As financial conditions around the world tighten, a good lesson in portfolio diversification is playing out. In 2020, growth stocks ruled the roost, especially those companies that benefited from COVID-influenced trends. Zoom, Zillow, and Peloton were some of the big winners that saw their share price quadruple in less than 12 months. But the music never plays forever and these stocks have all crashed back down to previous pre-pandemic levels.

In a diversified portfolio, these losses may have been offset by gains from the energy sector, which rose from dormancy to become the best performing sector in 2021. You wouldn’t have reaped the full reward of the tech boom in 2020, but you also wouldn’t have subjected yourself to the crippling losses that these stocks suffered in 2021 if you didn’t time the market properly. Portfolio diversification at its core is a simple adherence to some grandmotherly wisdom – “don’t put all your eggs in one basket”.

What is Diversification?

Investing is inherently risky. But there are two different types of risk: systematic risk and systemic risk. We’ll take a look at these risks and how you can lessen their impacts on your portfolio.

Systematic Risk

Systematic risk is the market risk that all investors take when putting capital into public markets. When events like the Great Recession, COVID-19 pandemic, or war in Ukraine happen, the effects reverberate throughout the entire market. Some sectors may be more affected than others, but geopolitical and economic triggers cannot be diversified away.

Systemic Risk

Systemic risk is the risk inherent to a single entity or asset. If you own stock or bonds from a publicly traded company and they go bankrupt, your holdings will be affected but the larger market will be largely indifferent. Unlike systematic risk, systemic risk is unique to each individual firm or asset and can be circumvented through diversification.

Imagine you have a diversified portfolio with 20 different public company stocks. If economic growth slows and a bear market occurs, all 20 stocks will be affected regardless of industry or size. Some stocks will be hit worse than others (and you may even have a winner or two that weathers the storm), but you should be prepared for your portfolio to be down overall in a bear market. However, if one of your stocks is forced into bankruptcy, only 5% of your capital will be permanently lost.

Now let’s imagine you have all your capital in a single company stock. You may have significant gains if you pick a winner, but you face both systematic and systemic risk when owning a single stock. Not only will your stock be affected by a bear market, but a singular event like an accounting scandal or failed product launch could cause your entire portfolio to drop 50% during a raging bull market. The goal of diversification is to remove the systemic risk from a portfolio by dividing capital amongst a variety of stocks, bonds, or other assets.

Types of Diversification

Location

Different economies have different risk factors and prospects for success, so diversification often takes an international tone when it comes to portfolio building. Buying assets located in a single country, even one as safe as the United States, isn’t a smart diversification strategy. Plenty of index ETFs and mutual funds exist that allow investors to access stocks and bonds from countries in both the developed and emerging markets. Having a mix of international assets alongside your domestic ones is a good way to diversify your holdings.

Company Size

Larger companies tend to be less risky than smaller ones, so index funds are often grouped by market capitalization. Large cap funds include some of the most established companies in America like Apple, Amazon, JPMorgan Chase, Berkshire Hathaway, and UnitedHealth. Small cap funds contain startups and lesser known companies that have more room to grow, but also a higher risk of failure. Grouping companies by market cap is a good way to diversify a portfolio since you’ll have exposure to a wide range of sectors within a single fund, regardless of whether you choose large cap or small cap indices.

Asset Class

For most people, diversification is about evaluating personal time horizons and building a portfolio of assets that reflects that timeframe. If you’re approaching retirement age and have a substantial nest egg, you likely don’t want too much risk in your portfolio and prefer to hold 50% stocks and 50% bonds. Or maybe even 40% stocks/40% bonds/10% gold/10% cash if you really want to play it safe.

The calculus changes for a young person who’s earning a high salary for the first. If you’re in your 20s or early 30s, you have three decades or more of work ahead of you. While 30 years of work may not sound too appealing, you also have time on your side. With a three decade time horizon, you can increase your risk tolerance and go 90% (or even 100%) into stocks without worrying about bear markets. In fact, if you’re young, a bear market allows you to buy your first stocks at a discount. As you get older and build your nest egg, you can add bonds to your portfolio and diversify away some risk.

Work With an Experienced Financial Advisor

Our knowledgeable financial advisors at Good Life Financial Advisors of Mt. Pleasant are here to help you plan your investments. Contact us today to speak to our consultants and learn more about the tools and guidance we offer.

Disclosures

The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

All investing includes risk, including fluctuating prices and loss or principal.