The Importance of Diversification

Each summer after school gets out, we send our kids to a variety of summer camps. I vividly remember one hot and humid afternoon when I was picking up my six-year-old son Sam from soccer camp. He was happily walking along, carrying his water bottle and backpack, and gently kicking his ball. When he saw me, his face lit up. He came running over and proudly pulled a one-dollar bill from his pocket. When I asked where he got it, he told me that he sold his bag of goldfish to one of his friends. I chuckled and patted him on the head and said, “that’s great, make sure you put it in your piggy bank when you get home.” The very next day he came home with twenty cents. I asked if he sold another bag of goldfish, but he informed me that he sold two Cheetos for ten cents each. Apparently, the full bag of Cheetos was too precious to give up completely. I applauded his entrepreneurial spirit, and gently reminded him that it’s okay to share his snacks with his friends too. Over the next two weeks he attended an art camp and would occasionally come home with a nickel or a quarter, and sometimes even a dollar. Although, he complained that on days when we sent him with a healthier snack option he had a hard time finding demand for it. This is when he began making and selling his artwork to his friends. I was impressed by his drive, and even more impressed that he diversified his product mix to meet his “customers’” demand.

Diversification can be a very powerful tool when it comes to your investment portfolio. In essence, diversification is owning investment vehicles that behave differently from one another. A good example is comparing a bond to a stock. During times of economic growth stocks tend to outperform bonds, but during times of economic uncertainty bonds typically fare better than stocks. Holding riskier assets like stocks and safer assets like bonds together in a portfolio can lower volatility and provide an investor with a “smoother ride” during turbulent market events. It is important to consider a diversified asset allocation mix, as it can be customized to meet the risk/return needs of individual investors. However, in this newsletter I am taking a closer look at the diversification benefits, specifically within the U.S. equity asset class.

As mentioned earlier, stocks behave much differently from bonds, and they also behave differently from one another. Therefore, it is beneficial to own a portfolio of stocks, rather than just a single investment. The relationship that two investments have to one another is known as correlation. If two stocks were to move in the same direction, they have positive correlation. A value of 1 represents perfect positive correlation. On the other hand, if they move in opposite directions, they have a negative correlation. A value of -1 represents perfect negative correlation. The below table is a correlation matrix comparing the five year returns of four stocks to one The Importance of Diversification Ian Estabrooks, CFA & Portfolio Manager another. The first two are Exxon Mobil and Chevron, two of the most well known oil majors. It’s no surprise that the correlation of their stock returns is 0.89. This number signals that historically the two stocks have traded similarly. There are several reasons for this. They have very similar business models, they are large-capitalization stocks, they both are headquartered in the United States, the price of oil greatly impacts their profitability. The list goes on… The next two stocks are Adobe and Microsoft, two very well known technology companies. Like the two energy companies, ADBE and MSFT also have a relatively high correlation to each other. But the correlation between the energy and technology stocks is much lower. As you can see in the matrix below, Adobe and Chevron have a correlation of just 0.23. Intuitively this makes sense as they operate completely different businesses and are affected by different factors.

But how many stocks should you own to have a well-diversified portfolio? Mathematicians have been debating this for decades, and the number seems to fall somewhere between 10 and 40 stocks, within the largecap equity space. A study by the CFA Institute suggested that diversification benefits are limited within large caps after constructing a portfolio of 10 stocks. Their research showed that the average standard deviation (measure of volatility) for a 10-stock large cap portfolio was 20%. A more diverse portfolio of 40 large cap stocks had an average standard deviation of 17%. So, adding more large cap stocks to a diversified portfolio has a diminishing impact to diversification. While this was true for largecap stocks, their research found that small cap portfolios benefit more from larger numbers of holdings. When moving from a portfolio of 10 small cap stocks to 40, the average standard deviation changed from just over 32% to 25%. The affect on the small cap portfolio was more than double that of their large-cap peers.

The takeaway is that diversification is important, but you don’t need a massive portfolio of stocks to achieve your goal. However, it does matter what stocks you pick.

It would not be prudent to own a portfolio of only technology stocks, or only energy stocks. Diversification across sectors is just as important. A well-diversified portfolio should hold stocks in most or all the 11 Global Industry Classification Standard sectors. This helps to mitigate idiosyncratic risk that can be caused by factors that affect specific industries/sectors. For example, stocks in the energy, utilities, and materials sectors are greatly impacted by changes to commodity prices, and bank stocks are affected by changes to interest rates. Each sector performs differently from one another, so it is important to achieve sector diversification. Similarly, it is also important to have diversification across different market-capitalizations. Adding small and mid-cap stocks to a large cap stock portfolio provides further diversification benefits, as they are impacted by different factors. For example, large cap stocks often do business globally, and can be affected by changes to foreign exchange rates or geopolitical challenges. U.S. small cap stocks tend to operate within the borders of the U.S. and are more insulated from global factors. The below correlation matrix shows the relationship between U.S. large cap, mid cap, and small cap. They certainly have a strong positive correlation to one another, but there is still some diversification benefit from combining them.

In conclusion, a well-diversified portfolio can help to reduce risk and improve risk-adjusted returns over the long-term. So, whether you’re hawking snack time treats to your camp buddies or building an investment portfolio, consider the importance of diversification.