Ask everyday investors what it means to craft a diversified portfolio and you’ll likely get a mixed bag of, well, diverse responses. Conversations about diversification often get lost in translation.
It’s very much akin to how consumers in various regions of the country may think about what kind of soft drink they’d like to have with their lunch. It’s a “soda” choice for consumers in the Northeast, or on the West Coast. It’s “pop” in the Midwest. Or how about a “Coke” in the deep South? That could mean a variety of sodas or the original Coca-Cola. It’s the same with diversification of investing portfolios. It can mean different things to different people.
[Sign up for stock news with our Invested newsletter.]
For starters, 25% of Americans say they do not have an opinion on whether their investments are diversified, according to a 2019 CNBC-Morning Consult survey of 2,200 adults throughout the U.S. The same survey also revealed that more than four in 10 Americans do not actively monitor their portfolios to make sure their investments are diversified. Only about 34% said they do review their investments for diversification.
If there’s one thing that many investment portfolio managers agree on, however, it’s that diversification is important. Here are some key points about why that is and how the traditional model of a diversified portfolio may be changing:
— Where did the diversification concept come from?
— Diversification among asset classes.
— Portfolio planning for both the short and long term.
— Portfolio composition may be changing.
— Diversification reduces the pain of losses.
— How employer plans encourage diversification.
Where Did the Diversification Concept Come From?
The concept of diversification is formally ascribed to the work of U.S. economist Harry Markowitz. In 1952, he penned an article for the Journal of Finance titled “Portfolio Selection,” in which he argued that investment risks and rewards are equally important for portfolio design. Markowitz was later awarded the Nobel Prize for his development of the Modern Portfolio Theory.
Common asset classes, like cash deposits, bonds and equities, inherently possess potential risks and rewards for investors. Portfolio diversification often includes more than just one type of investment to help investors buffer downside risks and potentially reap the rewards from multiple investment sources as they manifest over time.
“The past few years have been extremely volatile. As we watched markets rip back and forth, we were reminded of the importance of not keeping all of our eggs in one basket.” – Daniel Oldroyd, head of target-date strategies for J.P. Morgan
Informally, diversification is often linked to the basket-and-egg proverb, which can be traced back to Miguel de Cervantes’ novel “Don Quixote”: “To withdraw is not to run away, and to stay is no wise action when there’s more reason to fear than to hope; ’tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.”
Diversification Among Asset Classes
So far, diversification among a variety of asset classes has been a winning strategy for patient investors. Fidelity estimates that a hypothetical balanced allocation of 40% in bonds, 35% in U.S. equities, 15% in international equities and 10% in short-term securities (e.g., money-market funds
and certificates of deposit) would have provided investors with an average annual return of about 8% from 1926 through 2021.
What’s equally striking are the market swings and snapbacks this balanced portfolio would have experienced during this period, like a 12-month downturn of -40.6% and a rolling, 20-year positive return of 13.8%.
Portfolio Planning for Both the Short and Long Term
“It’s also important to remember that in the short term, there may be times when a diversified portfolio is challenged, (and) we believe the key benefit of diversification is striking the right balance between risk and return and building a portfolio that can lessen the impact of market shocks in certain asset classes,” says Chris Anast, chartered financial analyst and senior retirement strategist within the institutional analytics group at Capital Group, home of American Funds.
No one really knows what the future holds, either in terms of how long they might live or what market performance will be, especially in the short term. What is clear, however, is that people usually aren’t factoring in market performance when choosing their retirement date, says Daniel Oldroyd, chartered financial analyst, portfolio manager and the head of target-date strategies for J.P. Morgan. “This highlights the importance of managing risks from both long- and short-term perspectives.”
Portfolio Composition May Be Changing
What goes in the basket of investments, and what’s left out, are currently under significant review among institutional investors, however. Eight in 10 institutional investors, such as government and private pension consultants and portfolio managers for endowments, say that portfolios must evolve to keep pace with a changing world, according to data from a 2023 global institutional global survey conducted by Nuveen.
For example, beyond allocations to common investments, like U.S. equities and global bonds, institutional investors say they are taking a hard look at alternative options, such as private debt and equity (72%) and infrastructure (71%) to potentially boost performance in the coming years.
Diversification Reduces the Pain of Losses
Still, in the background, it’s the avoidance of undesirable outcomes that helps shape why diversification matters to both individual and institutional investors. Take, for example, the psychological impact of a loss. In their research article titled, “Prospect Theory: An Analysis of Decision Under Risk,” behavioral scientists Daniel Kahneman and Amos Tversky revealed that the pain of loss is psychologically twice as powerful as the pleasure of a gain.
This is a cognitive bias called loss aversion, and it may help explain why, according to Morningstar, investors yanked $370 billion from U.S. bond and equity mutual funds and exchange-traded funds, or ETFs, as the market plummeted in 2022.
“The past few years have been extremely volatile. As we watched markets rip back and forth, we were reminded of the importance of not keeping all of our eggs in one basket,” says Oldroyd. “For example, when looking at the past two years, real estate investment trusts, or REITs, closed 2021 up 41.3%, and then ended 2022 down 24.9%.”
How Employer Plans Encourage Diversification
Target-date funds are diversified, age-appropriate investment options designed to help workplace plan participants stay on track for lengthy retirement periods. As of the end of 2022, plan participants held $2.82 trillion in TDFs, according to Morningstar.
Portfolio managers for target-date funds carefully analyze a wide range of data to create investment strategies for workplace plan participants, from prevailing risks to demographic savings and spending patterns and earnings estimates for various asset classes. “The biggest risk for retirement savers is longevity risk or running out of money in retirement. While there are a multitude of risks that savers face, they all largely connect with the overarching risk of outliving their savings,” says Anast.
Takeaway
While a diversified investment strategy has its merits, it’s not optimal in isolation. Like a frosty root beer pairs with a cheeseburger and fries, a diversified portfolio works best when it’s linked with a comprehensive financial plan. Taken together, a well-designed plan can help investors determine what a comfortable retirement looks like, and a diversified portfolio can help deliver the outcomes investors want along the way.
More from U.S. News
What Is Dollar-Cost Averaging?
Why Diversification Is Important in Investing originally appeared on usnews.com
Update 05/31/23: This story was published at an earlier date and has been updated with new information.
