Portfolio Protection, Step #3:
In my article “5 Steps to Protect your Portfolio” the third step I discuss is diversifying your investments to reduce the volatility and risk of your portfolio.
You can think of diversification simply as this, “Don’t put all of your eggs in one basket.” Instead, create a portfolio that has a variety of non-correlating assets, essentially, assets whose prices move in opposite directions. That way, if one stock or sector or style of investing underperforms, you have a fighting chance that some of your other assets will rise, ultimately reducing your losses.
Many investors pay no attention to diversification. Instead, they find a sector or industry they like and invest their entire portfolios in one place. That’s great if all of those stocks just keep going up. But the laws of nature—and the stock market—never work that way for long. Consequently, those investors eventually lose their shirts because even the very best sectors don’t rule the market forever.
The bottom line is this: By adequately diversifying your portfolio, you reduce the risk that all of your assets will decrease in value simultaneously.
Having said that, you should know that there is no perfect selection of non-correlating assets. Like all aspects of investing, the correlation of assets is subject to change over time, through different economic and investment cycles.
As a result, you should think of your portfolio diversification as a moving target. You will need to monitor it regularly so that you can move investments in and out, as cycles change. Fortunately, the major economic cycles are generally years-long.
Broadly speaking, there are three major long-term economic cycles:
- Recession ends and expansion begins, the early cycle when the stock market generally makes the most impressive gains, and more cyclical and high-growth stocks (such as small caps) typically do well.
- The Fed raises interest rates as the economy heats up. About three months prior to this, and continuing for about nine months after, we enter a mid-cycle, when returns continue to be better than average, but not as good as in the early phase. Attractive stocs begin shifting to the cyclical, high-yield investments.
- An expansion ends and a recession begins. About six months prior to the recession, stocks begin to turn flat, then begin to decline during the recession, with investors flocking to less economically-sensitive, more defensive stocks.
We’ve had a tremendous run (the early cycle) since March 2009 when the Dow Jones Industrial Average bottomed out at 6,547. After fabulous returns in 2013, this year is shaping up to be more of a stock picker’s market, yet I believe that we are still in the early stages of an expansionary period.
According to Morningstar, the best sectors in the last three years were:
- Healthcare, 30.51%
- Technology, 24.20%
- Consumer Cyclical, 24.05%
- Financial Services, 22.21%
- Industrials, 20.79%
Fast-forward to how those sectors are doing so far in 2015:
- Healthcare, 14.46%
- Technology, 12.57%
- Consumer Cyclical, 11.52%
- Financial Services, 10.83%
- Industrials, 10.83%
Since the beginning of 2015, all of these sectors remain some of the best performers, but Real Estate leads the pack for year, with a 21.10% gain so far. But looking back 5 years, the best performers were Healthcare, Consumer Cyclical, Consumer Defensive, Industrials, and Communication Services. That gives you a good idea why diversification is so important. Had you just bought only the best-performing sectors of the last five years, you would most likely be suffering some losses or, at least, not gaining as much as you might have had you been more widely diversified.
As well as paying attention to market cycles, sectors and industries, I think investors should also diversify among these groups:
- Small-cap companies, with market caps between $300 million and $2 billion
- Mid-cap companies, with market caps between $2 billion and $10 billion
- Large-cap companies, with market caps more than $10 billion
- International stocks
- Growth stocks
- Value stocks
- Dividend-paying stocks
- Fixed-income investments
The percentage devoted to each of these investments will greatly depend on your personal investment style and risk profile, as well as how soon you will need the money you are investing. Please take my Investor Profile Survey if you would like to determine your risk tolerance. But during different economic and market cycles, investors may want to focus on moving a larger percentage of their portfolios into those companies that tend to gain during those particular periods of time.
