Diversification is usually one of the first risk management principles investors learn. It’s simple enough to understand. At its most basic, diversification is simply an extrapolation of the old advice not to put all your eggs in one basket. And it’s good advice.
Most investors make sure they’re diversified by industry, and sometimes by asset class. And diversification also usually includes quarterly or annual rebalancing to keep your best-performing assets from becoming too large a portion of your portfolio.
Diversification is especially important for long-term buy-and-hold investors. If you plan to hold most of your investments through multiple market cycles, you’ll want to do whatever you can to make sure your portfolio doesn’t get wiped out by one event or sector correction.
But diversification isn’t just about rebalancing by sector. At its best, diversification limits your exposure to any type of broad market influence, whether it’s a downturn in a specific sector, rising interest rates, a foreign political crisis or a totally unforeseen event.
Right now, rising interest rates are on most investors’ minds. You may know that rising rates will be bad news for bond funds, which will be stuck holding low-yielding bonds that depreciate in value as newer, higher-yielding bonds become available. But you should also be aware of the effect rising rates could have on other segments of your portfolio. REITs, utilities and other companies that carry a lot of debt will see their borrowing costs rise as interest rates climb. Preferred stocks will likely see some declines, and leveraged closed end funds and other funds will have to adjust.
But there are several industries and asset classes that will benefit from rising rates, and diversification can mean making sure you have appropriate exposure to these investments in your portfolio as well. This month, I’m adding a regional banking giant to the dividend growth tier of our portfolio to increase our exposure in that direction. Insurance companies are also beneficiaries of rising rates, and fund and fixed income investors will want to take a look at floating-rate securities and funds.
You can protect against other macro trends in the same way. The rising dollar is bad news for U.S.-based multinationals, but good news for international companies with significant U.S. sales, as well as domestic utilities. Rising consumer spending and lower unemployment have both meant bad news for interest rate-sensitive investments recently, but they’re great news for consumer discretionary companies. A sufficiently diverse portfolio can balance the negative and positive effects of things you can’t control.
Diversification as Protection Against Ignorance
There is such a thing as too much diversification. Warren Buffett has said, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
Many investors take diversification to an extreme, investing only in broad index funds because they believe it’s impossible to beat the market. Others buy so many stocks that their own portfolios begin to resemble index funds. But the more your portfolio starts to look like the broad market, the closer your returns will be to average. That’s fine if you’re happy matching the indexes, but not if you want to be above average.
In other words, even though diversification will help you limit risk by offsetting losing positions with winning positions, the opposite is also true—losses will offset gains and reduce returns.
If you know which way macro trends are going, weighting your portfolio toward the beneficiaries will generate better returns than balancing both sides. However, investors who were preparing for rising interest rates and rapid inflation in 2011 found themselves on the losing side of the trade for much longer than they anticipated. In fact, the difficulty of predicting the timing of major trends and macro conditions is the best argument for using diversification to offset exposure to things you can’t control, rather than trying to take advantage of them.