We’d all like to catch the next Tesla (TSLA) or Apple (AAPL), but for every high flyer, there are dozens of stocks that fall to the dustbin of history and deliver negative returns to their shareholders. Higher rewards, but also higher risk; it seems there are no free lunches on Wall Street…or is there?
Welcome, diversification. As far as I know, diversification is the only free lunch in the markets, and it is one of the most important tools investors have in achieving their long-term financial goals. But what exactly is diversification, what makes it so powerful, and-most importantly-how can you take advantage of this powerful concept?
What Is Diversification?
Noun – The process of a business enlarging or varying its range of products or field of operation.
Within the world of finance and investing, diversification most typically refers to building a portfolio of stocks with low or uncorrelated returns. Simply put, it’s the process of building a basket of investments where the returns of one stock are not 100% identical to the returns of another stock in the basket, such that the gains or losses in one holding are partially offset by the gains or losses in another holding and the overall change in portfolio value is moderated.
Why is Diversification Powerful?
Earlier I mentioned that diversification is the only free lunch in the markets, and here is why. In an efficient market, the only way to achieve higher returns is to take on higher risk. However, proper diversification offers a hack, it allows you to achieve similar returns with lower risk. As an example, imagine two stocks A and B with a correlation of .50 (i.e. they move together about 50% of the time and roughly half the magnitude of one another), both with an annual expected return of 15% and annual volatility of 20%. Investing in either A or B will get you 15% a year, with an annual volatility of 20%, but what happens if you invest evenly in each? The net result is a portfolio with an expected annual return of 15%, but now the annualized volatility has fallen to 17%. In this example, we get the same returns but decreased risk! Who wouldn’t want that?!?!
How Can You Take Advantage of Diversification?
In our example the decrease in risk was meaningful with going from 1 to 2 stocks, but what about adding a third or fourth stock? What about ensuring that our portfolio is not too heavily tilted towards any individual sector or too much towards value or growth-type stocks?
Focusing on a portfolio of stocks alone, in general, the more stocks you have the better diversified you are assuming they are in different sectors, different sizes, and different types. However, the marginal benefits of each additional holding decrease with each stock, and at a certain point, it becomes impossible to manage and keep track of too many stocks. Thankfully, different studies have shown that a well-selected portfolio of 20 to 30 stocks properly diversifies away company-specific risk and leaves only market risk (i.e. systemic risk, the cost of having market exposure). It’s worth noting that for investors with less than $10k, it would be more cost and time-efficient to simply buy a broad-based low-cost ETF such as SPY or VTI that provides instant diversification across 500+ US-based stocks. For a true globally diversified approach, VT gives you instant access to a basket of over 9,000 stocks.
The previously mentioned ETFs are great for folks who want instant diversification and don’t want to bother selecting individual names. However, if you want to build up your own basked of 20-30 stocks, I recommend using a broker like M1 Finance as their Pie system allows you to easily create a list of stocks, set the desired allocation, and automatically invest deposited funds according to your plan (also, they made rebalancing as easy as clicking a single button!).
What About Market Risk?
You’ve done it! Now you’ve created a properly diversified portfolio of stocks–either through a low-cost ETF or careful selection of 20-30 stocks—and you will get overall market returns of roughly 9% annually and annual volatility of about 15%. But wait, you’re still left with market risk. How do you reduce this? A post dedicated just on this topic will be released later, but in a nutshell the only way to diversify away stock market-specific risk is to invest in different asset classes. The classic example is pairing bonds with stocks. The correlation between asset classes is always changing, but historically stocks and bonds have been slightly negatively correlated to slightly positively correlated. Meaning combining these two assets would drastically reduce a portfolio’s overall volatility and while only moderately impacting returns.
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