What Does It Mean To Be Diversified? Here Are The Basics

What Does It Mean To Be Diversified? Here Are The Basics

Most investors know they’re supposed to be diversified (to have their money spread out into multiple asset classes) so if one stock or industry takes a fall, you’re able to weather the storm. If you aren’t diversified, it means you’re overly concentrated in a single asset class (stocks), a single sector (pharma or retail) or even a single investment (like Amazon or P&G), which would make your portfolio more susceptible to market swings, or the devastating failure of a single company.

It’s clear diversification is important, but just how diversified are we, really? A 2018 study by the Federal Reserve found that the median number of stocks held by individual investors was just three and a more recent study on stock diversification by the National Bureau of Economic Research (NBER) showed that many people don’t appreciate the benefits of diversification in their investment decisions. In the study, participants often overweighed individual stocks they perceived as high-quality (i.e. they held more of them than they probably should have) even when they had information indicating that a more diversified portfolio would perform better.

The truth is, we all have financial biases based on our past experiences and money histories. We may have strong loyalty to certain companies like the company we work for or the stock a grandparent gave us, or a strong dislike for others. But when it comes to diversification, we can’t let our emotions lead us.  “Basically, diversification means not putting all your eggs in one basket,” says Paul Kandel, a senior vice president and portfolio manager at Morgan Stanley. “I love chocolate ice cream. But I don’t only eat chocolate ice cream.”

Diversification Is Not Just About Assets or Industries

Portfolio diversification goes far beyond asset class, it even goes beyond sectors or industries. It can also involve having holdings across varying geographies (domestic, foreign), styles of investments (growth, value), size (small cap, mid cap, large cap) and industries (biotech, automotive, online retail, etc).

“[Prior to and in the beginning of the pandemic] we just loaded up on technology stocks,” Kandel says, “and then the market changed dramatically. What was really good for a while became really bad. It’s rare that all parts of your portfolio are always going up, and diversification allows you to get by when they’re not. You want to make sure that you have some holdings that can be offset, so that while some parts of the market may be descending, others are ascending.”

This is an important lesson, he notes, whether you’re new to the stock market or you’re a long time investor.

So, How Much Diversification is Enough?

While you can diversify by owning individual securities in different sectors of the market, beginners are generally best off with an ETF (Exchange-Traded Fund) or a mutual fund. (Note: Index funds also count. They’re a type of mutual fund that tracks a particular index like the S&P 500.)

“ETFs and mutual funds are in some ways very similar, but they do have some differences,” Kandel says. “They’re similar in that they are both a collection of stocks that are designed to replicate either a sector, an industry, or an investing style. So, the fund could be in semiconductors on a sector level. Or it can be technology on an industry-level. Likewise, it could be a large cap value fund on an investing level. Generally, if you are investing in ETFs or mutual funds, and have between five to ten of them, that’ll get you sufficient diversification because each ETF or mutual fund can have anywhere from 25 to 300 holdings. Once you start getting over ten of them in a portfolio, you’re not really getting any additional diversification from what you already have.”

One difference between an ETF and many mutual funds is that ETFs and index funds tend to be passive. Meaning that they’re designed to basically replicate the performance of a singular benchmark, such as the S&P 500 or the Russell 2000. There are even indices that represent the total stock or total bond market. But if you want to be more hands-on and prefer active investing, then you want a mutual fund with a manager whose job it is to beat a particular market benchmark. Note: ETFs tend to be a little bit more tax-efficient than mutual funds (including index funds) because mutual funds are forced to distribute their gains to their shareholders.

The Importance of Rebalancing

If you’re managing your own holdings, even if you’re in funds you don’t plan on trading, it’s still important to rebalance your portfolio periodically. Let’s say you start with $10,000 and have it in four equal pots of large-cap stocks, mid-cap stocks, small-cap stocks, and because you’re willing to take a little risk, emerging market stocks. You start with $2,500 in each pot.

After a year where the equity markets rise, you now have $4,500 in large-cap holdings, $3,000 in mid-cap, $2,500 in small-cap and $1,500 in emerging markets for a total of $11,500, a 15% increase in your first year. Well done. The problem is that if you were pleased with your 25% investment ratios when you started, now they’re all out of whack.

You don’t necessarily have to rebalance to get your holdings evenly matched again (with exactly $2,875 in each pot) but you should consider it, or you need to take the information you learned over the past year to perhaps change the areas of your diversification.

“At a minimum,” Kandel says, “an investor should rebalance at least once a year and make sure that they’re comfortable with the weightings. If you set your allocations and don’t do anything for a couple of years, and you have one group that does really well, you’re going to have a lot more exposure to that group than you initially wanted, so you’re not getting the balance that you thought you should have. If you’re an active investor, you may want to consider rebalancing more often. Maybe quarterly. It doesn’t necessarily mean you have to make any changes, but you should at least take a look and make sure that the allocation is what you were planning for and aiming for.”