I bet you know the popular saying that "you should not put all your eggs in one basket". The simple logic behind this proverb implies that you can lose all your resources if you direct them into one area.
Investing on its own could be a risky venture if you don't have proper knowledge of how to go about it. Hence, diversification in stock investing will require that you buy stocks from different companies, rather than from only one company.
Diversifying your portfolio is not as complicated as it sounds. In this article, we'll cover the importance of diversification in investing and guide you on how to create a diversified portfolio as an investor.
What is Diversification and why should you diversify
The main aim of diversification is to manage risk in your investment so that there'll be a difference in the performance of your investments cumulatively.
Imagine buying stocks of only one company, If the performance of the company reduces or they go bankrupt, it is going to affect your investment dramatically. Also, if you are investing in multiple asset classes, you will have less fear if one asset class eventually performs poorly.
For instance, generally, stocks perform better than cash and bonds in the area of returns, although they often present more risks. Bonds, on the other hand, don't produce many returns but most times hedge against risks during the period when the stock market is down. In doing this, the rest of your investment will be growing even if a part of your portfolio is declining.
So, let's dig into the subject. Divide et Impera.
Types of Diversification
Diversifying your investment portfolio doesn't have a particular formula. The basic rule is that you should invest in different financial assets so that your rates returns will be different and losses in one asset class might be compensated by another.
Another foreword here is that regardless of the type of diversification, the key thing is to chose assets which are not correlated. The correlation coefficient is the mathematical relationship which describe how much two assets tend to move together in the same direction.
Diversification across sectors
This is one of the easiest ways to create a diversified portfolio. In doing this you shall buy several stocks from different companies.
Hence, you shouldn't just restrict your investments to a particular sector so you won't have a great loss whenever there is an economic slowdown.
In general, the stocks are split on 11 sectors:
Rely heavily on the business cycle and economic conditions. Consumer cyclicals include industries such as automotive, housing, entertainment, and retail.
Top stocks: Amazon, Tesla, Home Depot, Alibaba, Toyota
Relating to the research, development, or distribution of technologically based goods and services. This sector contains businesses revolving around the manufacturing of electronics, creation of software, computers, or products and services relating to information technology.
Top stocks: Apple, Microsoft, Nvidia, Taiwan Semiconductor, ASML holding
Companies that make communication possible on a global scale, whether it is through the phone or the Internet, through airwaves or cables, through wires or wirelessly.
Top stocks: Alphabet (Google), Meta Platforms (Facebook), Vodafone, Orange, AT&T.
Financial firms including banks, investment houses, lenders, finance companies, real estate brokers, and insurance companies.
Top stocks: Berkshire Hathaway, JPMorgan, VISA, Bank of America, Mastercard
Businesses that provide medical services, manufacture medical equipment or drugs, provide medical insurance, or otherwise facilitate the provision of healthcare to patients.
Top stocks: Johnson & Johnson, AstraZeneca PLC, Pfizer, Abbott Laboratories, Merck & Co
Stocks of companies that mainly produce capital goods used in manufacturing, resource extraction, and construction. Businesses in the industrial goods sector make and sell machinery, equipment, and supplies that are used to produce other goods rather than sold directly to consumers.
Top stocks: Samsung Electronics, Citigroup, PT Bank,
Businesses engaged in the discovery, development, and processing of raw materials. The sector includes companies engaged in mining and metal refining, chemical products, and forestry products.
Top stocks: LG Chem, Newmont Corporation, Air Products and Chemicals, Barrick Gold, BHP Group Limited
The main segments of the real estate sector are residential real estate, commercial real estate, and industrial real estate.
Top stocks: Prologis, American Tower, Crown Castle International, Public Storage, Welltower
Stocks that provides consistent dividends and stable earnings regardless of the state of the overall stock market.
Top Stocks: Walmart, The Procter & Gamble Company, The Coca-Cola Company, PepsiCo, Costco Wholesale
Stocks that relate to producing or supplying energy. The energy sector or industry includes companies involved in the exploration and development of oil or gas reserves, oil and gas drilling, and refining. The energy industry also includes integrated power utility companies such as renewable energy and coal.
Top stocks: Exxon Mobil, Chevron, Shell plc, BP, TotalEnergies SE
Companies that provide basic amenities, such as water, sewage services, electricity, dams, and natural gas.
Top stocks: NextEra Energy, National Grid plc, Adani Green Energy Limited, Minera Valparaiso S.A.
To prove that it is good to diversify across sectors, we can look at the performance of all the sectors during the last year. Here are the returns as shown by Finviz:
As you can see, if you were invested mostly in the Communication Services or Consumer Cyclicals, you won't be too happy right now. Even the technology sector has significantly underperform.
But it is not as simple as throwing your money in different stocks. So let's work out some examples.
Examples of Diversification
Bad Diversification Example - Mastercard and VISA
Although your performance would have been brilliant if you invested in these two assets, it is not a good diversification example as both companies are operating in the same sector, and they are highly corelated.
Here is the performance since 2015 of a portfolio consisting of MA only and a portfolio of 50% MA and 50% V.
Please have a look at the Standard Deviation (Stdev). It has reduced a little bit, but on the other hand also the gain was reduced. As a consequence the Sharpe Ratio remained constant, which means we got the same return for a unit of volatility.
Before we go further, please note that in general diversification is aimed to reduce the portfolio volatility, or increase the return for a given level of risk (Sharpe Ratio). A diversified portfolio will never compete with a super performer like Tesla, but it will protect you against massive drops like the one we saw on TAL stock.
Good Diversification Example - Mastercard and Enviva
After reading this article and knowing that you have to diversify across sectors, you decide to compose your MA portfolio with EVA stocks.
Let's see how the three portfolios performed:
As you can see, the Standard Deviation went lower, while the return remained similar as in the previous example, thus the Sharpe Ratio increased.
But is your performance better?!
Well, there is no right answer for that question. Although the volatility is reduced, that came a the price of reduced performance, and also there was a negative year.
It all depends on your targets. In the end it is a matter of compromise between your target return and acceptable volatility. In this particular example, the 2.4% reducing of the volatility does not play a big role and the difference of $3,500 in return seems to be more important. However, you never know how the companies are going to perform, and that is what makes investing in the stock market a real journey.
Now, the unexpected fact comes.
Just look at the individual CAGR and Standard Deviation of our assets:
The Standard Deviation of EVA is 28%! So how does it come that it reduced the volatility of the portfolio?!
You already have the answer: Correlation. In simple words the volatility of EVA moves independently of MA volatility, and so it happens that the two stocks compensate each other's swings.
Let's see how we can measure that.
Mathematically, you can see the correlation matrix between these assets below:
As you can see, the correlation between MA and EVA is only 0.34, which means they are moving fairly independent.
On the other hand, the correlation between MA and V is 0.9, which means they move in tandem 90% of the time, thus it did not bring an advantage to diversify.
If you don't believe this kind of mathematical and statistical units, you can simply have a look at the chart below which represents the three stocks since 2015:
It is easy to observe on the chart with naked eye everything that I tried to explain up to now.
Is there a simpler way to diversify?
Yes, of course! You can do that by simply buying the broad market indices like S&P500 or the associated ETFs like SPY.
By doing that, you effectively "buy the market", as these kind of indices include hundreds of companies and you get exposure to all of them through one single transaction.
Many articles have been written about Passive Index Investing so it is not worth spending your attention here any longer.
Let's move to something more interesting instead. ⬇️
Diversification across asset classes
Generally, an investment portfolio includes a wide range of investments across several assets. They may include cash equivalents, cash, stocks, bonds, commodities, ETFs (exchange-traded funds), and closed-end funds.
To illustrate and example, I will show you the big players.
Here is the relative performance between stock market (represented by the S&P500 index) and the well known Gold:
The time is chosen by intention to start before the crisis in the 2008, so that you can see how good the gold performed during the crash. On the other hand, when the market rebounded, the gold started to fall.
So, you might ask yourself the question how did a 100% and 50%/50% portfolios perform?
Here is a simulation starting in 2006:
As you can see, the 50/50 portfolio has the least Volatility, the lightest Worst Year and the least Drawdown.
You can experiment yourself further with different asset classes, as you got the idea now.
Is diversification a free lunch in finance?
Yes, many investors and specialists are considering the diversification as being the only free lunch in investing. Statistically, it is possible to maximize the returns for a given volatility or to minimize volatility for a given return.
The subject can be studied in more details and statistical terms. Here we fall into area of Modern Portfolio Theory, where we speak about Strategic Asset allocation, Efficient Frontier and so on.
But more on that in a different article. If you want it to happen, support my work by following, subscribing and liking this post! 👍
Hope this was useful for you! Please note that the above content is not an investment advise and shall be considered only for informative purpose.
Feel free to share your opinions in the comments section below.
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