ETF Academy Why Diversification Is Important
Diversification is the principle at the heart of intelligent investing. Famously called “the only free lunch in finance” by Nobel Prize-winning economist Harry Markowitz, the thought is that by diversifying you reduce investment risk while sacrificing little in the way of return. Investing professionals diversify by spreading their money across different stocks and include other asset classes like bonds, real estate and commodities. ETFs make building a diversified portfolio possible with a relatively small amount of money.
Investment portfolios: Built on diversification
Most large institutional investors build their portfolios on the principle of diversification. It’s natural to want to maximise return while reducing risk. This is the difference between wise investment and speculation. As mentioned in the first course of the academy, in finance there‘s a relationship between risk and expected return. A higher level of risk tends to equate to a greater return. However, diversification can tip the scales to a degree, possibly offsetting the higher risk taken in pursuit of higher returns.
Portfolio diversification: Art or science?
The answer is both. Some institutional investors employ dozens of highly educated (and, in our opinion, well paid) experts in order to assess the optimal portfolio mix. You might want to be more pragmatic and apply the following rules of thumb:
- Compose the core of your portfolio from equities and bonds;
- Complement this with other asset classes, such as real estate and commodities (e.g., gold);
- Your equity portfolio should consist of a good amount of different stocks, ideally from different sectors and geographies.
Diversification: Invest regularly to avoid fluctuations over time
To say that markets fluctuate would seem an understatement at times. Unfortunately, it’s a natural trait of human behavior to buy when markets are high and sell when they’re low. The best way to avoid this is to diversify investing over time – learning the discipline of investing regularly without judging markets. For instance, if you invest regularly, like clockwork, every month, you might well buy when the markets are high, but you also will buy when they're low.
The table below shows the cost of investing at the wrong time. In the last 50 years, the longest it would have taken for an investment to regain its value after being invested at exactly the wrong time is eight years.
Patience pays off
Largest 5 drawdowns on the S&P 500 during the last 50 years and the years required to recover
|Crash||Date||Scenario||Drawdown||Time to recover
|Global financial crisis||October 2007||US housing credit collapse triggering an international banking crisis||-55%||773|
|OPEC oil embargo||October 1973||Combination of high inflation and economic stagnation||-48%||1453|
|Dot com bubble||March 2000||Speculative investing in US tech around the surge of internet||-47%||1017|
|Covid 19||March 2020||Largest stock market contraction since 2008 due to the fear of Covid 19 virus||-34%||97|
|Black Monday||October 1987||Greatest one day decline in US stock history mostly attributed to a combination of geopolitical events and computerized program trading||-33%||397|
Source: Total returns data from Bloomberg. Analysis: seekingalpha.
Diversification through funds
Funds are an excellent way to diversify – whether ETFs or traditional mutual funds. Typically, they spread investments across a large number of securities. They’re regularly rebalanced in order to avoid excessive exposure to any single investment.