Diversification is a very misunderstood tool. While many investors have a more-than-fair inkling of the concept, their application of diversification is often out of alignment with their intent.
Understanding diversification is key to unlocking its true benefits: more predictable portfolio-level returns and reduced portfolio-level volatility. Investors and advisers tend to see diversification as a risk mitigation tool, yet investors and advisers tend to define risk differently.
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Defining Risk and Volatility
Investors tend to define risk as the chance of losing money. The greater an investment’s chance of losing money, the greater the risk.
Advisers tend to define risk as volatility. An investment with greater volatility has greater risk than one with lower volatility. These aren’t incongruous, but they’re not the same, either.
Volatility is a measure of the range of expected returns.
A more volatile investment has a greater range of returns across time.
For example, let's look at two investments where the average long-term return is 8 percent. One investment varies widely from year to year — 95 percent of the time the return falls within 15 percent of its average, or 95 percent of the time the return falls between 23 percent (8 percent plus 15 percent) and negative 7 percent (8 percent minus 15 percent).
The other investment varies less widely — 95 percent of the time its return falls within 6 percent of its average. In other words, 95 percent of the time, the return falls between 14 percent (8 percent plus 6 percent) and 2 percent (8 percent minus 6 percent).
The first investment is more volatile. Its returns fluctuate more than the returns of the second investment.
The first investment is also more likely to incur a loss in any given year, as the range of expected returns is negative more often than it is for the second investment. But it doesn’t have to be that way.
Sometimes an investment with lower volatility also has a higher probability of loss with any given year. In that case, the definition of risk becomes important.
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The Role of Correlation
Diversification reduces risk (either definition) by taking advantage of different assets performing differently at the same time.
If two different assets perform nearly the same, they are highly correlated. If they move in the same direction but by different amounts, they’re positively correlated. But if they tend to move in opposite directions, they’re negatively correlated.
Correlation can range from +1 to –1. A perfect positive correlation — where two things change in the same direction in the same amount at the same time — is a correlation of +1. A perfect negative correlation is one in which two things move the same amount at the same time but in opposite directions. That comes out to a correlation of –1.
Perhaps a nice, easy-to-visualize example would help. Consider a swing set with two swings. Assume the two swings are pulled back together and released at the same time.
Picture them staying exactly next to each other as they go forward and back, up and down. They are perfectly positively correlated. They’re doing the same thing in the same amount at the same time. It doesn’t matter what they’re doing other than that it’s the same. They go up together, and they go down together.
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Now let’s consider another example with the same two swings. You pull both back, but you only release one. At the exact moment, the first swing reaches its maximum travel forward, you release the second swing.
They are at opposite points in their cycles, one is all the way forward when the other is all the way back, then they switch. They are moving exactly the same amount at the same time but in opposite directions — they’re perfectly negatively correlated.
There’s one last piece to this analogy. This time you pull one swing back and leave the other alone, it sits unmoving. You release the one swing and it goes back and forth, the other sits still. No matter what the moving swing does the other swing doesn’t move with it or against it. In this case, they’re not correlated at all. Their correlation is zero.
Why Is Correlation Important?
Diversification reduces risk to the extent there are differences in the correlation of the assets.
If all of your assets perform about the same at the same time, then you’re not really diversified.
For example, let’s say you own three mutual funds. All three of your funds invest in the stocks of large U.S. based companies. There will be differences in performance, but they’ll tend to be similar. You’re diversified within the asset class of large U.S. stocks, but if the market for large U.S. stocks doesn’t do well, your portfolio won’t do well.
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Asset Classes vs. Markets
Markets tend to be broader than their underlying asset classes.
Stocks, for example, are traded on markets. But there are a number of asset classes for stock investments. Stocks can be of large-capitalization companies, mid-cap companies, or small-cap companies. Each of those size breakdowns can be for U.S. companies or for international companies. You can further break international down into regions.
Similarly, bonds aren’t a single asset class, but rather there are a number of asset classes depending on the type of bond.
In addition to asset classes for stocks and bonds, there are assets classes for commodities, precious metals, real estate, cash, and so on. Each of those can be further broken down if desired.
But not everyone needs to or desires to. If you have a portfolio of $50,000, you don’t need to diversify into over 20 different asset classes. But you should probably diversify beyond holding three different large-capitalization U.S. stock funds.
Investing in highly correlated asset classes does little to reduce volatility or risk.
The true advantage of diversification comes from investing in asset classes that aren’t highly correlated.
If you have a mix of asset classes in which some are performing better than others, it should be apparent that while you’re limiting your downside potential, you’re also limiting your upside potential. Your portfolio will perform better than your worst asset class, but not as well as your best. So why diversify?
The asset class that performs the worst in one year probably won’t be the worst in other years. Likewise, there’s no telling in advance which asset class will perform best in any given year.
But diversification isn’t supposed to give us the best possible return. We chose diversification because we realize that no one can accurately predict where the best return will come from. And we realize we have a greater likelihood of achieving our goals if our returns are more predictable.
A properly diversified portfolio will have assets doing well and assets doing not so well all the time. The result across time is that on a portfolio level we have lower volatility and more predictable returns.
Individual asset classes will still have big swings, but overall, our investments are collectively far more predictable. That’s how a properly diversified portfolio helps us — it makes achieving our goals more likely as we have a more predictable portfolio-level return and less overall fluctuations in value.