Diversification -The Only (Almost) Free Lunch in Investing

The inventor of modern portfolio theory, Harry Markowitz, is credited with the famous quote, “Diversification is the only free lunch in investing.” However, this is not entirely true as maintaining a diversified portfolio can be emotionally difficult at times. For instance, when the S&P 500 reaches new all-time highs several times over the course of a bull market, and your portfolio is properly diversified holding not only stocks, but other assets such as bonds and alternative assets. Your portfolio likely goes up in value but may not be keeping up entirely with a runup of the stock market. You may be thinking, “Why hold anything else other than the largest U.S. stocks?” Looking back can make diversification look unnecessary and possibly provide some regret – knowing you could have owned more of the assets providing the highest returns possible.

The key is to remind yourself the performance of asset classes could have been different in the past and performance will be different in the future. No single person can predict with perfect accuracy how markets will behave in the short term nor with consistency. Markets are constantly evolving and adapting in ways we are unable to foresee. Diversification requires an investor to hold assets not in favor, or expect to always perform well, yet is a key tenet of portfolio construction and managing risk in a portfolio.

With the recent recovery of the stock market, this is an opportune time to reassess the diversity of your portfolio. The S&P 500 index had a total return of 26% during 2023 and has continued the climb in 2024 with an additional 5.5% total return as of this writing. Digging into the return figures shows over 70% of the index’s 2023 total return can be attributed to companies in just two economic sectors – information technology and communication services. Companies from the other nine economic sectors in the index returned a combined 7.6%. An undiversified stock portfolio holding stocks only in information technology or communication services would have outperformed the market during this period. Alas, a portfolio not holding stock in either sector would have soundly underperformed the market by a wide margin. It is very difficult to know which stocks, or even asset class, will be in and out of favor for a particular year.

Diversification serves as a defense mechanism during rising and falling markets and combined with differences in performance across assets, further highlights its importance. It can reduce a portfolio’s overall risk and produce more stable returns over time if done sensibly. Investment outcomes will always remain uncertain and experiencing market recessions will be normal for the long-term investor, with diversification as the main fundamental risk-management strategy you can employ in your portfolio. Four areas to consider when creating a diversified and durable long-term portfolio include your financial goals, asset allocation, asset class selection, and portfolio rebalancing.

Financial Goals

Strategically identifying short and long-term financial goals is essential for investors to establish appropriate time frames for their achievement. Typically, short-term goals require lower risk tolerance in investment portfolios, while long-term goals can accommodate a higher level of risk. Short-term goals, like saving for a family vacation or buying a new vehicle, usually need safer, less risky investments to protect your portfolio. Long-term goals, such as retirement savings, can withstand more risk because there is typically a longer time horizon to recover from any losses while being invested in the markets. Utilizing portfolio diversification serves as a critical tool to merge these differing goals, reducing the risk of falling short due to either being overly conservative or excessively risky in the portfolio.

Asset Allocation

Asset allocation is a fundamental aspect of investment strategy, aimed at balancing risk and return. The optimal allocation should be based on your goals, risk tolerance, time horizon, and diversification. Common asset classes to be considered for inclusion in the portfolio include stocks, bonds, alternative assets, and cash. Investors with longer time horizons and a higher risk tolerance would benefit from having a larger allocation to stocks, while those with shorter time horizons and lower risk tolerance may lean more towards bonds and cash. We believe asset allocation is the primary driver of long-term investment performance.

Asset Class Selection

Asset class selection is a crucial aspect of portfolio construction, and within each asset class, diversification is essential to manage risk effectively. Diversification within stocks involves diversifying across sectors, industries, geographies, and company size. For bonds, investing in a mix of government, corporate, or municipal bonds, with varying maturities or credit qualities is appropriate for diversification. For example, each asset class in a portfolio is expected to exhibit different risk and return characteristics and perform differently during any period in a market cycle.

Portfolio Rebalancing

Portfolio rebalancing is a critical component of maintaining diversification and risk mitigation. This process involves restoring asset classes to their target allocation percentages within a portfolio and provides a systematic approach for adjusting a portfolio rather than reacting to short-term market movements. Asset classes tend to perform differently under different market conditions, and fluctuations in markets can cause asset classes to deviate from their intended allocation, leading to unplanned exposure to risk. Managing risks and rebalancing prevents overexposure to assets experiencing recent growth and possibly overvalued, ensuring your portfolio remains aligned with achieving your goals and can enhance risk-adjusted returns over time.

Portfolio diversification is a cornerstone principle of risk management and successful investing to achieve your short and long-term financial goals. Spreading investments across different asset classes can potentially enhance portfolio returns and reduce overall portfolio volatility. While diversification cannot eliminate all risk of losses in a portfolio, it can help you withstand the inevitable volatile market conditions and reduce the impact of negative events on your portfolio’s overall performance. Effective portfolio diversification requires thoughtful planning and ongoing monitoring to ensure a portfolio stays aligned with your goals, risk tolerance, and time horizon.

With recent technological advancements, geopolitical uncertainties, the upcoming U.S. presidential election, and shifting market trends, staying disciplined and maintaining a diversified portfolio can provide you with the necessary resilience and flexibility to navigate through various market cycles and environments. There is no one-size-fits-all approach to diversification as each individual or family must take into consideration their own unique and special circumstances, while incorporating this strategy as part of their entire financial plan to achieve their goals and make their plan a success. Portfolio diversification plays a major role in our mission at Greenleaf Trust as we create comprehensive investment solutions helping our clients reach their goals using thoughtful portfolio construction with a long-term perspective and disciplined approach to investing.