The DIY investor’s guide to understanding diversification

The DIY investor’s guide to understanding diversification

Since day one of trying my hand at hands-on investing, I’ve been coming across the topic of diversification a lot.  And every time I’m in a discussion with someone about investing – and the concept of diversification is brought up – it seems that most people don’t really know what it means.  So here’s a short guide I’ve put together to help myself understand it better.  And through sharing, hopefully some of you can also gain some knowledge from it.

Diversification

According to Investopia: Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

That’s a mouth full, so let’s start unpacking it a little…

Why should I diversify?

1 – Minimising risk of loss

Portfolio Diversification

Let’s for example assume that your investment portfolio consists of one single company’s stock.  What whould happen to your investment portfolio if that company went completely bust?  It would lose 100% of its value!

I know of individuals who had large investments in their employer’s stock options programmes, who lost huge amounts of money when that company’s stock took a huge tumble…

Now, if you had for example 20 different companies in equal proportion in your portfolio and that same single company goes bust, your losses are limited to only the 5% you had invested in that one stock.

Why is this loss-limiting benefit of diversification so important?  It is because, whenever you incur a loss, it takes a lot more growth (of your investments) to make up that loss!!  Look at the following table, which compares the amount of gain you’d need to make up a loss, just to get your portfolio back to where it was:

Loss Gain

With enough diversification, if one investment performs poorly over a certain period, other investments may perform better over that same period, reducing the potential losses of your investment portfolio.

2 – Preserving capital

Retirement

Not all investors are in the accumulation phase of life.  Some who are close to (or already in) retirement have goals oriented towards preservation of capital, and diversification can help protect your savings.

How does this work?  As one approaches retirement, it is usually good practice to start moving some of your investments from high-growth (and thus high-volatility) investments to more stable (lower-volatility and thus lower-growth) investments.  Typically this means moving partially from equities into bonds, REITs, money markets or other lower-volatility options.

When you are in retirement and need to draw down on your investments to sustain you, there are certain rules-of-thumb one can follow to help you figure out how much money you can safely withdraw without diminishing your capital too much.  StealthyWealth wrote a magnificent blog post about using the 4% rule when calculating your safe withdrawal rates.

But how does diversification help in preserving my capital, you ask?  If you have all your investments in the stock market and need to draw down, say 4% every year to live from, what would happen when there’s a stock-market crash (a drop of more than 30% in the overall stock market)?  If your portfolio goes down 30% and you keep on withdrawing 4% (or even a higher percentage, since the 4% you would withdraw now suddenly is also 30% less and isn’t enough to sustain you), you’ll rapidly deplete your investments and run the risk of running out of money in old age.  And as mentioned above, even after the market picks up again, you’d need to make a lot more gains to make up for your losses, which might take years, even decades!

When diversifying into lower-risk (lower-volatility) investments, you’re smoothing your portfolio out a little, so that market crashes won’t affect you so much in retirement.

3 – Generating returns under widely different conditions

Return on Investment

As already mentioned, stock markets are very volatile.  Certain sectors within the stock market are also experiencing different levels of volatility.  So do other asset classes available to one’s portfolio.

A diversified portfolio means spreading risk by investing across different asset classes such as cash, fixed interest, property (REITs), local shares, international shares, commodities, etc.  This lowers risk by spreading your exposure to asset classes which are not highly correllated.  For example, different technology stocks (like Apple, Facebook, Microsoft, etc) will usually behave quite similarly and will create concentration risk for the investor.  By diversifying into different asset classs, like Financials, Energy and Health Care, you lower your risk, should we experience another Dot Com bubble, for example.

A well diversified portfolio also spreads risk across countries.  By investing globally, you lower your exposure to political and other localised risks, for example Brexit and its impact on investors in the UK.  Or the political uncertainty around property ownership we’re currently dealing with here in South Africa.

Another good way to diversify is across developed markets and emerging markets.

You can also spread your risk across currencies.  As a South African, I can tell you all about currency volatility!  Our Rand is one of the most volatile currencies on the planet, and having all your investments exposed only via this one currency can put you at very high risk.  By investing in many different currencies, high volatility in any individual currency poses a lot lower risk to your savings.

4 – Combining non-correlated assets

Correlation

When planning your diversification strategy, it is also a good idea to aim for assets with low correlation – or even no correlation – to help in lowering your portfolio risk.

What does this mean?  It means, we’re trying to find those classes of assets where a fall in one asset class won’t be seen in another asset class.  For example, the volatility of the whole S&P500 vs only the US REIT asset class, which has a correlation of only about 0.6, is one way to make use of low-correlation.

The downsides of diversification?

Downside

So now that you have a good idea of what the benefits of a diversified portfolio is, you want to know if there are any downsides to diversification?

The biggest downside is that a diversified portfolio will never be at the top of any “asset class chart” when ranked by performance.  Because we’re limiting our exposure (and risk) to any individual asset or class, we’re also limiting our rewards.  The NASDAQ for example has gained around 23.5% over the last 12 months, but a well diversified portfolio would not have seen that level of gain overall.

Investors can also become restless when they see the S&P 500 outperform their globally diversified portfolio during good times, or single stocks (like Netflix or Amazon) have stellar gains over a very brief period, which they didn’t capitalize on as they could have if they had all their eggs in that one basket.  This is true, a well diversified portfolio loses out on these individual super-performers, but remember, they also avoid the horribly poor ones as well!

Just think Steinhoff in recent South African history!

How do I diversify my portfolio?

Diversify

OK, so now that you know the good and the bad of portfolio diversification, how do you do it, you ask?

There’s a lot of ways to approach this.  You could do it quite manually and buy stocks in different companies, in different sectors, in different countries, buy and hold your own real estate, etc.  But this is surely a very difficult and time-consuming approach.  If you’re just a DIY investor like me and you’re looking for an easy, quick, cheap way to achieve good diversification, what I do is to just buy into an ETF or two that has high diversification built-in!

Take the SATRIX MSCI World ETF (if you’re from South Africa like I am.  Similar ETFs exist in most other countries, so do your own research) for example.  It lets you invest in 23 developed markets across the world and holds equities in about 1500 different companies, in a wide range of different sectors!

By holding just this one ETF in a portfolio you’re already very well diversified!  That’s great when you’re still in the wealth accumulation phase, but what about when you’re nearing retirement, as mentioned above, and you’d like to add less-volatile asset classes to your portfolio?  Again, you can just add for example a Bonds ETF (like ABSA’s Newfunds GOVI ETF) to add some ballast to smooth out your portfolio.  As easy as that!

NOTE:  I’m not a financial advisor, please discuss your portfolio with a professional!  I’m just sharing how simple and straight-forward a portfolio can be while still being well diversified.

Over-diversification is a real thing!

Complex

As mentioned above, if one can find good diversification within a single product (like the MSCI World ETF), it keeps things simple.  But sometimes we give in to FOMO and keep buying different ETFs when new products hit the market.

We end up with a portfolio that becomes difficult to analyse, more specifically, a portfolio where it’s difficult to calculate what our exposures are to specific markets, asset classes, sectors, currencies and so on.  This is because we lose track of what percentage exposure we end up with in each asset class, sector, country, currency or market, which we call concentration risk.

Rebalancing your portfolio

Rebalancing

One last concept to take note of when you have a well diversified portfolio is the idea of rebalancing.

Say you have a R10,000,000 portfolio that’s made up of 80% stocks and 20% bonds.  You have R8,000,000 diversified into many stocks, and R2,000,000 invested into a basket of different government bonds.  All nice and fuzzy!

Now the inevitable stock market crash hits and the market drops for example by exactly 30%.  Your stock portfolio drops by the same 30%, so your R8,000,000 in equities are now only worth R5,600,000.   (Let’s assume for the sake of this example, and for simplicity, that the bonds stayed the same at R2,000,000)

Your portfolio is now worth R7,600,000 and the stock/bond allocation changed from 80/20 to roughly 74/26!  You’re now a lot more invested into bonds than what you initially intended!

To rectify this situation, an occasional rebalancing of your portfolio is required.  What you do is to sell off just enough of your bonds and buying more equities to bring it back to the 80/20 allocation.

This isn’t something that needs to be done regularly.  As a matter of fact, it’s better to do this only once a year or so.  Selling and buying too often will put a drag on your portfolio’s performance and should be avoided.

Conclusion

So that’s diversification for you in a nutshell.  It’s not complicated and is easy to perform (especially nowadays with ETFs to our disposal), but it is a critical concept to ensure that you’ll have a good chance of reaching your financial goals in the future.

Happy investing!

Hamster

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