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Diversification is a key driver of returns

Don’t put all your eggs in one basket

By Sudhir SahayPublished 2 years ago 5 min read
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Diversification is a key driver of returns
Photo by Lukas Blazek on Unsplash

“Diversification is the only free lunch” [in investing] – attributed to Nobel Prize laureate Harry Markowitz *

Welcome to the latest post in my journey to build financial literacy for young adults and their families. In today’s post, we will discuss how diversification and rebalancing is a key driver of investment returns and how it helps reduce the likelihood of catastrophic loss.

One of the core tenets of building a portfolio is diversifying your assets. As explained in a great Investopedia article, “Diversification is a technique that reduces risk by allocating investments across various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.” **

The fundamental idea is that different assets and investments perform differently at any given time. By owning a bundle of assets, you manage the risk in your total portfolio. As a simple illustrative example, let’s look at what’s happening today. Energy costs are spiking so if you owned stocks in companies who have a high energy content within their cost structure such as airlines, those stocks are declining as their profitability decreases. Now, if you had diversified your assets by owning stocks of oil and gas companies, those stocks would have given you an offsetting increase in the stock portion of your portfolio. Depending on the share of your portfolio devoted to each of these sets of assets, the increase in oil and gas stocks could have more than offset the decrease in the value of your airline stocks.

So, the idea of diversification is to have a mix of assets across classes such as cash, stocks, bonds, commodities or real estate. In addition to diversifying across classes, you should also diversify within those classes. For example, in the stocks class, invest in a number of stocks across different industries and size of company. Ideally, these assets would either be non-correlated or have a negative correlation. That’s just a fancy way of saying that when one asset increases in value, that either doesn’t affect the value of the other investment (non-correlated) or the other is likely to decrease (negatively correlated) and vice versa. This way, even when a portion of your portfolio decreases, another portion either holds up or increases. Also, this protects you in case one of your investments “blows up” and goes to zero. You still have the other assets in your diversified portfolio and your total loss is limited to the percent of your portfolio which blew up.

If you layer on the practice of rebalancing, you can maximize the return for the level of risk implied by your portfolio mix. The idea here is that you check your portfolio on a periodic basis – most people do it once a year – and rebalance. That means to look at the percentage mix of each of your assets and, for those which are higher than your planned percentage, sell enough to bring it back to your targeted level. Then, you reinvest those monies into the assets which are lower than your targeted level. The reason rebalancing matters is that most investments go through cycles where they rise for a while and then fall for a while and then rise again (think of waves in a chart). By rebalancing, you are selling a portion of your assets which have outperformed and are in the increasing portion of the wave and put more into those which have decreased. As the direction of the assets’ waves change, your total portfolio should benefit.

Historically, portfolio diversification meant a mix of stocks and bonds as those were the easiest asset classes to invest in. Nowadays, there are so many easy ways to invest in other asset classes such as real estate, commodities or early-stage companies not to mention more esoteric assets such as crypotcurrencies, NFTs, wine or art. You can definitely expand the list of assets for your portfolio to go beyond stocks and bonds. While I am not a financial advisor and you need to think about what works best for you and your unique circumstances, I would recommend staying away in the beginning of your investing career from the more esoteric asset classes, but consider adding real estate and commodities.

In closing today’s post, I’m going to add a new section based on some great feedback from one of my readers: what are the practical steps you can do from today’s post? Here they are:

  • When building your portfolio, spread it across different asset classes such as stocks, bonds, real estate or commodities. If your current portfolio doesn’t have that diversification, make your newest investments into the areas where you don’t currently have exposure
  • Within each of the asset classes, have a few non-correlated or negatively-correlated investments
  • Have a target allocation across and within each of these classes
  • Every year (or another periodic time which works best for you), review your portfolio and rebalance back to your target allocation level

Thank you again for joining me on my journey to build financial literacy for young adults and their families. If you are interested in reading more of my posts, please access my author page at https://vocal.media/authors/sudhir-sahay where you can see all the posts I’ve published. If you have any questions on today’s post or if there are any topics you’re interested in my broaching in future posts, please let me know. I can be reached at [email protected].

* “Diversification is the only free lunch in investing"; Max Allison; https://www.netwealth.com/ourviews/diversification-is-the-only-free-lunch-in-investing

** The Importance of Diversification; https://www.investopedia.com/investing/importance-diversification/

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About the Creator

Sudhir Sahay

Sudhir Sahay is a Sales and Marketing executive and a father of two young men. Sudhir hopes to share his journey building basic financial literacy for his children and providing savings and investing advice to their friends and peers.

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