“A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts,” said Princeton economist Burton Malkiel in his book A Random Walk Down Wall Street. Rather than an insult toward experts, Malkiel demonstrates just how futile picking individual investments can be, even when they’re believed to be strong investments. And it shows just how crucial portfolio diversification is for investors of all levels. Why? By diversifying a portfolio among and across asset classes in effective ways, an investor can lower unnecessary exposure to risk and ultimately build a potentially more profitable investment portfolio.
Despite the benefits of diversification, the portfolios of many individual investors are missing vital components of this investment strategy, which can leave their portfolio holdings more concentrated, and therefore exposed to greater risk than they realize. In this article, we discuss the fundamentals of investment portfolio diversification and actionable ways to add meaningful diversification easily on the individual level.
- What is Diversification
- Why is Diversification Important?
- Ways to Diversify Your Portfolio
- Standard Diversification: Modern Portfolio Theory
- Investment Portfolio Allocation According to Modern Portfolio Theory
- Where Modern Portfolio Theory Comes Up Short
- Advanced Diversification: The 20% Rule
- Alternative Investments in the Private Market
- Next Steps
First, let’s examine the principles of diversification and why it exists.
What is Diversification?
Diversification is a risk management strategy used to reduce the risk of an investment portfolio. All investments involve some degree of risk, but some have more than others, and some have different types of risks than others. By making a wide range of investments in securities within and across asset classes with low or no correlation, an investor can reduce their concentration of similar investments, and exposure to unsystematic risk or volatility that they share. To understand that fully, let’s break down a few key components a bit further.
- Securities: A security is a passive investment of money in a common enterprise with the expectation of profits (debt, equity, or otherwise). Generally, stocks, bonds, and other financial instruments that are bought and sold are considered to be securities.
- Asset classes: An asset class is a group of securities, which share similar characteristics and behavior. Investments within the same asset class can be prone to the same risks. However, there is a lot of range within an asset class, which is why it’s possible to diversify investments within an asset class. Asset classes can be broken down further into subclasses, and as classification becomes more specific, levels of similar characteristics and behaviors become more concentrated.For example, a real estate investment can earn returns through a debt investment, such as a loan, or an equity investment, such as a home purchase. Regardless of whether the investment is publicly traded or privately held, the investment earns money the same way. Generally speaking, a debt investment can earn yield interest, and equity investments can return appreciation. However, the returns that investors receive – and the risks they incur – can vary based on the structure of their investment. An investor could invest in real estate through a publicly traded mutual fund, and also invest through a non-traded REIT. Each investment provides exposure to real estate, but each one is based in a different market, which means that they experience different market dynamics and their own individual sets of risk.
- Correlation: Correlation measures the degree to which the performances of investments are related to one another. If investments move in the same direction to the same degree at the same time, they’re considered to have a perfect positive correlation. If they move in opposite directions to the same degree at the same time, they’re considered to have a perfect negative correlation. Not many investments have a perfect correlation, but it’s common for investments to have high, low, or no correlation. In general, the more investments within a portfolio with low or no correlation, the more diversified it is.
- Unsystematic Risk (also known as specific risk or diversifiable risk): This is risk that is specific to an asset class or subset, rather than to the financial system as a whole. This could include risk that’s specific to a company, sector, industry, market, or another division within the financial system. The risk of loss posed by unsystematic risk for an investment portfolio can be mitigated by diversifying into investments that aren’t subject to the same unsystematic risks.
Why is Diversification Important?
Because risk reduction is at the heart of the principle of diversification, it’s important to understand which types of risk diversification can reduce, and how reducing risk can impact a portfolio’s wealth-building capacity. Diversification can help lower exposure to the risk of loss, which ultimately can improve the stability and earning potential of an investment portfolio. For most investors, diversification helps them build a strong portfolio for retirement savings. Some may want risky investments as part of their retirement plan, but most are seeking out the most stable, and reliable way to plan for their future.
Each kind of risk that investors face generally falls into two major categories: systematic risk and unsystematic risk.
As previously discussed, unsystematic risk is diversifiable, which means that exposure to it can be reduced by building a diversified portfolio of investments with low or no correlation to one another. With a portfolio of investments diversified against unsystematic risk, an investor can lower the impact of losses that their investments incur during a bad performance of a particular company, industry, or region – or during an economic downturn of a market, country or region.
Unlike unsystematic risk, which is limited to a subset, systematic risk is the risk that’s inherent to the financial system as a whole. Trends such as rising interest rates and inflation are examples of systematic risks. Beta is the measurement of systematic risk of an investment or investment portfolio in comparison to the market at large. Diversifying into asset classes with low beta may help lower the risk of some types of systematic risk. While it is not possible to diversify against the risk of an economic recession, it is possible to diversify into investments that can reduce losses in the event of the rise of interest rates or inflation. If interest rates were to rise higher, buying fixed-income assets with the capability of earning higher yields, such as bonds, could help counterbalance losses incurred by equity investments. And, an investment in hard assets, such as commercial real estate, can hedge against inflation increases.
Lowering Risk to Increase Total Portfolio Return Potential
When risk is properly mitigated through diversification, an investment portfolio’s potential to experience volatility is reduced. This makes an investment portfolio more stable, and its earning potential more predictable. Diversification can’t eliminate risk, but when structured well, a diversified portfolio enables an investor to earn better risk-adjusted returns.
Ways to Diversify Your Portfolio
Portfolio risk can be mitigated in many ways, but not all portfolio allocations are equally effective. Many investors have some portfolio diversification, but it’s often usually not as sophisticated as they believe, which can leave them needlessly exposed to diversifiable risk. Let’s look at two major diversification investment strategies, and the depth of diversification that they can provide.
Standard Diversification: Modern Portfolio Theory
Likely the most famous modern-day diversification strategy for individual investors is Modern Portfolio Theory. Modern Portfolio Theory was introduced by Harry Markowitz in 1952, using a formula that the economist developed offering investors a way to structure an investment portfolio to maximize portfolio returns for a given level of risk. In essence, Modern Portfolio Theory tries to offer a diversification method, which ensures that an investor is compensated for the risk that they take on. Some investors have greater risk tolerances than others, so Modern Portfolio Theory was created to help guide individual investors to maximize return potential according to the amount of risk that they’re willing to accept within their investment portfolios.
With greater risk, there’s usually greater reward potential. Investment portfolios structured according to Modern Portfolio Theory are measured against the risk curve of the efficient frontier, which gauges maximized return potential for a given risk level of portfolio holdings. If the investment portfolio holdings structure falls below the efficient frontier risk curve, then according to Modern Portfolio Theory, an investor is likely taking on more risk than needed to earn their expected return. There’s likely a better investment allocation available at the same risk level, which can offer a greater expected return, or vice versa, there’s a lower risk profile available at the same expected return level.
In general, this assessment is meant to help investors find the best risk-adjusted returns available at their chosen level of risk.
How are Investment Portfolios Allocated According to Modern Portfolio Theory?
Investment portfolios can be diversified for individuals based on their risk tolerance and financial goals. A mean-variance analysis of investments held within an investment portfolio, and its plot point along the efficient frontier risk curve help an investor determine how strong the allocation of their portfolio is given its target risk level. Because this formula takes weighted risk and correlations into account, it can help investors choose which asset classes and assets to invest in and how to rebalance their portfolios. It can help investors choose long-term and short-term investments, as well as investments with different liquidity levels.
To simplify this calculation, a reduced rule of “100 Minus Your Age” was developed. This rule only takes age into account, and not important factors such as financial goals or existing assets. This rule says that you subtract your age from 100, and the resulting number is the percentage of your investment portfolio that you should allocate toward stocks. The remaining percentage should be allocated toward fixed-income assets, such as bonds. For example, if you are 30 years, old, then equation would be 100-30=70. According to this rule, you should invest 70% of your portfolio into stocks and the remaining 30% into bonds. Using this scale, younger investors allocate more heavily toward riskier equity investments, such as higher-risk stocks, and older investors allocate to relatively safer income investments, such as bonds or annuities.
Where Modern Portfolio Theory Comes Up Short
Following this rule – whether closely or loosely – many investors have started index investing or “indexing”, or investing in one or a few index funds or exchange-traded funds (ETFs) containing domestic or international stocks or bonds, which track a particular index. Index investing can provide broad exposure to a market index or a smaller subsection of one. For example, an index fund or ETF could track the S&P 500 on the whole or track commodities from a specific country.
In 1998, index funds held 2.3% of all US equities. 30 years later in 2018, they own 17.2% of the market. With the rise of indexing, movement of publicly traded investments has become more correlated, which has reduced diversification potential among individual assets and asset classes that are traded publicly.
When Modern Portfolio Theory was introduced in 1952, investors faced a very different landscape across the financial markets. There were more non-correlated or lowly-correlated investment options in the public market. Since then, a number of investment vehicles, such as index fund and ETFs, have been introduced. Meanwhile, the number of stocks traded publicly has been dropping rather than growing. The number of publicly traded companies in the US peaked in 1996 at 8,090, and since then has declined nearly 50% to 4,336 in 2017. Other developed countries such as the United Kingdom, Switzerland, Germany, and France have experienced similar declines since at least 2006. So, while the number of investors has grown, the number of available investments has shrunk.
The combination of more investors, declining public investment options, and the ubiquity of index investments has made the diversification strategy behind Modern Portfolio Theory dated, and no longer capable of providing meaningful diversification among assets and across asset classes in the modern public market. Nonetheless, many investors use the Modern Portfolio Theory investment model as a stepping stone into diversification strategies. Several major robo-advisors who focus on public market investments, such as Betterment, Wealthfront, and Wealthsimple use Modern Portfolio as an investment strategy for developing the composition of their investors’ portfolios.
Advanced Diversification: The 20% Rule
The concept behind Modern Portfolio Theory – maximizing expected returns at any given level of risk by diversifying across assets and asset class with low or no correlation – is sound. However, the suggested allocation that accompanies this theory is no longer as compatible with markets as it once was, and investors can no longer adequately diversify unsystematic risk using Modern Portfolio Theory as they could decades before.
Fortunately, there have been advancements made within the past two decades to diversification strategies for investors at the individual level, which take into account new market dynamics and investment options.
Lessons from the Yale Endowment
For a 30-year period ending in 2015, the average equity mutual fund investor earned a return of 3.66%. On the other hand, for a 30-year period ending in 2015, the Yale endowment earned a 13.2% annual return. And, during periods of economic downturn, the Yale Endowment has remained largely unscathed. When the S&P fell 33% between 2000 and 2003, the Yale Endowment actually grew by 20%. During the 2008 financial crisis and its aftermath, the Endowment experienced a dip, but recovered. It experienced a large loss in 2009, but posted positive returns annually since 2010.
How was the Yale Endowment able to both boost earnings and mitigate losses?
Simply put, over the past 30 years, it has continued to branch out beyond nontraditional assets in search of alternative investments, which offer greater diversification power thanks to their lower correlation levels with increasingly correlated traditional assets, and higher earning power. In 1985, more than 80% of the endowment was invested in public market asset classes. By 2016, less than half of the endowment was invested in the public market. Due to changing the composition of its holdings, the endowment’s portfolio has experienced higher than expected returns and lower volatility than experienced by previous portfolio structures.
The allocation of the Yale Endowment is rebalanced often, but its focus on alternative investments remains consistent. The Endowment’s investment allocation relies on the mean-variance analysis of Modern Portfolio Theory, but adjusts its allocation based on its goals, time horizon, existing assets, investment options, and the shifting landscape of the investment industry, which has altered the portfolio composition needed to achieve true diversification.
Chief Endowment Officer, David Swensen, pioneered this investment model for endowment funds beginning in 1985. While this approach to advanced diversification has proven to be largely successful for Yale and other endowments, allocations may look differently for individual investors, because their wealth management needs and goals are likely different. However, the financial analysis and principles of diversification of unsystematic risk using uncorrelated assets and asset classes can be used by individual investors.
The 20% Rule for Individual Investors
David Swensen created a portfolio allocation model for individual investors, which established the “20% rule” more than a decade ago. The 20% rule says that investors should diversify at least 20% of their investment portfolio into alternatives, such as real estate. Swensen recommended a portfolio composition of:
In this model, 20% of the portfolio is invested in the alternative asset class of real estate. Allocating a large chunk of the portfolio to an alternative asset class helps provide the portfolio with useful diversification to lower the risk of volatility of a portfolio otherwise invested mainly in stocks and bonds. Swensen is not alone in his support of the 20% rule. Blackstone has also found that an investment portfolio with a 20% allocation to alternative investments is likely to perform better than one invested only in traditional investments.
While many institutional investors, including both endowments and pensions, readily invest 20% or more toward alternatives, individual investors are not as diversified. While goals, time horizons, and other factors may vary by investor, if an individual investor is a long-term one, it behooves them to seek out investments that reduce diversifiable risk in order to raise returns in up markets and mitigate losses in down markets.
Alternative Investments in the Private Market
A crucial distinction for the 20% rule is the fact that it applies only to alternative asset classes, which refers to investments with low or no correlation with traditional investments. Therefore, when investing in real estate, an investment such as a publicly traded REIT wouldn’t provide meaningful diversification, because as a publicly traded investment, it shares many of the same characteristics – and therefore risks – as other publicly traded investments. Due to this, the class of alternative investments generally refers to investments held in the private market.
The private market operates under very different dynamics than the public market. Where the public market is very efficient, the private market is inefficient due to many reasons, including information asymmetry, fragmentation, and friction – all of which can actually benefit an investor. Due to these different buying and selling dynamics, private market investments generally have little to no correlation with the performance of public market investments. Therefore, they can offer powerful diversification against unsystematic risk and, in some cases, even systematic risk. This is why they’re considered a crucial component of an advanced diversification strategy.
With the number of publicly traded companies declining, and correlation among publicly traded assets growing, it will become increasingly important for individual investors to use advanced diversification strategies to achieve useful diversification for their investment portfolios. Historically, individual investors haven’t invested in the private markets in high volumes, because these markets were heavily closed off to nonaccredited investors. This limited access to advanced investment strategies for many, and restricted access to alternative investments to all but institutional and accredited investors. However, the creation of new investment options has helped to open up the private markets to individual investors to a greater extent making advanced diversification more attainable.
Individual investors stand to gain substantial benefits, including boosting return potential while lowering portfolio volatility, by diversifying their portfolios using assets with low or no correlation. Those heavily invested in the public market are likely missing out on useful investment diversifiers in the private markets, which have the power to help investors build stronger, more weather-proof portfolios.
Likewise, those who invest in one or a few assets of a single type in the private market likely have a more diversified portfolio that those who stick to the public market only, but their private market assets share risk. For example, an investor who owns two rental properties in the same city on top of their portfolio of stocks and bonds has some exposure to the private market, but those assets share many similarities, including risks. Branching out beyond beyond a single asset type and diversifying by location, asset type, time horizon, and other considerations can provide crucial diversification within asset classes and markets.
While alternatives that fall under the 20% rule have historically been out of reach of individual investors, some are now widely available giving investors a way to strengthen their portfolios in a way that wasn’t previously possible. Fundrise is the first investment platform to create a simple way for anyone to access institutional-quality private real estate investments, its historically consistent, exceptional earning potential, and diversification power. Fundrise not only offers access to the asset class of private market real estate, it also offers diversification within the asset class. Through Fundrise Investment Plans, investors can receive instant exposure to a diversified portfolio of dozens of both debt and equity real estate investments across the US.
The traditional barriers impeding access to advanced diversification strategies have been significantly lowered thanks to the creation of new investment options, and the technology that powers them. It’s up to each investor and their financial advisor to determine their optimal investment strategy, but the more advanced the strategy, the stronger the investment portfolio will likely be.