Expanding your investment universe by holding securities across many market segments can help manage overall risk. In a word, we call this “diversification.” But diversifying within your home market may not be enough. Global diversification helps you better manage the many market risks inherent in pursuing expected market returns.
Diversification is among your most important financial friends. After all, what other single action can you take to dampen investment risk while investing toward your personal goals? Academics and practitioners alike have documented the powerful benefits of diversifying across the investment universe.
What is diversification? In a general sense, it’s about spreading your risks around. In investing, that means that it’s more than just ensuring you have many holdings, it’s also about having many different kinds of holdings. Compare this to the adage about not putting all your eggs in one basket. It’s like ensuring your multiple baskets contain not only eggs, but also a bounty of fruits, vegetables, grains, meats, and cheese.
While this may make intuitive sense, many investors come to us believing they are well-diversified when they are not. They may own a large number of stocks or stock funds across numerous accounts. Upon closer analysis, we find they are piling the bulk of their holdings into large-company U.S. stocks, rather than spreading them across the investment universe.
Think of a portfolio concentrated in U.S. stocks as the relatively undiversified equivalent of many baskets of plain, white eggs. Overexposure to what should be only one ingredient in your financial diet is not only unappetizing, it can be detrimental to your financial health. Poor diversification:
Combined, these three strikes tend to generate unnecessary costs, lowered expected returns, and perhaps most important of all, increased anxiety. You’re back to trying to outguess instead of play along with a powerful market.
Instead, consider the wide world of investment opportunities available these days. You can access them using low-cost funds offering efficient exposure to capital markets around the globe.
In other words, to best capture the full benefits global diversification has to offer, we suggest turning to fund managers who focus their energy – and yours – on efficiently capturing diversified dimensions of global returns. Brokers or fund managers who instead fixate on trying to beat the market are likely wasting their time and your money. You may still be well-diversified, but you’re weighing down your investments with extra costs and pointless distractions.
Who needs that, when diversification alone can help you have your cake and eat it too?
Let’s circle back to our earlier point about how diversification helps you manage your investment risk. When it comes to investing, risk is like a power tool. It can help or hurt you, depending on how you use it.
Before we even had words to describe it, most of us learned about the benefits and dangers of risk. If you never took a good tumble as a toddler, you’d never learn to walk on your own. Then again, it’s best if your parents teach you how to cross a busy street, rather than discovering that risk on your own.
Similarly, you’ll find two different kinds of risks in the investment universe: avoidable, concentrated risks, and unavoidable market-related risks.
Concentrated risks are the ones that wreak targeted havoc on particular stocks, bonds or sectors. Even in a bull market, one company can experience an industrial accident, causing its stock to plummet. A municipality can default on a bond even when the wider economy is thriving. A natural disaster can strike an industry or region while the rest of the world thrives.
The science of investing informs us: We can avoid concentrated risks. They’re the equivalent of dashing into traffic without looking both ways first. Bad luck still happens. But you can dramatically minimize its impact by diversifying your holdings widely and globally, as we described in our last post. When you are well diversified, if some of your holdings are affected by a concentrated risk, you are better positioned to offset the damage done with plenty of other unaffected holdings.
If concentrated risks are like bolts of lightning, market-related risks are encompassing downpours in which everyone gets wet. They are the persistent risks that apply to large swaths of the market. At their highest level, they are the ones you face by investing in capital markets to begin with. If you stuff your cash in a safety deposit box, it will still be there the next time you visit it. (It may be worth less due to inflation, but that’s a different risk, for discussion on a different day.) Enter the investment universe and, presto, you’re exposed to market risk.
Hearkening back to our past conversations on group intelligence, the market as a whole knows the differences between avoidable and unavoidable risks. Heeding this wisdom guides us in how to manage our own investing with a sensible, evidence-based approach.
As touched on above, if you try to beat the market by chasing particular stocks or sectors, you are exposing yourself to higher concentrated risks. Since you can easily avoid these risks by diversifying across the investment universe, you cannot expect to be consistently rewarded with premium returns for taking them on.
Every investor faces market risks that cannot be “diversified away.” Those who stay invested when a market’s risks are on the rise can expect to eventually be compensated for their steely resolve with higher returns. But they also face higher odds that results may deviate from expectations, especially in the near-term.
All this is why you want to take on as much, but no more market risk than is personally necessary. Diversification becomes a “dial” for setting the right volume of market-related risk exposure for your individual goals.
Whether we’re talking about concentrated or market-related risks, diversification plays a key role. Diversification is vital for avoiding concentrated risks. In managing market risks, diversification helps you adjust your desired risk exposure to reflect your own purposes. It also helps minimize the total risk you must accept as you seek to maximize expected returns from across the investment universe.
To see all 10 principles of Evidence Based Investing at a glance, please visit our Evidence -Based Principles Guide. These principles inform our investing process.
Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.
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