Diversification: A $500k Example
Diversification: A $500k Example
You’ve heard the word, we all have. Diversification. It has been called “the only free lunch in investing” by Harry Markowitz, the Nobel prize winning economist. But what is truly behind its importance, beyond clichés such as: don’t put all your eggs in one basket?
To explore, let’s suppose someone has just received an inheritance to the tune of $500,000. Turns out this person (we’ll call him Jim) is far behind in his goal for financial independence, so he decides not to spend a dime of this inheritance and instead invests it all.
Jim decides to be aggressive with this investment and uses it all to buy shares in one stock. It’s a tech company, and he saw it recommended in an article who referred to it as a ‘growth stock’. So there it is, Jim has his entire investment portfolio in one stock. But of course, this isn’t just his investment portfolio, this is his future. His quality of his life 10 years down the road is now completely dependent on one company. Even if we give Jim the benefit of the doubt and assume he researched the company before investing, that doesn’t change the extreme level of risk he has taken on. No matter how promising the company’s product is and how strong its fundamentals are, there is simply no telling what tomorrow will bring, let alone what years down the road will bring.
So, instead of investing $500k into one stock, suppose he had put $250k each into two stocks. It’s another promising tech stock, so his potential for growth hasn’t necessarily changed, but his risk has considerably been reduced. Don’t get me wrong, the risk is still high, but lower than it was before without sacrificing growth potential. When he was invested in one stock, if it goes belly-up, so does he. When he’s invested in two stocks, what are the chances both go belly up? Still possible, but less likely.
Now we can take that same logic and apply it further. Instead of two stocks at $250k, he decides to invest $100k into 5 stocks. Again, he has chosen all growth stocks, so the growth potential remains, but the risk has yet again been decreased. Could all 5 go belly up? It’s still possible, but chances are considerably lower.
After a lot of thought and consideration, Jim finally decides to invest $10k each into 50 different stocks. All well researched, all with strong fundamentals. His 50-stock portfolio has dramatically lower risk than a 1-stock portfolio. And yet, because he has chosen all growth stocks, his growth potential is still high. In other words, he has reduced risk without substantially sacrificing potential return.
This isn’t just diversification for the sake of diversifying, this is diversification with intent. He wanted an aggressive portfolio with high growth potential, but also wanted to lower the risk as much as he reasonably could. The portfolio still contains high systematic risk, and could drop significantly during a recession. But he has substantially reduced unsystematic risk. He is no longer dependent on the performance of one particular company. Bear in mind, he has chosen all growth stocks. He still lacks diversification in the context of sectors and asset classes, but diversification into these areas could come with lower return potential, which doesn’t align with his goals.
I’ve heard before that some people, in order to diversify, simply put in equal dollar amounts into each of their 401(k) available funds, with no thought whatsoever on what those funds are invested in, and how that relates to their particular goals. This is an example of diversification without intent, without a plan. Probably better than sitting in cash, but it has vast room for improvement.
Diversify with intent, to reduce risk, to pursue your particular goals; don’t diversify just to say you diversified. Do that, and you have gotten the only free lunch available in investing.
Are you not sure if your investments are diversified with intent? Reach out to me for a review of your portfolio and I’ll happy to share my thoughts.
Ryan Page, CFP®, MBA®
Office & Text:720-826-1092
The opinions voiced in this material are for general information only and are not intended to provide specific advise or recommendation for any individual.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
