Diversification Can Smooth Returns And Mitigate Portfolio Risk
Portfolio diversification should be implemented as a risk mitigation measure. It simply means allocating your investments among a number of assets. As...
You want your portfolio to be diversified, so you buy a handful of stocks: Apple (NASDAQ: AAPL), Tesla (NASDAQ: TSLA), JPMorgan Chase (NYSE: JPM), UnitedHealth Group (NYSE: UNH) and Procter & Gamble (NYSE: PG).
Seems like a good approach, right? You’ve got stocks from the tech, consumer discretionary, financial, health care, and consumer staples sectors.
But there’s a problem. Although they are mature, established firms with plenty of liquidity, they still represent one asset class: Large-cap domestic stocks.
So what’s wrong with limiting your portfolio to familiar, U.S.-based companies?
The biggest problem is a risk, although it may not seem so at the moment.
U.S. stocks outperformed their international peers for the past decade. Meanwhile, large-cap outperformed small caps on a 10-year basis, although the S&P 600 small-cap index is outpacing the S&P 500 year-to-date. That means in recent years, investors who lacked diversification didn’t suffer.
The reason for diversification is to decrease investment risk. That’s important as one asset class declines, and you want another investment to offset that loss. Sometimes your securities will move in the same direction, but at different rates. Even that can help mitigate severe downdrafts.
What’s Your Risk Tolerance?
While many stock traders and even long-term investors fancy themselves as swaggering risk-takers, they often panic at the first sign of a market correction.
I saw this among my financial advisory clients, some of whom prided themselves on having a “high-risk tolerance.” It’s not really anything to be proud of, as risk tolerance is not a random indication of being a brave investor, but instead, it’s pegged to your investment income needs and your time horizon, among other factors.
Some of these clients who liked to think of themselves as having high-risk tolerance would call in a panic after a Presidential election, for example, or if they had a “hunch” markets would reverse lower, asking for their portfolio to be reallocated with more cash.
As these clients had financial plans, and I worked with them to generate the retirement income they would someday need, these portfolio shuffles weren’t terribly devastating.
But without a strategy for diversification, investors can find themselves in a similar panic situation. Instead, wouldn’t it be easier to design a portfolio that can withstand various market cycles?
That’s where the risk mitigation part comes into play.
Diversifying, far from being done for its own sake, should be implemented as a risk mitigation measure. You’re simply allocating your investments among a number of assets. As different asset classes rise and fall, you’ll have exposure to the winners at any given time, as well as the losers.
There are ways to tactically allocate a portfolio to take better advantage of what’s leading, but even strategic allocation, where the asset classes are set and then rebalanced, will give you exposure to the leaders.
Even if you run a trading account, you can (and should) diversify according to sector and equity asset class. For example, in the portfolio referenced above holding Apple, Tesla, JPMorgan Chase, UnitedHealth and Procter & Gamble, you could add some stocks from other sectors, as well as a mix of small caps from different sectors. That would decrease the risk of a big hit if one area of the market skids while others hold up better.
Diversification In Long-Term Accounts
In a long-term account, you can diversify using equities, bonds and alternatives such as commodities or liquid real estate in the form of tradeable REITs. International diversification can also help smooth returns.
Mitigating risk can improve returns, by reducing the probability of sharp or prolonged declines.
If you’re a trader, you may already focus on position sizing and risk mitigation with options or other hedging vehicles. You can apply that same thought process to other investment accounts without so much active trading, but with regular rebalancing to maintain your intended allocation.
Diversification can’t eliminate what’s called “systematic risk,” which occurs when an event such as a global pandemic (as a recent example), rapidly rising interest rates sends stocks lower. However, investors can certainly take control of the aspects of their portfolio where they can diversify away some risk.
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