Key Take Aways
- Diversification helps smooth out portfolio returns
- Two core types of risks: idiosyncratic and systematic
- False diversification happens when an investor holds a basket of similar holdings
- Asset class diversification helps provide true diversification and reduce the risk associated with crisis correlation
Tickers shared in this article are for educational purposes only, and to support your own research.
Don’t Put All Your Eggs In One Basket
Most investors have likely heard this age-old advice that in a nutshell tries to get investors to spread their capital across different holdings to minimize the impact of any one investment experiencing significant losses. Typically within the stock market, this means holding multiple stocks, ETFs, or mutual funds, but this is an oversimplification and can result in an investor holding a portfolio of very similar holdings. This creates the illusion of diversification, or rather False Diversification, and the negative consequences of this are only shown in times of crisis—just when an investor most needs the benefits of true diversification.
Background on Risk
Before getting into why we need true diversification, we need to understand a bit about risk in financial markets. Now, this can be a bit technical, but rest assured it is worth the read. On the other side, you will be a much more well-informed investor.
Though risk means different things to different investors, the investment community has centered on volatility as the definition of risk in financial markets—more precisely, the standard deviation of returns (the percentage change from one period to another).
With this simplified definition of risk in mind, we can then break down risk in the markets into two core components: idiosyncratic risk and systematic risk. Modern portfolio theory is built on the notion that risk and returns are different sides of the same coin and for an investor to obtain more return they must take on correspondingly more risk; however, not all risk is rewarded, and some investors may inadvertently take on unneeded risk without any corresponding increase in expected returns.
I don’t know about you, but taking on risks without being compensated is not my idea of a fun time. So let’s move on to learn about different types of risks, and how we can make sure we are fairly compensated for risking our capital
Idiosyncratic risk
When thinking about an individual stock, we can quickly think of risks that might be unique to that stock. For example, with biotech stocks, FDA approval or denial is a very real risk that is unique to only that one stock with a drug under review. Alternatively, the idiosyncratic risk can be a company’s CEO or a large project in a politically unstable environment. Idiosyncratic risks are not exclusive to individual stocks, a sector as a whole could be exposed to idiosyncratic risk. For example, the energy sector is heavily reliant on the price of oil and natural gas. Looking to Big Tech, there exists idiosyncratic risk in the form of government regulation.
Systematic risk
Moving away from individual names, and even individual sectors, we know that being in the market generally exposes us to some level of risk. Right now in late 2021, the market as a whole is being impacted by risks associated with inflation and more aggressive future rate hikes by the Federal Reserve. These are risks that impact all stocks, and thus the entire asset class of U.S. equities—some names and sectors may be hit more or less compared to others, but all equities will be impacted.
Diversify away from the idiosyncratic risk
Within the stock market, idiosyncratic risk can be reduced and eventually eliminated through the power of diversification. If your portfolio consists only of 1 biotech stock, you are taking on a heavy amount of idiosyncratic risk. Your entire portfolio is impacted by the success or failure of an upcoming FDA review or clinical trial. This might not seem like an issue, however, you are taking a large amount of risk and are not being appropriately compensated with higher expected returns in proportion to the higher level of risk you are taking. According to Modern Portfolio Theory (MPT), investors are only fairly compensated for taking on systematic risk, not idiosyncratic risk.
So what can be done? You could reduce the amount of idiosyncratic risk in your fictitious 1-stock portfolio by buying another name, but the level of risk reduction depends heavily on what name you buy. If you buy another biotech stock, or another closely related competitor, the benefits of risk reduction will be a lot less compared to buying a stock in a completely different sector—such as a utility company or a consumer discretionary stock. We can then continue adding stocks to the fictitious portfolio until we have eliminated all idiosyncratic risk.
How Many Stocks To Eliminate Idiosyncratic Risk?
Many academic studies have shown that a carefully selected portfolio of roughly 20-30 stocks would effectively diversify away all idiosyncratic risk and leave only systematic risk (a more detailed post on this topic can be found here). But with the rise of low-cost ETFs like VOO and VTI we can do even better, and instantly get access to 500 plus companies with a single buy! The result is a portfolio with a significant decrease in volatility and an overall higher risk-adjusted return.
So Then What Is False Diversification?
Earlier we saw that a portfolio of 20-30 stocks mostly eliminates idiosyncratic risk, so what if we do 100 stocks, 200 stocks, or 1,000 stocks? Or even better, what if we buy dozens of super diversified ETF’s that themselves have hundreds or thousands of individual names? We can buy VOO, SPY, QQQ, IJR, VTI, DIA, and other low-cost diversified ETFs using almost any broker such as M1 Finance, Ally Invest, and TD Ameritrade to name a few. Our portfolio must then have virtually no volatility, and always positive expected returns, right?
Well not quite, we have now run into the issue of false diversification. False diversification occurs when an investor creates a portfolio of economically similar holdings that all move more or less together. For example, if an investor held SPY, QQQ, and VTI they might think they are well-diversified when in reality all three are more or less all the same thing. They each follow the movements of U.S. stocks broadly.
A more common scenario is an investor finds themselves holding a basket of different mutual funds. Some funds may be classified as low risk, moderate risk, or high risk. When plotting the performance charts of all three fund types, we would see they all move up and down roughly in tandem. More formally, we would say the holdings within the portfolio are highly correlated.
Correlation, A Quick Overview
Correlation is a measure that shows the strength of a linear relationship between two or more variables. Thinking of stocks A and B, their correlation value could range between -1 and +1, where -1 means the two stocks typically move in opposite directions, and a value of +1 indicates the two stocks usually move together. A correlation coefficient of 0 means it is a coin toss; if stock A goes up, it is 50/50 if stock B will go up or down.
Crisis Correlation Risk
Okay, so you simply need to get a basket of uncorrelated stocks and the problem is solved! Well…almost. If you have a portfolio composed exclusively of stocks, you are still not as diversified as you would think, even if you went out of your way and calculated the correlation matrix yourself. You would still have exposure to crisis correlation risk, which essentially states that during times of crisis correlation between stocks goes to 1.0. During the Financial Crisis of 2008 and, more recently in March 2020, virtually all stocks went down together. In a twist of fate, when an investor most needs the benefits of diversification, that’s when correlation shoots up, and all stocks move in lockstep—and almost always lower.
How to Protect Your Portfolio From False Diversification
All hope is not lost! If in March 2020, all or most of your stocks were heading lower, you might be wondering what can be done. Welcome, different asset classes!
Up to this point, we have talked about reducing idiosyncratic risk by adding more stocks with low levels of correlation to one another and this does its job. However, it still leaves us with the systematic risk inherent to investing in the stock market. Buying more stocks will not solve the problem; the only option is to invest in other assets outside of stocks, such as U.S. government bonds, gold, corporate bonds, and real estate. The table below shows the average correlation of monthly returns between different asset classes using easily tradable ETFs.
From the above chart, we can see that U.S. Stocks (VTI) are negatively correlated to long-term U.S. Treasury Bonds (TLT), with a correlation coefficient of -.31, while VTI and GLD (Gold based ETF) has almost 0 correlation with each other. Combining these three assets into a portfolio would result in a portfolio with significantly lower volatility than VTI alone, and result in higher risk-adjusted returns, which simply means an investor is getting more returns per unit of risk. This concept of risk-adjusted return is measured by the Sharpe ratio, which shows how much an investor is getting paid per unit of risk.
It is important to note that though a diversified portfolio across different asset classes will likely have higher levels of risk-adjusted returns compared to a concentrated portfolio, it does not suggest higher levels of absolute returns as highlighted by the below table. The table clearly shows higher total returns from simply holding VTI, but the table also shows that a portfolio composed of U.S. stocks, bonds, and gold has very similar levels of returns to a pure stock portfolio but with a 33% reduction in portfolio volatility. More precisely, the Sharpe ratio shows that an investor only in stocks is getting ‘paid’ 0.67% annually in expected returns forever 1% of annual volatility, while the two other portfolios are getting paid roughly 0.80% in annual expected returns for the same amount of risk. Additionally, in the far right column, we can see the maximum decline from peak to trough in each portfolio during the market crash of 2008 as well as the Covid related crash in March 2020. Note, these are all pre-tax returns and do not account for inflation, but it shows the story fairly clearly.
| Allocation | CAGR | Annual Volatility | Sharpe Ratio | Crisis Returns (2008, March 2020) |
| VTI: 100% | 10.69% | 15.09% | 0.67 | -51%, -21% |
| VTI: 60%, BND: 40% | 8.38% | 8.98% | 0.81 | -31%, -12% |
| VTI: 60%, BND: 20%, GLD 20% | 9.35% | 9.89% | 0.83 | -29%, -12% |
Conclusion And Next Steps
Now, this is not investment advice, and I highly encourage you to talk to your qualified investment professional. And always consider your financial situation, investment objectives, and risk tolerance before making a major investment decision. But, for any lazy long-term investor, this should be triggering your curiosity in a big way. This is a good spot to kick off your research, and drill down into your portfolio and see if you are holding a basket of very similar ETFs or mutual funds that only make it look like you are diversified. If you are holding a portfolio composed of highly correlated assets (stocks, ETFs, and mutual funds), then your portfolio may be suffering from false diversification and perhaps it’s time to consider adding different asset classes into the mix. It’s hard to see the negative impact of false diversification when stocks are only going up, but as history has shown, the pain of false diversification shows itself during times of crisis when investors most need the benefits of diversification.
If you are starting from scratch or are still relatively early in your investing career, I highly recommend using M1 Finance to set up and automate your investing process. I take advantage of their Pie system to setup up my target allocation up front, set up reoccurring deposits, and they take care of automatically buying according to my plan and make rebalancing very easy.
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