In my last entry, we began discussing the topic of portfolio risk management, specifically discussing portfolio allocation or the amount of risk within a portfolio. In this installment, we will continue the risk management discussion but the focus here will be on portfolio diversification.
Many people are familiar with the term diversified portfolio but for those of you who aren’t it is basically the concept of spreading your investments around. For those of you who have been around long enough to remember the classic case is Enron, which was a huge and very successful energy company in the late 1990s and early 2000s. The problem with Enron was that they committed fraud with their accounting and the profits they were reporting were non-existent. The employees of Enron received their pension all in Enron stock so when the fraud was exposed, the company filed for bankruptcy and the stock went to zero. All of the employees lost their pension which was all tied to Enron stock. While Enron might be an extreme example, it certainly highlights the risk of having a concentrated position in any single asset.
There is more to diversification though then just making sure you invest in more than one company. The goal of having a diversified portfolio is that no one event leaves you’re a major portion of your portfolio at risk. Now the truth is you can’t diversify away all risk. There are some things that happen that are on such a scale that they impact everything. The financial crisis is a prime example of this as it took down the value of every major asset class. Natural disasters, wars, and other acts of God are examples of other things where it is hard to diversify away risk.
As an investor, you must understand that things change within the economy, world politics, consumer tastes, and technological advancements that can impact the fortunes of a company, an entire industry, or even a country. The key goal with diversification is to not have one of these changes put too much of your investment portfolio at risk. Below are the different ways you want to try and diversify your portfolio to help manage these risks as they occur.
This is basically the Enron scenario I laid out above. Any single company can experience a significant downturn due to poor management decisions, financial mismanagement, scandal, or one of the other reasons listed above. Blockbuster Video is another good example of this. We all used to go to Blockbuster to rent our videos but then along came a little upstart called Netflix which changed the way we consumed this content. Blockbuster failed to adjust to this new technology and consumer tastes and now has one remaining store while Netflix is worth over $200 billion.
A study by the University of Michigan concluded that it takes 25-50 individual holdings to have a diversified portfolio. In addition to spreading out your investments between multiple companies the other rule is to try and not have any single holding be more than 5% of your total portfolio. This can be a challenge for those that work for a company where the 401k match is company stock, offer an employee stock purchase plan (ESPP) that allows workers to purchase the stock at a reduced price or receive company stock as part of their total compensation. In these cases check your company rules on when they allow you to sell the stock. These rules were put into place as a result of the Enron scandal. Be aware of how concentrated you are getting and do the best you can to keep this in check.
The S&P 500 is made up of 11 unique sectors. Think of these as different areas of business. The five biggest sectors are Technology, Health Care, Consumer Discretionary, Communication Services, and Financials. Each sector contains companies that are related by the broad type of business they conduct. For instance, the Consumer Discretionary sector includes Amazon, Home Depot, McDonald’s, Nike, and Starbucks. These companies would most likely take a hit in a recession as people would likely look to spend less money on home improvement, eating out and new clothing but would tend to do well if the economy is going strong. Another sector such as Technology or Consumer Staples might still perform fine in a recession as they are less reliant on individuals having discretionary income.
This is just a deeper dive into the sector diversification. Say for example you have investments in Facebook, Twitter, and Snap. These are all part of the much broader Technology sector but largely all play specifically in the social media space. The risk here is that something could come along that could change the outlook of all social media companies. For instance, in the past couple of years, Congress has had several issues with various social media companies. If they were to pass a law that hindered their business models the stock prices of all social media companies could take a hit. This new law though may not have any impact on other tech companies like Apple, Salesforce, Nvidia and Adobe that don’t have a social media component.
Companies that you can invest in come in all sizes. While they are big enough companies to have issued stock and be listed on a public market they run a vast range in their market size (number of shares x stock price). Within the S&P 500 alone which is home to ‘large’ companies, Apple currently has a market cap of over $2 trillion while Macy’s comes in at roughly $1.5 billion which is less than 1% the size of Apple. Different forces can be beneficial or harmful to companies of different sizes. Coronavirus, which was generally hard on all companies has widely been viewed as being much harder on smaller companies in general than large companies. On the other hand, Congress could pass a tax law that could target large companies by having them pay a higher corporate tax rate. The market has classifications of mega cap, large cap, mid cap, and small cap. Spreading your investments out between the various market cap classifications is key to having a diversified portfolio.
This concept involves spreading your investments across different geographies around the world. Different countries will go through economic ups and downs at different times. The common geographic classifications are domestic, international, and emerging markets. In the early to mid-2000s the US stock market was returning an average of 14% from 2003-2007 but Emerging Markets returned an average of 37% over that same time.
Spreading your investments around and not just being focused on US investments only would have let you participate in those explosive Emerging Markets returns. Now had you thought you needed to go all-in on this Emerging Markets trend you would have been rudely greeted with a 53% loss in 2008 which was the worst performing segment of that year.
Investment style diversification
Another way companies are classified is where they are in their lifecycle. The common designations here are growth and value. Growth companies (current examples include Amazon, Google and Facebook) tend to be earlier in the lifecycle and are experiencing rapid growth in sales and/or income. Value companies (think Coca Cola, McDonald's, and Verizon) tend to be more well established and with more stable revenue and income or can be companies that have experienced a downturn and whose stock can be purchased at a relative bargain. Growth companies have enjoyed superior investment performance since the mid-2010s, but in the early 2000s value stocks outperformed growth by a good margin.
In the last post, I talked about how mixing in bonds or other fixed income assets help an advisor with portfolio allocation. Well, there is also diversification within fixed income investments. Fixed income assets come in different maturity lengths. Bonds or Treasury securities, for example, can range from 1 to 30 years before they mature. Longer term debt pays higher interest rates but is more vulnerable to changes in interest rates.
Another way to diversify your fixed income holdings is by credit quality. Many fixed income instruments are debt that has been issued and you are receiving interest payments and then eventually your principal. The higher the credit quality of the debtor the lower interest rates you will receive. Lower quality debtors need to pay a higher rate of interest but are more susceptible to default if there is an economic downturn.
A well diversified portfolio will have a little bit of everything. This may keep the portfolio returns from achieving the peak numbers one could reach if they were in the hot segment of the moment but that would require being invested 100% in that segment of the market and we have just discussed the risks of doing that. This approach will tend to smooth out your returns as even if part of your portfolio is encountering issues you should have plenty of other areas doing just fine.
Most of us achieve this diversification by investing in mutual funds or ETFs in our investment accounts. For example, an S&P 500 index fund alone will give you access to a pretty well diversified portfolio all by itself. This gives you access to a wide variety of companies, sectors, industries and many of these large companies have an international presence. In addition, most of us have access to an international fund in a 401k account to help get better access to non-US based companies. Some plans may have access to a total market fund which would have holdings in all categories.
Diversification along with allocation goes a long way to managing the risks of your investment portfolio. Hopefully, you found this informative and helpful. If you are wondering if your investments are properly aligned to manage risk and would like help I would love to hear from you. Feel free to reach out to firstname.lastname@example.org or schedule a conversation here.