Myths & Breakthroughs

Planning Your Diversification Strategy? 4 Important Things to Consider

Diversify, diversify, diversify. As an investment strategy, diversification is a strategy that few in the industry contest. After all, the logic seems self-evident: Investing in just one investment is an enormous gamble. Returns are never certain, and if the security takes a hit, there’s nothing to fall back on. Spreading your portfolio across multiple investments might mitigate that risk.

This is true.

However, the belief that a broadly diversified portfolio will shield your investments from a stock market crash is flawed. If diversification is the sole methodology for managing the risk in your portfolio, it can sometimes hold you back.

Before you diversify, consider the following:

  1. Diversification does not protect against systematic risk
  2. One of the core benefits of diversification is that it is designed to mitigate negative returns from the risk of investing in one specific company or industry. By investing across many companies and industries, poor performance by one can potentially be offset by a rise (or no fall) in another.1

    What diversification does not protect your portfolio against is a downturn across the entire economy, or rather the systematic risk associated with a major market crash.2

    During the 2008 economic crisis, Squire Asset Management observed that, regardless of our level of diversification, many investors suffered significant losses in the money they invested in stocks and their overall portfolios. Though diversifying your portfolio across multiple investments such as stocks and bonds can help manage risk, a better strategy to managing the overall risk to your portfolio from a stock market crash is to reduce your allocation to stocks before the market drops too far. This isn’t as difficult as you might think.

  3. Diversification often assumes it’s impossible to outperform the market
  4. Getting out of the market at the right time supposes that you or your financial planner can skillfully navigate the ups and downs of the market. According to the efficient market hypothesis (EMH), this is not possible. The theory proposes that the market is so efficient that, at any given time, its prices reflect the true value of a stock (and there is no over- or under-valuing).

    The EMH theory fits neatly within the diversification mantra. If you can’t beat the market through careful stock selection, market timing, or a trend following tactical approach then a widely diversified portfolio offers the best odds, right?

    Although past performance does not guarantee future results, the EMH study certainly didn’t asses all asset managers worldwide with a view to finding those who were beating the market by skill. As such, EMH remains a highly controversial theory. Some think the theory is completely dead, as they consider its findings are unscientific and its non-inclusive results false and misleading.

    Diversification has its merits, but those merits should not be used to dismiss other strategies outright.

  5. Over-diversification often leads to oversights
  6. Exactly how many stocks should you have? Studies disagree, and have disagreed for decades. An early study by Ben Graham in 1949 argued that 10-30 stocks was sufficient for a portfolio to manage stock specific risk and that additional stocks marginally contributed to the goal of managing the risk of market volatility3.

    The findings were backed by others, including John Evans and Stephen Archer in 1968 who suggested 10-15 stocks as the ideal4. Meir Statman later cited 30-40 stocks as the ideal5, though it can be argued that his research shows very modest reduction in risk when portfolios expand between 10-20 stocks. So the value of the 11th stock is very minimal.

    Risk: Standard Deviation
    Number of Stocks

    Those studies agreed on one major thing: the number of investments needed to diversify is small. This represents a major focus change for some investors. It’s also a potentially major opportunity for some investors to optimize their portfolios.

    The greater the size of your portfolio, the greater the risk of managing it. You can start to lose track of what you have, which impairs your ability to effectively rebalance your portfolio. You also risk taking on overlapping holdings and incurring greater expenses in transaction fees, low balance fees, and so forth.6

  7. Diversification might reap lower potential returns in bull markets
  8. The argument in favor of investing in a large number of holdings, is that there’s a better chance of capturing the performance of the highest performing stocks in a batch of, say 300, than a selection of 10 or 157. Unfortunately, there’s a trade-off.

    Even if you net these stocks, the strategy of managing risk through diversification can remove the potential for larger returns.

Explore the tools and tactics available to you, and consider how these strategies align with your needs. Diversification should be considered, but how much depends on your financial goals, risk tolerance, time horizon, and of course, your confidence in the skill of your advisor.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

Article tracking number 1-541169

Footnotes

  1. Heinzl, John. “Why you should diversify.” The Globe and Mail. Jan. 21 2010.
  2. ibid
  3. ibid
  4. Evans, John L., and Archer, Stephen H. “Diversification and the Reduction of Dispersion: An Empirical Analysis.” The Journal of Finance, December 1968.
  5. Statman, Meir. “How Many Stocks Make a Diversified Portfolio?” Journal of Financial and Quantitative Analysis. Vol. 22, No. 3, September 1987.
  6. McWhinney, James E. “Introduction to Investment Diversification.” Investopedia.
  7. Heinzl, John. “Why you should diversify.” The Globe and Mail. Jan. 21, 2010; Whitby, Jason. “The Illusion of Diversification: The Myth of the 30 Stock Portfolio.” Investopedia. June 20, 2011.

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