The Value of Diversification in Any Market Environment

April 2022

The COVID-19 pandemic and recent geopolitical turmoil have brought unsettling market volatility. While disruptive market events can cause concern, volatility and risk are unavoidable parts of investing regardless of the prevailing market environment. Episodes like these highlight the importance of diversification, a core principle of portfolio management focused on building exposure to various drivers of risk and return that can help a portfolio withstand volatility and smooth returns over time.
 
We share our perspective on diversification and its value in a portfolio context.
 
Why is diversification such an important pillar of investing?
 
In simple terms, diversification is the idea of not putting all your eggs in one basket—holding assets that zig and zag at different times. Diversification means investing in assets that provide exposure to distinct and varied drivers of risk and return, such as various asset classes, sectors, and geographies. The overall goal is to reduce risk and smooth returns, ultimately helping investors reach their long-term goals—and hopefully experience less stress along the way.
 
Understanding diversification requires understanding risk. Investment risk is commonly defined as volatility, or the rate at which the price of an asset increases or decreases over time. An individual stock’s volatility is partially determined by the risk that something negatively affects that company. Combining multiple stocks across different sectors in one portfolio mitigates position-specific risks as they begin to cancel each other out.
 
Because risk/return factors vary across asset classes and sectors, investments perform differently across market environments. This is highlighted in the chart of annual asset-class returns below. As you can see, the featured asset classes have been leaders and laggards at various times, while the portfolio—which provides diversified exposure across asset classes—generally stays toward the middle.

Asset Class Performance

In general, as more positions across different sectors are added to a portfolio, overall risk will decline. As the number of portfolio holdings increases, the incremental benefit of adding additional positions eventually diminishes. Academic theory suggests the diversification effect may be maximized with as few as 30 positions.
 
Diversification in practice
 
One way to tap into the risk-muting power of diversification is to broadly allocate across global equities, fixed income, and alternative assets as well as domestic and international markets.  This can include alternative assets, such as private equity and real estate. Private equity offers the tradeoff of a longer term, relatively illiquid investment in a private business in return for potentially higher, more stable returns. This exposure can offset the shorter-term volatility of public equity markets. Real estate similarly offers exposure to different risk drivers and time horizons relative to equities or fixed income and thus will perform differently relative to these asset classes.
 
Correlations evolve and market leadership changes over time, so it can be helpful to regularly and systematically rebalance portfolios to maintain effective diversification. One way to achieve this is to practice what is called “disciplined rebalancing”—trimming exposure to sectors and asset classes that have outperformed and adding to portfolio holdings that have underperformed. This is viewed as a way to “buy low and sell high” while seeking long-term exposure targets that are set according to an investors’ specific goals, investment horizon, and risk tolerance.
 
To achieve true diversification, think beyond your investment portfolio
 
Being thoughtful about diversification should extend beyond the composition of your portfolio. For example, your job—one’s “human capital”—carries unique risk and return qualities. A teaching job with a pension and job security, for example, can be seen as parallel to the stable, secure income of a bond holding.  A biotech company executive, on the other hand, may face a career with much more upside/downside uncertainty—similar to a small-cap stock—as well as highly concentrated exposure to one particular industry.
 
Careful financial planning can help identify this human capital risk and consider adjustments to asset allocation or industry/sector weightings to offset certain risks specific to your individual situation. Being more strategic about diversification also includes being mindful of where assets are located—such as in taxable vs. tax-exempt structures.
 
For more information on diversification and to discuss a diversification strategy that may be appropriate for your situation, please contact your BDO wealth advisor.