Managing risk is important.
Every day we use tools like seat belts and helmets to manage the inherent risks arising from daily activities like driving a car or riding a bike. Managing risk does not guarantee a positive outcome, but statistically and historically speaking, those who use the tools available to them to reduce risk have a better chance of achieving a positive outcome during adverse circumstances.
Financial risk management is not much different, and diversification is one of the most efficient tools available to investors to manage risk. To understand diversification and why it can be beneficial, it’s important to understand the inherent risks of investing.
One can generally break investment risk into two major categories (both related to uncertainty in the future):
Systematic Risk: Macro-level risks related to broad markets, regions and asset classes. Recent examples include: recessions following the technology bubble or financial crisis of 2008, and events like Brexit that have broad based effects on multiple economies.
Unsystematic Risk: Micro-level risks involved with specific investments. Recent examples include: data security issues like those we’ve seen at Equifax, Facebook, and Target, as well as accounting scandals that have rocked multinational companies like Valeant Pharmaceuticals or Enron.
What is Diversification And How Does it Work?
In its simplest form, diversification is akin to the adage, “don’t put all of your eggs in one basket.” In practice, diversification means owning a variety of asset classes, including those that are out of favor.
If we adjust the adage to “don’t put all of your fruit in one basket”, the analogy becomes more appropriate for holistic portfolio management. We can think of a portfolio as a fruit stand. It would be prudent to sell a variety of fruits instead of just one. If a large unforeseen event like a hurricane wipes out the orange groves in Florida, it would be helpful if you also sold apples from the Northeast or bananas from Hawaii.
Think of the hurricane as “systematic risk” and the different types of fruit as different asset classes (equity, fixed income, and alternatives).
It would also make sense to use different suppliers of oranges, for example, so that if one supplier had unforeseen problems with irrigation (or accounting), you would still have oranges to sell. This represents “unsystematic risk.”
To take the analogy a step further, a responsible fruit stand owner would also want to sell a variety of types of oranges, apples and bananas. People often have different tastes, and sometimes prefer navel over blood oranges, or Granny Smith over Macintosh apples. Think of these different types of individual fruits as different size, styles and sectors within each asset class.
How Does an Investor Apply the Fruit Stand Analogy to Their Portfolio?
Portfolio diversification works the same way. Investors first diversify at a very high level by using different asset classes (equity, fixed income and alternatives).
Next, they diversify within each asset class by investing in different geographies, and then further by choosing different styles, sizes, and sectors.
Finally, investors attempt to diversify away from any risk involved with a specific company or investment. They do so by investing in a large number of companies by using pooled investments like mutual funds and ETFs, or by purchasing a sufficiently large number of individual securities.
When an investor understands the different types of asset classes, sizes, styles and sectors, as well as their relationships to each other and the broader environment, they can construct their portfolios around their specific risk tolerance.
The goals of different investors are usually not the same. A young couple with no children, for instance, may want to try to maximize their returns with the understanding that they may be more volatile, while a retired couple might desire steadier returns to take their family on vacation every few years.
What is “Disciplined Rebalancing” and Why is it Important?
Once you’ve determined the best mix of investments to achieve your goals, it’s important to stick with it.
It may be tempting to look at a stand that sells only oranges when they are seeing record sales and decide that you’d like to order less apples and bananas in favor of more oranges. But by the time you get your new orders ready to go, there could have been a hurricane in Florida, or trends may suddenly change again, and people start favoring apples over oranges.
This is similar to “chasing returns” in investing. Consider the technology bubble or financial meltdown of 2008 — investors who decided to invest primarily in technology stocks or financial stocks suffered much greater losses than those who diversified more broadly across asset classes and sectors.
“Disciplined rebalancing” means sticking to your allocation targets, even if that means selling a security or asset class that is in favor in order to purchase one that is not. Systematically, this creates a pattern of “buying low and selling high.”
Diversifying your portfolio can reduce the inherent risks involved with investing. Diversification uses the relationships of different investments with each other and with the broader investment environment to reach a desired level of risk in a portfolio. Disciplined rebalancing aims to ensure the portfolio remains in line with your risk tolerance and personal goals.
An important element of a healthy portfolio is diversifying in a manner that fits your personal investment style, your risk-tolerance level, and your long-term goals – and then stick with it.
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