in one basket, you can enjoy your free lunch and will be much better positioned for whatever the market may throw your way.
To learn more, please contact your financial advisor.