Diversification: I Know I Should, But Why?

Photo credit: malomar

Any discussion of the tenets of long-term investing includes the recommendation for diversification. This concept is delivered almost without thought – after all, as children we are taught “Don’t put all your eggs in one basket!”. But have you ever stopped to consider just why we should diversify?

Of course, in the example of the saying about the eggs, it’s simple spreading of risk: if you have all your eggs in one basket and you drop that basket… all your eggs have broken! By spreading your eggs into a second basket, if one basket is dropped, only those eggs in that basket will break, and you’ve still got one basket of good, unbroken eggs.

What if we add a third basket? A fourth? As you might imagine, it soon becomes too clumsy to carry so many baskets (potentially one for each egg). One person couldn’t possibly manage twelve baskets effectively just to harvest a dozen eggs. So, while diversification makes sense to a degree, you always must keep in mind that it can be applied to an extreme and you lose the efficiency of the basket, plus your costs increase.

Enough about eggs for now though. Why do we preach diversification in investing? The root of this concept (at least in the modern age) come from something called “Modern Portfolio Theory”, which was developed by a fellow named Harry Markowitz. The overall theory is pretty weighty so we won’t cover it completely here (although I’d be happy to discuss it with you if you wish). The gist of the benefit of diversification follows.

Decisions about investments are always made in an environment of uncertainty. This is because, even though we have a belief that our investments will hold their value and will increase in value over time, there is no certainty that this will be the case. We can study the past performance, the present activity, and many pieces of information about the particular security – but we have no surety that the increase we hope for will occur.

This uncertainty is due to the continuous up and down volatility in investment prices. As an example, if a stock is worth $20 now and was worth $15 last week, we have no idea if it will be worth $30 tomorrow or possibly even $10. This shouldn’t be a surprise: how many times have you seen something in the news that seems like a good thing for the economy, like an interest rate cut – only to see the market drop like a stone at the release of the news? The opposite happens just as often.

So – what’s a guy to do? Enter diversification.

Diversification – Your Key to Reduce Volatility

It’s not hard to understand that every dollar you save in taxes and overall costs of investments equates to an increase in your bottom line total return. What may be difficult to follow though, is that diversification of risk can reduce volatility, and therefore reduce loss. An example may be the best way to get this point across.

Let’s say you have $1,000 in your overall portfolio, and through the year you have achieved a 20% gain. Shortly thereafter, your investment experiences a correction, amounting to a 20% loss. Most folks would think that you’ve just held ground and broke even in your account – but most folks would be wrong to think so. What happened is that your account gained 20% to a value of $1,200, and then the account lost 20% or $240 (.20 times $1,200), so in the end you have actually lost a net amount of $40. Just for grins, the result is the same if you work things in the reverse as well: a 20% loss gives you a balance of $800, and then a 20% gain ($160) gives you a final balance of $960, for a loss of the same $40.

For purposes of comparison, let’s look at another situation: a 10% gain followed by a 10% loss. From our previous example, we know that this isn’t just “holding ground” – we have lost a total of $10 in the process. We started with $1,000 and gained 10% to a value of $1,100, and then experienced a 10% loss ($110), for a final balance of $990.

What’s truly important to note about these two examples is the relationship of the volatility (the percentage size of the gains and losses) to the actual dollar loss realized. In the first case, the volatility was double that of the second (20% versus 10%), but the resulting loss was quadrupled!

If we took the first example and changed the volatility to a 40% swing in either direction, the resulting loss is even greater – a gain of 40% gives us $1,400, and the following loss of 40% ($560) brings us to a final balance of $840, for a loss of $160, which is sixteen times the loss we suffered in the 10% example. If you’re a mathematician, you’ll notice the relationship here: the level of volatility that we experience results in an exponential loss in the account. If we had a 50% gain followed by a 50% loss, our overall loss would be twenty-five times the loss in the 10% example, and so on.

It doesn’t take long to understand why it is important to keep volatility in your portfolio low: the smaller the “swings” of volatility, the lower your potential loss. When you increase the “swings” of volatility by a factor of one, your potential losses increase exponentially.

So – if I’ve done my job and explained this properly, the question on your mind at this point should be: “How do I get myself some of this low volatility?” And if you’ve been reading carefully up to this point, the answer should be obvious: diversify.

And how do we do that? Much the same as the eggsample from earlier, you want to find a place (or group of places) to invest your money that will result in less volatility. All investments are affected by various things around them – oil and gas companies are impacted by the cost of crude oil, banks are impacted by interest rates and the credit crunch, department stores are impacted by inflation, employment, and the seasons. What we look for are investment vehicles that are diverse enough to not all be impacted by the same kinds of things in the same magnitude at the same time. Therefore we diversify into different capitalization-weightings, different countries, and different sectors, all in an effort to reduce the overall risk of loss (volatility) in our portfolio.

For example – by investing in the S&P 500 index, we are diversifying across many different companies, sectors, and industries in the US marketplace. In addition to this investment, we might add a holding in the EAFE index (Europe, AustralAsia and Far East), further diversifying across different countries, companies, sectors and industries. By doing so, if something happens that makes United States Steel’s stock to lose 20% in value, the impact on our portfolio is minimized, since US Steel is only a very small portion of our portfolio. By the same token, if an event should occur that caused the stock market in Singapore to suddenly crash, and this event was limited in its exposure to just Singapore, then as before, since we’re diversified among many countries, our exposure to volatility is minimized.

I hope this explanation helps you to understand one of the very basic pillars of investing discipline. I would be remiss, though, if I didn’t point out that diversification can also have a negative impact on your gains. When you reduce the volatility in your investments, you’re not only reducing the downside swing, but the upside swing as well. What we give up is the “once in a lifetime” homerun-type of investments.

For example, if you happened to put all of your money in Google at it’s initial offering in August of 2004, by the end of that year you could have doubled your money. In the diversification example using the S&P 500, you would have had a small percentage of your portfolio in Google, and your overall return from August to December in 2004 would have been 10.8%. For an example on the other side of the coin, if you had placed your nest egg in Enron stock in late 2000, by mid 2001, you could have virtually nothing left, while the S&P 500 had fallen by a mere 17% during the same period. Reducing volatility, while it causes you to give up the spectacular gains, will also save you from the spectacular crashes. And we all know which one happens more often.