Market Beat: Understanding diversification
July 22, 2014
When it comes to investing, the old adage, "Don't put all of your eggs into one basket," makes a lot of sense. If you drop the basket, you could break all of your eggs.
The term used in finance is "diversification." According to Wikipedia, diversification means reducing non-systematic risk by investing in a variety of assets. Systematic risk is defined as risk to the entire financial system, and non-systematic risk is defined as risk to one company or asset, and is also known as company-specific risk.
If you were to invest all of your money into just one stock, you'd be exposed to both systematic risk and non-systematic risk — in other words, you'd have the risk of that stock performing poorly and also bear the risk that something happens to the entire financial system.
You can control the company-specific risk by spreading your money around into several stocks. If you were to invest in the large cap S&P 500 index fund, your money would be spread out into 500 different stocks, and your non-systematic or company-specific risk would be lower.
Another way to reduce risk is to add more funds to get exposure to small cap stocks and international stocks.
Adding more index funds will provide further diversification and lower risk, but it's important to understand just how much diversification you'll have.
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If we study the correlations among the major stocks indexes, we find that at the present time they are very highly correlated. In other words, they have a fairly strong tendency to move in the same direction at the same time.
Foreign-developed markets have about a 90 percent correlation to the S&P 500, and emerging markets have a correlation over 85 percent. So, adding international funds helps diversification; however, they have a strong correlation to one another.
By adding another asset class like bonds, you can get further diversification, but can also lower returns over time. It's important to know the correlations between your bond funds and your stock funds.
There is a big difference between using a Treasury bond fund for diversification purposes and a high-yield bond fund. High-yield bonds have a high correlation to the S&P 500, about 75 percent, so they don't provide as much diversification as Treasuries which have a negative correlation of minus-0.33 percent, or investment grade corporate bond,s which have a very low correlation of 0.11 percent.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.