When I was a financial advisor, I used to explain investment diversification as a way to limit exposure to some parts of the market. That way, if one specific industry or sector imploded, then at least some of your money would be “safe.” But, limiting risk is only half of the benefit of diversification.
Over the last few decades I have been an investor through two very different recessions. I have found that there is more to diversification than just limiting risk.
Done right, diversification can help you profit from all market conditions.
What is Diversification
In my opinion, a portfolio is diverse enough if it meets two criteria:
- The portfolio behaves predictably in all market conditions; and,
- Parts of the portfolio move differently in the same market conditions.
Let’s look at a few examples to illustrate my point. In each example, let’s invest $10k in exactly two investments, with 50% in each.
Example 1: Individual Stocks
If you’ve read my book, you know that I pretty much hate individual stocks as an investment tool for individual investors. They are just too much of a gamble. Plus, most investors would have to invest much too large a percentage of their net worth in any one individual stock, making them too concentrated on one specific bet. And, if it starts to feel like a bet, you know what I’m going to say next… if you want to gamble, go to Vegas.
Investing is not gambling.
But, for the sake of an example, let’s say you buy $5,000 two of the largest and most successful companies in the US. Looking at the list of the largest companies in the S&P 500, you would pick Microsoft and Apple. But, we want to be diversified, so let’s not pick two tech companies. Scrolling down the list, the next is Berkshire Hathaway, which is a conglomerate of lots of companies, which probably muddies our example, so we’ll skip it. The next non-tech and non-conglomerate is #6 on the list, JP Morgan Chase.
So, now you have $5,000 of Microsoft and $5,000 of JP Morgan Chase. Assuming this is your only $10k, then your entire fortune is in the hands of very few people. With this portfolio, here is a list of things that can wipe out your hard earned fortune:
- CEO of Microsoft says something stupid (like Tesla CEO Elon Musk)
- CEO of JP Morgan says something stupid (like Countrywide CEO Angelo Mozilo)
- Microsoft makes big (bad) decisions and falls from grace (like all of these examples)
- JP Morgan makes big (bad) decisions and falls from grace (like Wells Fargo)
- Tech sector collapse (like 2000)
- Banking sector collapse (like 2008)
- Recession (like 1970, 1973, 1980, 1990, 2001, 2008…)
I don’t know about you, but I worked very hard for the money I have. I am not about to put it into a situation where someone other than me can do something stupid and wipe out my money.
Of course, if I do something stupid and lose my own money, that’s another topic for another day.
So, to make sure that one person or one company cannot destroy your hard earned money, individual stocks are not the way to go.
Example 2: Stock Index or Mutual Funds
For the next example, we are going to buy two stock funds that happen to be index funds. Let’s put $5,000 into a fund that mirrors the S&P 500 (the 500 largest companies in the US), and another $5,000 into a fund that mirrors an index with slightly smaller companies, the S&P 400 Mid-Cap Index.
With this portfolio, you have only bought two indexes, but it will behave as though you have bought 900 companies (about 500 in one and about 400 in the other). Your biggest holding is Microsoft at 4.25% of the S&P 500, which would about $212.50 of your $5k in that fund. So, even if one of the CEOs in your portfolio completely blows it, and the company ceases to exist overnight, the most you are out is $212.50.
With that in mind, let’s look at our new exposure:
CEO of Microsoft says something stupid CEO of JP Morgan says something stupid Microsoft makes big (bad) decisions and falls from grace JP Morgan makes big (bad) decisions and falls from grace
- Tech sector collapse
- Banking sector collapse
At this point, you have limited your exposure to almost all of the big issues plaguing the portfolio in Example 1. No one CEO, PR issue, corporate strategy, or industry shift can implode your portfolio. We have not eliminated the risk completely, but we have minimized it for almost all of these issues.
However, this portfolio still has the risk of falling apart if there are big seismic shifts in the economy. If a whole sector takes a big hit, or if there is a recession, then your portfolio will violate rule #2 from the beginning of this article: all parts of the portfolio will decline at once.
An all stock portfolio will crash during a recession. It has happened in all of the recessions before. It will happen in all of the recessions to come. So, what can you do about it?
Think beyond stock.
Example 3: Expanding into Bonds
For this example, we are going to stick with just two investments, and just $10k. But, instead of buying two stock funds, we are going to use half the money to buy a bond fund.
So, with the $10k, let’s buy $5,000 into the same S&P 500 index from Example 2. And, with the other $5,000, let’s buy a mutual fund that invests only in investment grade (aka highly-rated) corporate bonds issued in the US.
Now, we know from Example 2 that we have eliminated a bunch of categories of risk from the portfolio buy buying an index fund. But, recession and sector collapses are still a problem. So, what happens to Stocks and Bonds during a recession?
Well, I said it before (and it bears repeating) stock portfolios crash during recessions. So, you can expect the $5k that is in the S&P 500 index fund to take a hit during the next recession.
But, here is the magic. Bonds generally do not fluctuate as much as stocks. And, sometimes, bonds actually become more valuable during a recession.
Take a look at 2002 and 2008. Huge recessions. Massive stock market corrections. However, the bond market did not collapse.
Now, imagine that you had been invested 50% bonds and 50% stocks going into 2008. with our $10k hypothetical portfolio. By the end of 2008, you would have lost 40% of the stock value, which would be about $2,000. The bonds would have increased by 5%, which is $250, so the total portfolio would have been off by $1,750. However, there are two massively cool things that happen to investors with both stocks and bonds.
- The bonds keep paying dividends. Skip to this article to learn about dividend investing.
- Stocks are on sale, and you have money set aside to buy them!
The second point refers to rebalancing. At the end of 2008 in this example your portfolio has $5,250 in bonds and $3000 in stock. That means instead of 50%/50%, your portfolio has 65% bonds and 35% stock. It is time to sell some of those bonds and buy more of the S&P 500 index in your portfolio, which, by the way, is 40% off!
So, yes, even though your portfolio’s total value is down from its peak, you are still profiting. You are getting paid for having money in the form of dividends from the bonds, and you are poised to profit from the decline in stock share prices.
You have a strategy to not only weather the recession, but use it to continue to get paid for having money. So, let’s look at our list of risks now that we have both stocks and bonds in our portfolio:
CEO of Microsoft says something stupid CEO of JP Morgan says something stupid Microsoft makes big (bad) decisions and falls from grace JP Morgan makes big (bad) decisions and falls from grace Tech sector collapse Banking sector collapse Recession
Looks pretty good to me.
First, I want to clarify that these examples are just over simplified illustrations to highlight a point about diversification. They are not investment recommendations.
In fact, I would not recommend only having two investments. Generally, I have five investments that I like, assuming your portfolio is large enough to make it worth dividing into so many chunks. Those five investment categories are: Large Cap Stock, Mid Cap Stock, International Stock, High Yield Bonds, and Investment Grade Corporate Bonds.
Dividend investing and rebalancing are how I make sure that my portfolio is positioned to profit in every market condition. To learn more, grab my book from Amazon and focus on Part 3: Managing Investments.
In that chapter you will learn about the different types of investments available to you, the five (and only five) investments I have in my portfolio, how to decide which model portfolio is right for you (with three examples to choose from), the magic of rebalancing, dividend investing, and what happens when you never spend the principal.
Second, no strategy can eliminate all risk in investing. It will always be possible to lose money. Even a perfectly diversified portfolio will likely decline in share-value during a recession.
However, diversification allows you to know how your portfolio will perform during the next recession (rule #1 from the beginning of the article), and allow you to use the part of your portfolio that is performing well to top-up the part of your portfolio that has declined (rule #2), which will accelerate your recovery out of the recession.
Third, this is not a recommendation to try and time the market.
I used rebalancing to illustrate the opportunity in example 3, but that was not a recommendation to just rebalance once when you think the market has bottomed out. I always recommend rebalancing on a set schedule, which removes your emotions from the decision. You can decide on your own schedule based on how much effort you want to put into your investments. I like to rebalance at the beginning of every calendar quarter. Some people like semi-annually, which is also fine.
So, just set yourself a calendar reminder to rebalance regularly, and forget about trying to time highs and lows in the market.
I hope this has been helpful! I welcome your comments with your thoughts and questions. And, don’t forget to subscribe to the newsletter to get notified whenever a new article is posted.