How much diversification is enough? And how can you achieve it in your portfolio? Our guide breaks everything down.
Do you or your money-savvy friends ever discuss portfolio diversification? If you have investments, especially if they’re long-term ones earmarked for retirement, diversity of holdings is essential because no single investment will be on the upswing forever. A balanced portfolio allows for hedging the market when it’s great, and when it’s not so great (which we’re unfortunately all too familiar with right now).
“Basically, diversification means not putting all your eggs in one basket, says Paul Kandel, a senior vice president at Morgan Stanley. “I love chocolate ice cream. But I don’t only eat chocolate ice cream.”
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Kandel says that portfolio diversification can 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.).
“For the last few years 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 offset, so that while some parts of the market may be descending, others are ascending.”
Kandel says that diversification is important whether you’re new to the stock market or have been an investor for a long time.
So, how much diversification is enough?
You can diversify by owning individual securities in different sectors of the market, but Kandel says that beginners generally like to purchase an ETF or a mutual fund.
“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 a mutual fund that Kandel chooses to stress is that ETFs tend to be passive in that they’re designed to basically replicate the performance of a singular benchmark, such as the S&P 500. But Mutual funds, for the most part, are more skewed towards active investing – they have a fund manager – and are basically designed to beat that benchmark. That means that it could do better. Or worse. “The second difference is that ETFs tend to be a little bit more tax-efficient than mutual funds because mutual funds are forced to distribute their gains to their shareholders,” Kandel says.
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 re-balance them periodically.
Let’s say you start with $10,000 and have it in four equal mutual fund 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 of the Dow rising, 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 re-balance to get your holdings evenly matched again, with $2,875 in each pot, but you need to 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.”
Knowing When It’s Time For Professional Help
Whether you can handle diversification on your own or you need a professional money manager to guide you all depends on your level of wealth, your confidence, and how much time you want to dedicate to your portfolio.
While the typical amateur investor may have their mutual fund accounts, and maybe trade some stocks occasionally when they get a hot tip, a professional money manager is likely to be more attuned to overall market trends, better understand investments which may have beneficial tax consequences, and know about investment vehicles that the amateur investor may not have access to.
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“I think that where the professional can come in is to provide some additional products and insight that the amateur may not necessarily be aware of,” Kandel says. “There may be some diversification products that are available only through a professional. Think about things like private equity, which is generally non-correlated to the market and will give you additional diversification from the market. But an individual investor may not have access to it, or may not be able to invest the minimum amount required.”
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