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What are the benefits of diversification in a portfolio? Why does this minimize your risk?
A diversified portfolio is one that features holdings in a variety of industries, countries, and asset classes. The idea is that when your holdings in one industry, country, or asset suffer, your holdings in other industries, countries, and assets will offset your losses.
Find out the main benefits of diversification and how you can create a diversified portfolio below.
The Benefits of Diversification
When looking at the benefits of diversification, it’s important to consider Modern Portfolio Theory.
Developed by Nobel Prize–winning economist Harry Markowitz, Modern Portfolio Theory in its purest form uses complex mathematics to diversify a portfolio in such a way that it earns a particular return with the smallest amount of risk. More basically, it asserts that a diversified portfolio—one that features holdings in a variety of industries and countries—is more likely to be profitable than a homogenous one. This theory emphasizes the risk-associated benefits of diversification.
Essentially, a diversified portfolio includes assets in different industries, countries, and asset classes.
But what does diversification look like in terms of actually constructing a portfolio? Diversity in terms of industry is key, especially when investing in U.S. equities. A common benchmark in terms of diversification is 50 U.S. stocks, equally sized and operating in a range of industries.
However, scholars have found that diversification in terms of industry can only get you so far. In fact, studies have shown that 50 is a kind of magic number: A portfolio of this many (equally sized and well-diversified) stocks reduces risk by over 60%, but the further addition of US equities has little to no effect on risk reduction.
To reap the full benefits of diversification and reduce risk further, investors have to look beyond U.S. stocks—they must diversify geographically and in terms of asset class as well.
International Diversification
Financial analysts have often noted that global markets move in the opposite direction of U.S. markets. Take, for example, a jump in the price of oil. This sort of event can have a negative effect on countries with a large industrial sector or high demand for fuel, for example Europe, Japan, or the U.S. But it can also have a positive effect for oil-producing firms in the Middle East and Southeast Asia.
An analysis of portfolios with various combinations of U.S. and EAFE (developed foreign country) stocks illustrates the point. From 1970 to 2017, EAFE stocks boasted a better average annual return than the S&P 500, though the stocks were more volatile year to year. It turns out that during that period, a portfolio with 82% U.S. stocks and 18% EAFE stocks provided the highest returns with the lowest volatility. That is to say, adding some degree of specific risk to the portfolio actually reduced the portfolio’s risk overall.
Asset-Class Diversification
With greater globalization has come higher correlation coefficients among US and international stocks (though geographical diversity in your portfolio can still mitigate risk). An additional measure that can offset risk is holding bonds as well as stocks among your investments.
For example, during the financial crisis of 2008, when returns on stocks plummeted and retirement wealth evaporated, Barclays bond index fund had a 5.2% return. Bond markets can provide returns when stocks go haywire.
Malkiel’s Take on the Benefits of Diversification
Economist Burton Malkiel is a firm believer in the benefits of diversification, especially international diversification. He notes, from 1970 to 2017, a portfolio with 82% US stocks and 18% developed-foreign-country stocks provided the highest returns with the lowest volatility of any mix of the two (including 100% US).
The key to consistent and positive returns over the long run is (a) diversification among asset classes (stocks, bonds, REITs, etc.) and (b) diversification within asset classes (negatively correlated common stocks, a mix of corporate bonds and TIPS, etc.). This way, you can reap the full benefits of diversification.
But remember: Diversification can only work if you stick to it. Overtrading, biting on hot new issues, betting the house on a stock your dentist recommended—these common pitfalls (described in Chapter 11) are bound to lead to disappointment.
Alternative Ways to Diversify Your Portfolio
Here are some alternative ways you can diversify your portfolio:
1) Real Estate
The first way you can diversify your portfolio is by investing in real estate. People who rent their domiciles miss out on the tax breaks, earnings potential, and personal gratification of owning a home. For example, under the US Tax Code as of 2018, mortgage debt interest up to $750,000 and property taxes up to $10,000 are tax deductible. Capital gains on real estate up to $500,000 are also tax-free. Although housing bubbles have happened—see the account of 2008 in Chapter 4—owning a home has proven to be a reliable means for families to hedge against inflation and realize returns.
For those investors without the means or desire to buy a home, real estate investment trusts (or REITs) provide a nice alternative. REITs consist of real estate assets—apartment buildings, offices, and the like—packaged into securities that can be traded like common stock. REITs offer competitive dividends and returns; and, since real estate prices are only moderately correlated with stock prices, they are an important part of a fully diversified portfolio.
Some REIT mutual funds that Malkiel recommends are Fidelity Real Estate Index Fund (FRXIX) and Vanguard Real Estate Fund (VGSLX). Some ETFs include Fidelity (FREL) and Vanguard again (VNQ), plus Schwab (SCHH) and iShares (USRT).
2) Bonds
Bonds are an essential component of a well-diversified portfolio. There are a number of bond options in addition to the traditional, interest-earning bond, including zero-coupon bonds (or “zeroes”), which sell at a discount and simply pay out their face value at maturity, and tax-exempt bonds, which comprise state or municipal debt that earns interest tax-free.
If you’re planning to buy bonds directly—rather than gaining exposure through a mutual fund—then your best bets are new issues. Newer bonds generally offer better yields than established bonds, but only buy bonds rated A or above by Moody’s or S&P.
Investors interested in exposure to a wide range of bonds can opt for bond mutual funds from companies like Fidelity and Vanguard. Popular bond substitutes include Treasury inflation-protected securities (TIPS), whose face value rises to keep pace with inflation, and high-dividend stocks.
3) Foreign Bonds
Another option to further diversify your portfolio is foreign bonds (emerging-market bonds in particular can feature high yields). These bonds can be risky, however, so make sure they’re offset by high-quality U.S. assets.
4) Treasury Inflation-Protected Securities
Inflation is a bondholder’s nemesis: It tends to cause interest rates to rise, lowering the price of your bond, and it reduces the purchasing power of your coupon payments.
Enter Treasury Inflation-Protected Securities (or TIPS).
TIPS are Treasury-issued instruments whose face value rises to keep pace with inflation. Say, for example, your TIPS totaled $1,000. If the consumer price index—the default metric for measuring inflation—rose 3%, the face value of your bonds would rise to $1,030 and your coupon payments would be assessed on this new face value.
Although TIPS are a great inflation hedge and portfolio diversifier—because they don’t react to changes in prices like stocks and bonds do—they feature high tax exposure: Both the coupon payments and the rise in face value are taxable. Thus TIPS are best used in tax-advantaged retirement plans.
5) Gold, Collectibles, and Commodities
Assets like gold, fine art, baseball cards, and commodities futures are extremely fickle and don’t pay interest or dividends. Unless you have ample resources in other instruments, assets like these should only occupy a modest part of your portfolio.
Take gold for example. At the beginning of the 1980s, an ounce sold for over $800. By the early 2000s, it sold for $200. As of 2018, it sold for $1,200. Simply put, it’s too volatile to be a large part of your investments, but a modest position (say, 5% of your total portfolio) can be worthwhile in a well-diversified portfolio.
6) Index Funds
Of course, diversification is the key to a successful portfolio. But one need not abandon index funds to diversify: There are funds that track REIT, corporate bonds, international capital, and emerging market indices.
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