Diversification, or spreading risk between different assets, is a key concept in the world of investing.
This practice can help manage volatility because not all stocks move the same way when the broader market swings. It also prevents a big drop in a single security from inflicting major damage on an account. And perhaps most important, diversification can reduce the kind of bad emotional reactions that happen when accounts swing in value.
There’s no one-size-fits all approach to diversification. However, investors can make better choices partly by considering these three factors:
- Trading and investment goals
- Risk tolerance and personality
- Time frame
Pick the Right System For You
All traders and investors have the same goal of growing their money over time. However the market offers many roads to get from Point A to Point B.
For example, a 65-year-old who recently retired and wants to live off investments will have different goals than a 25-year-old college graduate. The older investor may be more interested in capital preservation, so will diversify more. The younger saver could want higher absolute returns, so will concentrate more capital in sectors likely to appreciate.
Next the trader must look inwardly in an unbiased fashion. How much volatility can he or she can handle?
Timeframe also matters because different stocks needs different time to perform. Beaten-down value stocks, for instance, may sit for a long time before rallying. Fast-moving growth stocks can behave very differently and work over shorter timeframes.
Although a good system can reduce losses, at a certain point all investors must tolerate some bumps along the way to really grow their capital. That means all systems require a balance.
Diversifying With ETFs
Exchange-traded funds (ETFs) make it especially easy to diversify capital across stocks, bonds, currencies and commodities.
Here are some advantages of ETFs:
- ETFs can be traded intraday and do not carry the same high costs as traditional mutual funds.
- Industry group and sector diversification can be easy with ETFs because less company-level research is required. ETFs also eliminate single-stock risk.
- ETFs can allow access to global markets without currency conversion.
- Portfolio beta can be reduced. (See below.)
There are also some potential disadvantages:
- ETFs sometimes have more fees than individual stocks.
- Dividends are usually lower compared with underlying securities.
- Performance can differ from the underlying index. This is especially true with leveraged ETFs.
- Diversifying with ETFs may reduce concentration on strong parts of the market and make outperformance harder.
Diversification With Beta
Another way to diversify is to build a portfolio with less beta. This is a measure of how much a stock moves relative to a broad index like the S&P 500.
The benchmark’s beta is always 1. A stock with a beta above 1 implies that the stock is likely to fluctuate more than the market, whereas a stock with a beta under 1 moves less.
For example, a stock may have a beta of 2. If the S&P 500 falls 3 percent in a day, this stock is likely to fall 6 percent.
This also applies to an entire portfolio. Your holdings may have an average beta of 3, which means a 5 percent drop in the overall market can hammer you by 15 percent pretty quickly.
Beta and Portfolio Construction
This shows the importance of construction a portfolio carefully. What’s the average beta of your holdings? How do they interact in different market conditions? These questions can be critical to surviving volatile markets.
In some cases traders may want to take more risk by increasing beta. Regardless of the circumstances, savvy traders anticipate how stocks will behave and adjust accordingly. Even if they want to overweight a certain favorite industry group, they may want to opt for smaller size in one or two high-beta stocks.
Alternately the trader can reduce their portfolio volatility by mirroring the overall industry group with an ETF. That eliminates single-stock risk while still benefiting if their analysis is correct.
Diversification and beta are helpful tools for traders looking to regulate swings and mitigate risk. While they may not be necessary for everyone, many benefit from implementing both into their strategy. Some may find that they are being too conservative by over diversifying while others may find it less stressful. Either way, traders should at least consider diversifying with ETFs and beta.