Broken Windows and Diversification

Have you ever wondered why diversification in your portfolio matters?

Before we answer the question, have you ever heard of Michel de Nostradamus?

Nostradamus was born December 14, 1503 in Saint-Remy, France during the Renaissance. He was a physician and an astrologer, and was regarded for his insight and ability to foretell what the future held. In 1547, he began making long-term predictions, which were published in his 1555 book entitled Les Prophesies. This 16th century seer gained fame when he seemingly predicted pivotal events in world history that purportedly occurred centuries later.

In the markets, there is no sage who can accurately predict individual company related factors, industry trends, world occurrences, supply and demand, investor sentiment or government actions with pure exactness. Markets change in real time based on many factors affecting stock, bond and other asset prices. Prediction is of questionable value unless its degree of accuracy and regularity is known with precision.

So, what does Nostradamus have to do with diversification? It can be explained with a broken window analogy.

What happens when a baseball is thrown at a window with a single pane of glass? The entire window shatters.

Now, what happens when a baseball is thrown at a window divided into four panes of glass? Only one quarter of the window shatters.

Lastly, what happens when a baseball is thrown at a window divided into seventy-two panes of glass? Phew! Only one of the seventy-two panes of glass shatters.

The point of the analogy is unless you are Nostradamus and can also predict with precision, you never know when the baseball will be thrown, but when it happens, what type of window would you want to own? It would be a good idea to have a multi-pane window that minimizes the damage.

Diversification is a portfolio tool used to protect against market risk. For investors, one of the most important considerations is managing portfolio risk. Diversification is the practice of building a portfolio with a variety of investments that have different expected risks and returns.

Owning a broad, diversified mix of investments is “best practice” in managing a portfolio in order to lessen the impact of the proverbial baseball being thrown. Combining stocks of differing industries, countries and risk profiles, along with other investments such as bonds, alternative assets, cash and cash alternatives can reduce an investor’s overall risk. The varying asset classes work together to reduce permanent loss of capital and overall volatility. Over the long term, spreading risk across differing investments increases overall investment success.

Holding investments which react differently to the same market or economic event is why diversification matters. For example, when the economy is expanding, stocks will tend to perform better than bonds. On the other hand, when the economy is contracting, bonds tend to have better returns. When the markets move from growing to slowing, an investor can reduce their chances of losses by holding a mixture of both stocks and bonds.

Greenleaf Trust constructs diversified portfolios built on our clients’ financial plans, balancing their appropriate investment objectives along with their ability and willingness to accept risk. The market landscape is ever-changing, yet Greenleaf Trust’s adherence to diversification is built on a disciplined, long-term orientation to serve our clients well in reaching their financial goals.

Since there is no oracle known to predict with precision when a baseball will be thrown at your window, diversification matters.