There is only one free lunch in investing: diversification and a diversified portfolio. When thinking about how to invest one’s money, most people think about which stocks to buy- in the sense of the hot tips of today and the potential stars of tomorrow. Less thought is put into building a robust portfolio that will stand the test of time: policy changes, changing economic conditions, emerging new technologies, and deprecated business models can all impact individual investment performances.
There is no way of predicting the future. Instead of relying on luck, there are ways to improve your odds: the magic word is diversification. With this article, we try to give you the basic knowledge for creating a robust, diversified portfolio.
Performance of single Stocks
Let’s start with a look at the performance of single stocks. Imagine you are back in 1990 and choose a stock to invest in. We could have selected Procter & Gamble. Or Goodyear Tire & Rubber Co., Or maybe split the money and buy both.
Look at how our investment would have unfolded during these 31 years.
Above graph shows the cumulative monthly returns. As we can see, Procter & Gamble would have been a good choice- you would have made a 39x! With Goodyear, however, things wouldn’t look so bright: a meager 1.9x. Keep in mind that this are real returns: the results are adjusted for stock splits, dividends and inflation (however tax and trading fees are not considered).
With the knowledge of 1990, there was no way of forecasting which stock would thrive- and which one would wither. If we had bought both stocks, the resulting returns would look like the green line- each dollar invested would have brought 20. Less than PG alone, but way better than GT. If back in 1990 we would have had the choice of buying only PG or only GT or both of them 50:50- the latter would have been a rational choice.
Stocks, Sectors and industries
Both Companies operate in very different industries: Procter & Gamble produces household & personal products, part of the so called non-cyclical “Consumer Staples” sector. Goodyear, as part of the auto components industry on the other hand, belongs to the “Consumer Discretionary” sector. Companies belonging to different sectors tend to behave differently to changing economic conditions, like a growing/ shrinking economy or rising/falling inflation.
Thus it makes sense to diversify your investments into different sectors, and different countries/ regions of the world. You can find the full Global Industry Classification Standard online, providing a full taxonomy for most companies you can buy stocks of.
Admittedly, this is a very simplified example, but lets start easy and increase complexity while we move on. As you can see, by diversifying we reduced the volatility of the overall portfolio, and the risk of choosing the wrong stock and thus losing money.
From individual stocks to indices
What if we look at a basket of stocks? For example let´s have a look at the Standard & Poor´s 500- a very broad stock index covering the biggest companies in the US. Let´s have a look a it´s 30 year performance (compared to above mini portfolio of PG and GT):
We can see two effects: compared to the mini portfolio, the S&P 500 returns are lower (around 13x). While the curve looks somewhat smoother, in general both graphs look very similar in their ups and downs. Why is that? Shouldn´t be 500 individual stocks enough to smooth out the effects of thriving and withering companies?
We can see two effects: compared to the mini portfolio, the S&P 500 returns are lower (around 13x). While the curve looks somewhat smoother, in general both graphs look very similar in their ups and downs. Why is that? Shouldn´t be 500 individual stocks enough to smooth out the effects of thriving and withering companies?
Diversifying Asset Classes
All stocks belong to an asset class called equities. In fact, by buying a stock you buy a fractional ownership issued by the company. Stocks in general have a pretty high correlation with each other- as a simplification they move up and down in a quite similar fashion. While it would take another full article to explain correlation and how it affects diversification (and we will publish one in the future), for now it should suffice that the stock markets in general behave somewhat similar. Especially during “stock market crashes”- pretty sharp corrections of an index- stocks in general lose a lot of their value in unison. Look at the down spikes in above picture in 2000, 2008 and early 2020.
So, what are other asset classes besides equities? A short and incomplete list:
- Fixed Income (Bonds, TIPS)
- Commodities (basic goods like oil, gold, wheat, soy, …)
- Real Estate (in an exchange-traded form like Real Estate Investment Trusts)
- Currencies
- Cryptocurrencies
Lets have a closer look at some of those asset classes and if they behave differently from equities. Again we plot inflation adjusted data- this time we can see a different picture.
There are assets that have negative correlation (one goes up, the other down and vice versa): see Bonds and Commodities (especially from 2014 on).
We also see assets that seem to be uncorrelated (see Commodities and TIPS) and we see assets that have a high correlation (see Bonds and Equities).
A heat-map of those assets correlations gives a clearer impression. High correlation is represented by values close to 1, High negative correlation to -1. Non-correlated assets are between zero.
One important thing to note: those correlations are not static, they change over time due to different economic conditions and vary depending on the time frame you look at it. A century-long set of yearly data will give different correlations than a “last six months daily data” set. If we want to use correlation as a tool when constructing a portfolio, we have to apply the same time horizon to both the strategy and the historic correlation.
Further Diversification
All asset classes follow the same logic we already outlined for equities: you can break them further down: for example commodities can be split into groups like
- Industrial Metals (e.g. Aluminium, Copper, Nickel)
- Precious Metals (e.g. Gold, Silver, Platinum)
- Energy (e.g. Crude Oil, Gasoline, Natural Gas)
- Grains (e.g. Corn, Soy, Wheat)
- Soft (e.g. Cotton, Coffee, Sugar)
- Lifestock (e.g. Hogs, Cattle)
Other asset classes like bonds can be split by the issuer (governments or companies), some asset classes can be split regional like North America, South America, Europe, Asia-Pacific, Africa) or even by country.
Another important aspect is diversifying your strategies and/ or time frames. The same “not all eggs in one basket” logic can be applied to use different investment/ trading strategies. You can segment your portfolio into different parts where you buy and sell based on different principles. One could be following a short-term strategy, focusing on quick trades. Another could be long-term investing, based on macro trends. As different strategies tend to perform differently through time and changing conditions, you should also keep this in mind when building and maintaining a diversified portfolio.
Putting it all together
Because we don’t know the future, it makes sense to diversify through all those aspects. Diversification reduces the impact of adding a foul egg to your investment basket- by just using many different baskets.
By combining assets that behave differently in changing environments, you can reduce the volatility of your portfolio and smooth your returns. While you will miss the stellar returns of the one to-the-moon tech unicorn (would you have identified and bought it soon enough?), a company going bust will not zero out your whole portfolio. By owning many different assets, you reduce the impact of each asset-specific risks to your portfolio.
In one of the next articles we will pick up from here and explain how to utilize this knowledge and actually construct a portfolio.
If you have additional questions or feedback, please leave a comment or drop a mail to feedback@6xfreedom.com
