Remember This About Portfolio Diversification
Philosopher George Santayana famously said, “Those who cannot remember the past are condemned to repeat it.” Unfortunately, humans have a history of doing just that.
For example, in the 1800s Ireland ended up planting a single variety of potato to feed its growing population. While first successful, this reliance on monoculture farming greatly contributed the Irish Potato Famine. Since, studies have shown polyculture, in which several crop varieties are planted in the same space, can reduce a farmland’s susceptibility to disease and climate changes.
Still, the short-term yields of the present occasionally create a forgetfulness of the past. In 1970, the popular use of a single corn variety helped cause the loss of more than a billion dollars’ worth of corn when a fungus spread among U.S. crops. In the 1980s, California growers were forced to replant around 2 million acres of grapevines when the single variety they depended on was decimated by an insect infestation.
Investors should be wary of similar forgetfulness when managing their portfolios. Portfolio diversification, like agricultural diversification, is a widely used strategy to help minimize the potential of a big loss by spreading risk. Economic and market conditions change as rapidly as the weather, so it’s exceedingly difficult to determine which investments will thrive in the future. Just because an asset class performed the best one year doesn’t necessarily mean it will do the same the following year.
However, some investors are condemned to continuously chase after high returns. Current market trends can convince an investor to overweigh their highest-performing asset in hopes they will continue to outperform. To help avoid such behavior and prevent a fallow portfolio, here’s what to always remember about portfolio diversification:
1. Many does not equal diversified
Holding several investments in a single asset class doesn’t mean a portfolio is well-diversified. For example, owning a portfolio filled only with hundreds of tech stocks in the late 1990s, during the dot-com boom and bust, would not have diversified your risk.
Generally, diversification may lower risk when investments are negatively correlated, meaning their prices typically move in opposite directions. Investing across asset classes, such as stocks and bonds, may reduce the general risk of investing in the market, known as systematic risk. Further, holding several investments within those asset classes may decrease unsystematic risk, or the risk of investing in a particular company.
2. Lowering risk doesn’t necessarily mean sacrificing return
Although risk and return are related, diversification doesn’t necessarily sacrifice one for the other. Instead, diversification may boost returns while lowering risk when compared to a single asset class. It’s possible at times that a portfolio holding separate asset classes produces a total return greater than the respective returns of each individual asset class. Since it is not subject to the volatility of a single asset class, it may also do so with lower risk.
3. Even the most diversified portfolios can still lose
Investors generally know the history of the stock market crash of 1929. Some investors remember their firsthand experiences during other market downturns such as in 1987 and 2008. The reality is that some market declines are so severe, not even the most diversified portfolios are immune to losses. Risk cannot be entirely diversified away. However, portfolio diversification may stabilize risk to help lower a portfolio’s sensitivity to market swings and, hopefully, do the same to the investor.
In the end, it’s better to focus on the fruits from the entire portfolio rather than just one component.