Reducing Risk with Diversification

Reducing Risk with Diversification

August 11, 2020

Diversification is a basic concept that's critical to building a portfolio able to withstand the test of time. It is the process of spreading your money among a variety of securities to reduce exposure to any one investment or asset class. The premise behind diversification is easy to grasp: When you diversify across a range of investments, you may reduce risk by creating the potential for better performers to compensate for poor performers.

Effective diversification involves more than simply owning a jumble of different investments. It means selecting a mix of securities that may not react the same to a given set of conditions -- investments that carry a low correlation to one another. Correlation is a statistical measure of the degree to which two securities perform the same under particular market conditions. For instance, if you choose stocks of two companies that make the same product and serve the same market, chances are that they will move in tandem when conditions affecting their industry change. Owning both would be unlikely to lower risk in your portfolio. Alternatively, owning stocks of companies that operate in different segments of the economy may help improve your risk-adjusted return, although past performance is no guarantee of future results.

Diversifying by Industry1

As this chart demonstrates, combining stocks from different industries or sectors -- Consumer Staples, Information Technology, Financials, and Materials in this case -- may potentially result in a portfolio that has less risk than the individual industries or sectors. Of course, the portfolio may also have somewhat lower returns than some of the individual industries or sectors -- a trade-off that long-term investors may be willing to make.

Diversification vs. Asset Allocation

On its most basic level, diversification can be applied to asset classes by allocating your investments among the three fundamental asset classes: stocks, bonds, and cash. Your asset allocation is the percentage of money you decide to put into each asset class based on your goals, risk tolerance, and time horizon. Technically speaking, asset allocation may potentially reduce market risk; diversification potentially reduces company-specific risk. Together, they may help reduce portfolio volatility over time. Keep in mind that neither diversification nor asset allocation guarantees against investment losses.

Both asset allocation and diversification are particularly important when a market takes an unexpected downturn. In such a shift, some investments are inevitably affected more than others, and the overall effect of a downturn on a diversified portfolio may potentially be mitigated. Consider the investor who invested 100% in financial stocks at the beginning of 2008 (the last year the stock market as a whole declined), as represented by the total returns of the S&P 500 Financials index. He would have lost approximately 55% of his investment by the end of the year. If the same investor had diversified his holdings to encompass a broad representation of all stocks by investing, for instance, in an index fund that paralleled the S&P 500 index, he would have lost only about 37% over this period. If the same investor had further diversified his portfolio by allocating 20% to cash and 30% to bonds and invested the remainder in the same S&P 500 index fund, he would have narrowed his losses to about 16%.2

Putting Concepts to Work

The first step in building a diversified portfolio is to determine your asset allocation. How you diversify your portfolio among stocks, bonds, and cash will depend upon your specific goals, your time horizon, and your risk tolerance. A financial professional can help you determine an allocation that suits your specific needs. You'll also want to revisit your asset allocation on an annual basis, making appropriate alterations depending on your goals.

With your allocations determined, you're ready to begin choosing investments for each asset class. Here, you have two basic options. The first is to research and assemble individual securities for your stock, bond, and cash allocations. Taking this route, however, can require a significant amount of research. In addition, you would need to commit adequate time to monitor and manage the individual securities.

Alternatively, you could diversify by selecting a mix of mutual funds or exchange-traded funds. Because they hold baskets of securities, such pooled funds provide instant diversification, although the degree of diversification varies depending upon each fund's investment strategy. A fund that replicates a broad market benchmark such as the S&P 500 would provide greater diversification than a fund specializing in one sector of the economy, such as utilities or health care.

Diversifying by Investment Type or Style

Within the different asset classes, you can also diversify your holdings by investment type or style. For stocks, there are a number of different styles to choose from: growth vs. value, large-cap vs. small-cap, domestic vs. foreign, or sector/industry. These and other style groups are all represented by numerous mutual funds that may react differently to market circumstances.

For bonds, there are many different types to select from. You may choose to diversify by type (government, agency, municipal, corporate), maturity, credit quality, or specific bond features, keeping in mind that different bonds react differently to market interest rates and other factors.

However you choose to diversify your portfolio, remember that diversification works two ways. Although it can cushion the impact of a falling market, it can also dilute returns on the upside. Ultimately, you should balance your degree of diversification with your overall appetite for risk.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

Important Disclosure Information

The comments above refer generally to financial markets and not Bazis Young portfolios or any related performance. The content of this article should not be considered financial advice. The article is not intended to  offer specific investment recommendations and  is general in nature and should not be considered a comprehensive review or analysis of the topics discussed. This article is not a substitute for a consultation with an investment adviser in a one-on-one context whereby all the facts of the attendee’s situation can be considered in its entirety and the investment adviser can provide individualized investment advice or a customized financial plan. Opinions expressed are current as of the date shown and are subject to change. Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss.  All investments carry some level of risk including loss of principal. Information or data shown or used in this material was received from sources believed to be reliable, but accuracy is not guaranteed. This information does not provide recipients with information or advice that is sufficient on which to base an investment decision. This information does not consider the specific investment objectives, financial situation or need of any particular investor and may not be suitable for all types of investors. Recipients should consider the content of this information as a single factor in making an investment decision. Additional fundamental and other analyses would be required to make an investment decision about any individual security identified in this report.

Bāzis Young Investment Group, LLC is a registered investment adviser with the Securities and Exchange Commission.  Registration as an investment adviser does not imply any level of skill or expertise. Any discussion of specific securities is provided for information purpose only and should not be deemed as investment advice or a recommendation to buy or sell any individual security mentions or to allocate assets in any manner discussed.

1Source:ChartSource®, DST Systems, Inc. For the period from January 1, 1990, through December 31, 2017. Sector performance based on the performance of the GICS sectors of the S&P 500 index. Real estate data begin from September 2006. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. Past performance is not a guarantee of future results. © 2018, DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. (CS000133)

2Source: DST Systems, Inc. Bonds are represented by the total returns of the Bloomberg Barclays U.S. Aggregate Bond index. Cash is represented by the Bloomberg Barclays U.S. Treasury Bill 1-3 Month index. Individuals cannot invest directly in an index. Past performance is no guarantee of future results.

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