The key to understanding the importance of diversification lies first with understanding risk. There are two types of risk when it comes to investing. If you’ve ever taken a finance or statistics class you’ll likely remember learning about unsystematic vs systematic risk. Understanding their differences helps investors maximize their investment returns. As advisors, it’s key to helping our clients get the most “bang for their buck”. This article will discuss what unsystematic vs systematic risk is, and how diversification can help you get the most out of your investment portfolio.
Unsystematic vs Systematic Risk
From an academic perspective, unsystematic risk is “diversifiable”. Meaning, it’s the risk that can be diversified away by constructing a portfolio of securities that at a basic level, are different or non-correlated. For example, if an individual had a portfolio of only Amazon stock, the portfolio carries a large amount of unsystematic, or diversifiable risk. The portfolio isn’t maximizing returns for a given level of risk because there’s the risk that can be taken away simply by adding another stock to the portfolio. By selling half of the Amazon stock and purchasing Disney stock, the investor reduces their unsystematic risk because their portfolio now contains two different companies, in different sectors, with different financials etc.
On the other hand, systematic risk is the risk that can’t be diversified away. For example, investors can’t control the overall market and its fluctuations on a day-to-day basis. We can’t control interest rates and whether they will go up or down. And we can’t control inflation. These are just a few of the examples of risks that aren’t under an investors control.
The goal of an investment manager is to diversify away all the unsystematic risk in a portfolio by adding securities that are essentially “different” in order to maximize the return for a given level of risk. The given level of risk should align with the investors “tolerance” for their investments to decline in value, and their need to achieve a particular return for stated goals. Part of our financial planning process involves understanding what level of risk our clients are comfortable taking, and what risk may be necessary in order to achieve the goals they’ve discussed with us.
Why Diversification Matters
Now you understand the basics of unsystematic vs systematic risk, let’s focus on why diversification matters. In our previous example, an individual’s entire portfolio consisted of Amazon stock. That individual also is employed at Amazon and receives a salary in addition to the stocks awards he receives as part of his compensation. From the individuals perspective, they may not see the risks the associated with their current financial situation. His cash flow and stock assets all come from his employer. If an unfortunate situation occurred where he lost his job, or a disabling accident occurred, his entire financial situation would be upended.
Alternatively, if he sold his Amazon stock, and invested in a diversified portfolio of ETF’s and index funds, he’d have a much safer cushion to fall back on if access was required to those funds.
But what if Amazon’s stock is rocketing upwards and I like the investment?
While Amazon has had a historically great run, it’s not to say that a diversified portfolio wouldn’t do just as well when compared to the majority of other individual stocks. Just because a particular stock is up 20% year over year, doesn’t mean the rest of the market isn’t either. If you invested in an index fund of the S&P 500 last year, you would have earned roughly 21%. Meaning, on average, the 500 companies that make up the index performed at 21%! You can achieve that return by diversifying your risk across all the companies rather than one, which reduces your risk of achieving a lesser return.
Diversification reduces the volatility of your overall portfolio. As you can see in the picture below, in general, asset classes perform and experience different stages of the market cycle at different times. In the case of 2008, the last market recession, a diversified portfolio was down on average 26% compared to large-cap growth stocks (S&P 500) which were down 38%. As you can see, a diversified portfolio consistently performs in the middle of all asset classes.
Why diversify though if I know that won’t achieve me the highest returns in any given year?
Over time, the compounding of consistent returns and reducing the volatility of a portfolio can POTENTIALLY result in a greater portfolio balance than if you invested in only one asset class. We say potentially because every investor is different and past performance does not guarantee future returns. If you’re comfortable investing in stocks only, your method of diversification may be through owning stock in different sectors, market caps, and geographical locations to name a few.
The key takeaway is diversification helps take the unknown out of trying to pick the best performing asset class on a year to year basis, and instead focuses on maintaining consistent, less volatile, and somewhat predictable returns over long periods of time.
In the process of building wealth, taking calculated risks through concentrated positions isn’t necessarily a bad thing as long as you understand the risks! In fact, many of the world’s richest people earn their wealth through concentrated positions in their own business, or a particular stock. However, for the vast majority of people, it’s not feasible, nor can they tolerate the risk involved with such investments. If you can’t sleep at night because you’re worried about all your hard earned money being reduced by 10% (defined as a market correction, and are a natural part of the market cycle) what’s the point? That’s not healthy. Having a diversified portfolio that allows you to sleep, CAN grow into significant wealth with time, compounding, and discipline. Probably not Gates or Bezos type wealth, but enough to achieve the goals and life you envision if you take the steps necessary to achieve them.
Managing risk, diversifying your portfolio, and knowing what’s needed to reach your goals, are all part of our financial planning process. If you have questions about how your portfolio is currently constructed, how much unnecessary risk you may have, or need help defining and tracking your goals, schedule a free consultation with us today.
Levi is the Co-Founder, Financial Planner of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!