There’s an old story that goes like this: two farmers are sitting in the feed store, talking over the prospects for the coming season. One says to the other, “How’s your cotton crop looking?” The other replies, “I didn’t plant cotton; I’m too worried about the boll weevils.” “Well,” the other says, “then I guess you’ve put all your land in corn.” “Nope,” comes the reply, “I didn’t plant corn either; too worried about drought.” More surprised by the minute, the first farmer says, “No cotton, no corn… Did you at least plant wheat?” “No, I was too worried about the army worms.” “Well, what in the world are you doing for a crop this year?” asks the first farmer. “I’m not making a crop,” the other fellow says, “I decided to just play it safe.”
Obviously, we know that nothing worthwhile—including making a living—comes without risk. This is certainly true with investing. Investors are constantly weighing the trade-off between risk and reward, seeking the balance that allows them to achieve their most important financial objectives. And the fact is that no significant reward is devoid of risk; there is no completely risk-free investment. Even cash is subject to risk, since inflation is robbing it of purchasing power, every single day.
So, how can investors find the right balance between risk and reward? One of the best tools for managing risk while still maintaining the potential for reward is diversification. You have probably heard the proverb: “Don’t put all your eggs in one basket.” That, in essence is what diversification is: spreading your investment “eggs” among different “baskets.”
What Diversification Is—and Isn’t
It’s important to understand how effective diversification works. True diversification means holding assets that are uncorrelated, which means that the prices of the assets are affected differently by various market and economic forces; they tend to not move in tandem. In other words, an effectively diversified portfolio can benefit from lower volatility, since what causes some assets to lose value may cause others to gain. The overall diversification helps to balance the risk among different types of assets, allowing the investor to benefit in a wider variety of market scenarios.
So, suppose an investor has a portfolio made up of a hundred different value stocks (companies with stock prices lower than the fundamental value of the company justifies). Is the investor diversified? Not really, because even though she is holding a lot of different assets, they are all essentially the same type; they are highly correlated and will tend to move in the same direction under various market conditions. When one of her stocks is down, many of the others will tend to be down at the same time.
Let’s consider another example: mutual funds. Let’s say someone has five different mutual funds in their account, and they think that means they are diversified. After all, a single mutual fund typically invests in dozens or even hundreds of different holdings, right? So if I have not one, but five different mutual funds, I should be diversified, shouldn’t I? Eggs in lots of different baskets. But not so fast… what are the funds’ investment goals and objectives? If all five funds are trying to invest in dividend-paying stocks with growth characteristics, they are going to be highly correlated with each other. In other words, all the baskets containing your eggs are really the same basket; you aren’t effectively diversified.
The classic, somewhat simplistic example of effective diversification is stocks and bonds. Stocks, as shares of company ownership, tend to rise and fall with the perceived underlying value of the company. Bonds, on the other hand, which represent money loaned to the company, are primarily affected by the perception of a company’s credit-worthiness. In this way, stocks and bonds are non-correlated; their prices move in different directions for different reasons. This is why many well-diversified portfolios will have holdings in both equity investments (stocks or stock mutual funds) and fixed-income assets (bonds or bond funds). In many cases, having a portfolio that combines such non-correlated assets yields more effective diversification.
Getting Diversified
It’s also important to understand that diversification is not a one-size-fits-all concept. Each investor is different, with different goals, values, and tolerance for risk. Appropriate diversification for a mid-career professional will probably look very different than appropriate diversification for someone two years from retirement.
This is where a qualified, fiduciary financial advisor can be of tremendous help. They can help you look at the assets in your portfolio and determine what they really are and which other assets they would be correlated with. They can also work with you to determine the most cost-effective and tax-efficient way to replace assets in the portfolio in order to achieve better diversification.
At Mathis Wealth Management, we understand that the key to success for most investors comes with having a better understanding of their investments and how those assets support their most important goals. We work with clients to custom-design portfolios that balance risk and reward in a way that matches the client’s needs and objectives. To learn more, visit our website to read our article, “Your Investment Philosophy and Your Strategies for Success.”
Disclosure: Diversification does not guarantee profits or protect against loss in declining markets.
