Kent Insley quoted in U.S. News & World Report
U.S. News & World Report
Why Diversification Is Important in Investing
By Coryanne Hicks
June 5, 2019
What Is Diversification?
In practical terms, diversification is holding investments which will react differently to the same market or economic event. For instance, when the economy is growing, stocks tend to outperform bonds. But when things slow down, bonds often hang on better than stocks. By holding both stocks and bonds, you reduce the chances of your portfolio taking a big hit when markets swing one way or the other.
DIVERSIFICATION IS spreading your risk across different types of investments, the goal being to increase your odds of investment success. It's like saying since no one can know for certain who is going to win this race, let's bet on everyone.
Diversification is important in investing because markets can be volatile and unpredictable. By diversifying your portfolio, you "reduce the consequences of a wrong forecast," says Ryan Nauman, market strategist at Informa Financial Intelligence's Zephyr in Zephyr Cove, Nevada.
Diversification can go more than product-deep. "Diversification to us also means the makeup of the teams that are managing our money – not just the investments themselves," says Liesel Pritzker Simmons, co-founder of Blue Haven Initiative, a Boston-based family office focused on impact investing. "If all of your fund managers went to Harvard Business School between 1985 and 1992, there will be a certain world view they share regardless of how diverse their underlying funds are."
The Benefits of Diversification
You may have heard diversification referred to as the only "free lunch" in investing. "This is because compounding returns is the key to growing wealth or a portfolio over time, along with avoiding large losses," says Kent Insley, chief investment officer at Tiedemann Advisors in New York City. "An investment that declines in value by 50% must appreciate by 100% to recoup its original value."
While individual asset classes can suffer severe declines, "it's very rare that any two or three assets with very different sources of risk and return, like government bonds, gold and equities, would experience declines of this magnitude at the same time," he says. So even if stocks tanked 30%, your bonds and gold would keep your portfolio from falling as far.
The benefit of diversification in your investments is to minimize the risk of a bad event taking out your entire portfolio. When you keep a high percentage of your portfolio in a single type of investment, you risk losing it if that investment sours.
There's also the "opportunity cost of not being diversified," Nauman says. "If you're not diversified, you may miss out on growth opportunities in a different asset class that you are not exposed to."
When you're invested in the winning team, however, diversification can feel like a punishment. It's hard to keep money in a lagging – or worse: a declining – investment when your other investments are doing so much better. But it's important to remember that today's top-performer may become tomorrow's fallen star.
"During a bull market, it can be easy to forget that the market delights in surprises," Dabit says. "The best safeguard against market cycles, while still benefiting from the upside, is through committing to a well-diversified portfolio and long-term focus."'
Diversification is important regardless of your time horizon and goal. Any time you're investing in the stock market, you should aim for a diversified portfolio.
As your goals or timeframe change, "the levers to shift should be on how aggressive that diversified portfolio is built," Dabit says. Investments allocated to a long-term goal can lean more heavily on stocks, for instance, than those geared toward near-term goals. But even if you're 80% stocks, you should diversify those stock holdings across sectors, regions and size.
How to Diversify Your Portfolio
Contrary to sometime-popular belief, diversification is not a number's game. He who owns the most investments doesn't necessarily win the crown. The trick to diversifying your portfolio is owning investments that play different roles on your team.
Think about diversification as building a baseball team. A team of only right fielders – even if you had 100 of them – won't do you much good in a game. To have a well-rounded team, you need outfielders and infielders, pitchers and a catcher. Likewise with your portfolio.
Each investment in your portfolio should serve a different function. For instance, for stock diversification you may have an S&P 500 index fund for exposure to U.S. large-cap stocks and another focused on small-cap stocks. You'd want domestic companies and international, and representatives from all 11 market sectors.
Your bond portfolio should be similarly diversified across "both short and long term bonds, corporates and sovereign debt, and high and lower quality bonds, to help reduce the inherent risks associated with fixed income products," Nauman says.
For optimal diversification of risk in a portfolio, Ed Egilinsky, managing director and head of Alternative Investments at Direxion in New York City, says to consider alternative investments such as commodities. Alternatives don't have a "high degree of correlation to traditional investments" like stocks and bonds.
When stocks and bonds are stuck moving up and down, alternatives can move diagonally. They're a bit like taking the escalator instead of the elevator to your goals. With alternative investments in your portfolio, you're less likely to get trapped between floors.
How to Tell if You're Diversified
An easy way to determine if your portfolio is diversified is by looking at your current performance. Diversified investments won't move in the same direction at the same time. If some of your investments are up while others are down, you've got diversification. Think of diversification as a Christmas tree: Red and green together means you'll fair better in all weather.