Diversification is crucial to successful investing.
No matter how smart or well-informed you are, the future value of an asset is highly unknowable.
Concentrating your wealth in a few assets exposes you to a high risk of devastating loss.
In this article, we discuss diversification, why it’s important, and how to ensure you’re doing it properly.
Correlation is the key
The key to good diversification is correlation.
Owning 100,000 different assets is not helpful if they are highly correlated,
meaning they tend to increase and decrease in value at the same time.
On the other hand, a portfolio with just a few uncorrelated assets may
be well diversified.
For example, if you owned stock in hundreds of different businesses related to
travel/tourism, you likely got hammered in early 2020 (COVID).
Those stocks are highly correlated.
You were better off holding stock in just a few businesses, along with government bonds and
a piece of real estate.
Types of diversification
As just discussed, diversification is not just buying a handful of different stocks.
You should consider other types of assets, including at least bonds.
This is called asset class diversification and is discussed below.
Even within the stock market, you should consider purchasing stocks of companies
with different size, industry and location.
Conflicting information
If you read a lot, you’ll find conflicting information about diversification.
Most sources argue for diversification, but you will also find detractors.
This is because, while preventing the worst outcomes, diversification also prevents
the best outcomes (your net result will be between your best- and worst-performing investment).
Warren Buffett has said diversification “makes very little sense for those who know what they’re doing.”
His cohort Charlie Munger says, “it’s taught in all the business schools, but they’re wrong.”
Does this mean you shouldn’t diversify?
Probably not.
After all, these guys themselves diversify across stocks, industries and even regions to some extent.
Let’s clarify their statements.
First, they are not advocating buying just one stock.
In other statements, they've indicated that at least a few different assets should be held.
Their intent is more to argue against broad market index investing, and even then it only
applies to a small subset of the population, read on....
They’ve stated that over 99% of people should diversify extensively.
Most people overestimate their investing skill and underestimate the risks associated with investments.
Even if you have the required knowledge / skill, it will be limited to a small subset of suitable investments,
and there may not be any “good deals” in that subset.
This may explain why Warren (via Berkshire) has bought S&P 500 index funds.
He’s essentially limited to high market-cap investments with high trading volume.
Furthermore, he’s not knowledgeable enough to understand (and therefore buy) most large-cap tech stocks.
So, in many situations, he may be unable to pick a suitable investment.
Another thing to consider was pointed out in a 2020 memo by Howard Marks.
In their younger years, Warren and Charlie could easily identify companies trading below any reasonable account of their worth.
Today, however, there are thousands of experts and sophisticated computer systems analyzing endless information on virtually every publicly traded company.
The prices of “cheap stocks,” if they exist, are quickly bid up to a fairer value.
Good deals are harder to identify now.
Equity diversification
Equities (stocks) make up the largest portion of most portfolios.
Unfortunately, they can also be the most unpredictable and volatile.
For this reason, diversification within equities is critical.
Consider diversification not just among companies,
but also among industries and countries / regions.
Politics or currency problems could destroy a country’s stock
market in short order.
Likewise, a disruptive technology could decimate an entire industry quickly.
Let’s say you’re an expert on travel-related businesses like airlines and hotels.
No matter how hard-working, well-informed or smart you were, if you concentrated your investments in this industry, you probably lost half your worth in February-March 2020 (COVID).
Unless you can predict all the major events of the future (technology breakthroughs, floods, wars, pandemics, cyberattacks, …) you risk such losses.
The best way to minimize this, and still enjoy the potential high returns of equities, is equity diversification.
Index funds
Luckily, equity diversification doesn’t have to be complicated.
Buying and holding just one
index fund may be the smartest way for most people to invest in stocks.
Index funds can be purchased with very little cost (small fraction of 1%) and spread your investment over all stocks in an index.
For example, popular S&P 500 index funds spread your investment over all companies in the
S&P 500.
The value of an index fund tracks an underlying index, which is an average of a group of stocks included in that index.
For example, the
FTSE Global All Cap Index includes over 98% of publicly traded companies in the world (including all sizes, industries and regions).
You can easily “buy” this index via an ETF like VT.
Not all index funds provide “good” diversification.
Some track specific industries or regions and may not be suitable for you.
For example, there are index funds that track the performance of Brazil’s stock market, or the US oil industry.
You’d need to buy many of these to get reasonable diversification, partially eliminating the simplicity index funds can offer.
Arguments for reducing equity diversification
There are reasons to reduce equity diversification.
As discussed earlier, someone with a cool head and lots of knowledge about a sector may want to diverge from a broad index and select businesses likely to outperform.
This should be done with care and humility, and still include some amount of diversification.
Going “all in” on a few stocks / sectors is extremely risky, even for the most knowledgeable and skilled investor.
A growing percentage of investors want to “put their money where their morals are.”
According to a 2019 Morgan Stanley survey, 85% of individual investors were
interested in sustainable investing, up from 75% in 2017.
Whether it’s supporting climate change initiatives, social causes or other beliefs,
some investors are willing to be overweight in some businesses / industries, while completely avoiding others.
In addition to the risks associated with reduced diversification, this approach has weaknesses.
First, it can be difficult to assess how companies rate on your moral compass.
Some companies
Greenwash data to increase ESG scores.
While rating agencies produce objective ESG scores, the metrics chosen are subjective.
Given that these scores govern the flow of billions of dollars, corrupt actors may “rig” them to serve their interests.
Furthermore, the “big picture” impact of certain businesses can hard to know.
For example, let’s say the US decides to close its oil businesses tomorrow.
By itself, this may be an environmentally unfriendly action.
This would divert more capital to potentially less responsible oil producing countries.
The US would have drastically less resources to work on green initiatives, while other oil producers would have new resources to double down on drilling new wells, invade another country, or potentially other negative endeavors (some of these endeavors could further increase oil usage!).
So it’s not clear that defunding big oil is a “green” action.
Another problem with this approach is the likelihood of reduced returns.
When too many people buy into a sector, without regard for valuation, the sector will become overpriced.
These investors will typically earn lower long-returns, and hence have less ability to fund future endeavors.
Bond diversification
Diversification within bonds is not as critical as in equities.
However, there are crucial things to be aware of.
The right mix of bonds can significantly reduce overall portfolio volatility.
The high yield mistake
A common mistake for beginners is to load up on high yield bonds.
Not only does this lack diversification in your bond portfolio, but it can greatly reduce overall portfolio diversification.
High yield bonds behave like stocks—their returns often move in unison.
This runs against the goal of diversification, which is to hold less correlated assets.
There are three key types of bonds: corporate, municipal, and government.
Corporate bonds are sold by businesses and risk default if the business is unable to earn enough money to pay bondholders.
Interest earned is subject to federal, state and local taxes.
These bonds vary from high risk (high yield) to low risk (low yield) and this risk is measured by
various credit rating agencies (see quality below).
Municipal (muni) bonds are issued by state or local governments.
These bonds are typically exempt from state and federal income tax.
These bonds are generally lower risk than corporate bonds, but higher risk than government treasuries.
Government bonds issued by the treasury or federal agencies (e.g. Fannie Mae) are considered the lowest risk.
Treasuries are often called “risk-free” investments, though I don’t like that phrase (there are risks).
These bonds offer excellent diversification to equities—when one goes down, the other typically goes up.
Quality
Bond issuers have credit ratings just like us.
Quality here refers to the issuer's credit rating.
The three main
credit
rating agencies for bonds are Moody’s, Standard & Poor’s and Fitch.
They assign scores based on likelihood of default.
As discussed earlier, low quality (high risk of default) bonds don’t diversify equities well.
That doesn’t necessarily mean we should go all in on high quality bonds.
High quality bonds come with low yields, and sometimes struggle to keep pace with inflation.
Maturity
Maturity refers to the length of the bond’s life, e.g. a 5-year bond or a 20-year bond.
When interest rates drop, older bonds with higher coupon rates become more valuable.
When rates rise, older bonds lose value.
Diversification over maturity ("laddering") is highly recommended to minimize drawdowns
associated with interest rate movements.
Country and industry
This follows what we said about equity diversification.
You probably don’t want all your corporate bonds to come from just a few industries or even countries.
There are many factors that could harm an entire industry / country, causing most / all
such bond issuers to default (fail to pay you).
Asset class diversification
Some of the most diversified equity portfolios dropped over 30% from mid-February to mid-March 2020.
A study by
Magnify Money
reported that almost a quarter of investors sold all their stock in March 2020 and 42% sold some stock (after the big drop).
The message is clear: equity diversification alone is not enough for most people.
Bonds are one example of an asset that often (not always) moves counter to equities.
I was lucky enough to be holding a lot of long-term treasury bonds (e.g. TLT) in early 2020.
As stocks fell in the COVID panic, I was able to sell these bonds at a large profit and buy stocks at heavily depressed prices.
This is what asset class diversification can do for you—reduce volatility and enable you to purchase other assets if / when prices fall.
Unfortunately, there are unpredictable events that can negatively impact an entire asset class.
Diversification across asset classes softens these blows and can prevent people from panic selling in such scenarios.
The March 2020 meltdown is just one example.
In 2008, portfolios with sufficient bonds or gold drastically softened the blow of the financial crises.
More importantly, such portfolios encouraged people to stay invested (pure equity investors were more likely to exit the game and not return for years).
Argument against asset class diversification
There’s a downside to asset class diversification, however.
Asset classes other than stocks typically provide lower long-term returns.
If you were 100% certain you didn’t need to access your money in the near term,
and you knew you could hold on through whatever pandemic, war, etc. may crash the
stock market, then you might consider very little asset class diversification.
The problem with this—none of us are lucky enough to be in that scenario.
Even the most risk-tolerant, long-term investors typically have at least 10% of their savings outside of equities.
You never know when you or a family member may become sick, unable to work,
or some other catastrophe may occur.
Asset classes to consider
Since you probably want to diversify among asset classes, what should you buy?
Popular alternative investments include bonds, real estate, and commodities like gold (and Bitcoin).
None of these are likely to outperform equities over the long haul, but each has attractive qualities.
Many experts would only recommend bonds and real estate for the average investor.
There’s a good reason for this—these are the only assets that have an underlying reason for appreciating.
Money lent out via bonds is used to create goods and services that typically allow the borrower to repay the investor, with interest.
People are willing to pay to use real estate for housing or commercial purposes,
money that can be returned to the owner (after maintenance and other costs).
Commodities like gold and Bitcoin don’t have an underlying reason for appreciating.
When you buy one of these assets, you hope someone else will be
willing to pay you more for them when you want to sell.
This is often referred to as speculating rather than investing.
As Bitcoin proponents can point out, this sometimes works amazingly well.
However, these speculations often end up with little or no gains over the long-term.
When asked about gold, check out what Jack Bogle had to say after 2:00 in the video below.
Balanced and target date funds
Asset class diversification does not have to be complicated.
A key thing you need to answer beforehand is when you're likely to start accessing the money in your investment—your time horizon.
The sooner that is, the more bonds or short-term investments you should hold.
A single balanced fund or
target-date fund
is suitable for most people.
All you have to do is buy one of these funds, and they will take care of the diversification and rebalancing.
With a target-date fund, they'll shift your asset allocation over time towards safer (shorter-term) investments when you expect to access the money.
All this can be had for a small expense ratio, typically less than 0.25%.
If you want to take control yourself, you could start by examining target date funds and example
portfolios like Ray Dalio’s
“all weather fund.”
It’s highly diversified among asset classes including equities, bonds, gold and commodities.
As the name indicates, this portfolio aims to weather most storms
without significant loss of capital.
It is not likely to earn high returns over the long run—the price you pay for stability.
Summary of historical correlations
The table below shows correlations between pairs of assets/indexes.
This is the correlation of calendar year total returns over the historical data
we have available for both assets/indexes (see the leftmost column).
For example, to find the correlation between the S&P 500 and gold,
look where the S&P 500 column meets the gold row.
The value is 0.11 and is measured from 1955 to the present.
I say 1955 because the gold data is 1955-present (there's additional, older data for the S&P 500,
but it cannot be used in this correlation calculation).
S&P500
US Small-cap Value
NASDAQ-100
Gold
Bloomberg US Agg Bonds
MSCI World ex USA
S&P500 (1928-)
US Small Cap Value (1928-)
0.80
NASDAQ-100 (1986-)
0.82
0.38
Gold (1955-)
0.11
-0.06
-0.02
US Agg Bonds (1976-)
0.28
0.21
0.11
-0.09
MSCI World ex USA Equity (1970-)
0.68
0.47
0.59
0.08
0.09
US Real Estate (1978-)
0.47
0.72
0.19
0.20
0.14
0.36
Future correlations may be much different.
Conclusion
Here’s a quick recap of the takeaways.
Diversifying among asset classes reduces volatility and risk. If you're risk averse or potentially need
to withdraw your investments within a few years, consider higher asset class diversification, particularly into bonds.
Within equities, broad diversification across countries and industries is probably your best option.
