Moderating Risk through Diversification
By Bryan Dooley | October 16, 2017
Global equity markets continued to push through to new highs last week. Notably, the S&P 500, the Dow Jones Industrial Average, Germany’s benchmark DAX index and the MSCI World Stock index all reach record levels as investor confidence was stoked by anticipation of stronger corporate earnings and faster global growth. Meanwhile, the greenback has retreated from a recent rally while Sterling strengthened but remains well off its September highs on concerns that the ongoing Brexit debate will ultimately result in a messy divorce.
With equity markets still hovering near its highs, I believe it a good time to address the concept of diversification. As Warren Buffett once said, “There are two rules of investing: Rule #1: Don’t lose money and Rule #2: don’t forget rule #1!”
In the world of investments never losing money in the short run is a difficult, if not impossible objective. However, diversification embraces the notion of preserving capital by limiting downside moves through both good times and bad by not keeping all your eggs in the same basket. In most cases, investors would be wise to construct a portfolio that includes an intelligent mix of fixed income, equities, cash and possibly other asset classes. Having a balanced portfolio improves the odds of reaching important financial goals while experiencing an acceptable level of market price volatility in the interim.
While many advisors, including ourselves, regularly attempt to forecast the direction of the markets and prognosticate which asset classes will do best over the next year or two, history shows these predictions are not always exactly on the mark. What we do know is that different asset classes perform well during different times while others do not.
Moreover, even within a particular asset class subsector returns can be quite divergent. Year-to-date the S&P 500, a broad measure of the U.S. stock market, is up about 14%, but within the index, the energy sector has declined over seven percent as of this writing. Therefore, a stock portfolio heavily concentrated in oil and gas companies would have experienced a high level of downside risk this year.
Investing across a wider spectrum of regions and countries provides a further level of diversification. Central bank policies, government agendas, demographics and economic growth drivers vary considerably from country to country. Spreading your bets across multiple regions reduces country-specific risk.
While regional exposure outside of an investor’s homeland can reduce country risk, this strategy generally also creates some currency risk. U.S. dollar-based investors, for example, had something to brag about over the last two years ending in 2016, but year-to-date the greenback has been under severe pressure while investing in other currencies such as euro-denominated securities has paid off.
Despite the potential for currency risk, investing abroad has appeal from both a risk and a return standpoint. North American investors who focus exclusively on local markets may be missing out on growth opportunities elsewhere. For one thing, emerging markets are on the rise again. China, the largest of the EM’s countries, has it has seen its share of the world market capitalization soar from less than 2% in 2003 ago to over 10% today.
Importantly, diversification does not mean beating a benchmark every month, but rather focuses on protecting the total portfolio against large swings in value. Proper diversification ensures some portion of the account is doing well, or at least holding up during challenging conditions.
During the financial crisis in 2008, the S&P 500 stock index fell about 37%, but U.S. Treasuries, as measured by the Barclays U.S. Treasury index, were up 13.7%. Gold also proved to be an attractive diversifier, increasing in value by about 6% for the year. Maintaining a balanced portfolio during this tumultuous period would have eased the pain somewhat.
The most basic building block of a diversified portfolio is an acceptable ratio of equities to fixed income. Looking at historic investment returns over time, the month-to-month price changes in these asset classes are generally uncorrelated, meaning that more often than not stock and bond prices move in opposite directions.
This inverse relationship also makes sense intuitively. When geopolitical uncertainty and economic fear prevail, investors demand the safety of bonds and push up fixed income securities’ prices. But when the coast is clear, investors clamor for the extra return traditionally provided by equity investments as the so-called ‘risk trade’ moves in the other direction.
A diversification issue I have run into frequently over the years, is single stock concentrations. Often an individual comes in with a large holding in one security, perhaps because they worked for the company for a long time and were allowed to purchase shares at a favorable price.
In this situation, I make a point of explaining the risks of single security concentrations and usually try to help them set up an aggressive diversification plan. Moving forward on this plan is especially important if the person is retiring or otherwise changing their objectives. Holding a large percentage of one’s portfolio in a single security incurs an extremely high, and probably intolerable level of company-specific risk.
Whether investing on one’s own or hiring the services of a professional, diversification should be a cornerstone of your strategy. Proper diversification helps build and preserve wealth over time without causing excessive volatility and sleepless nights.