I have to admit, it can be difficult to explain good diversification with clients. How do I explain they should embrace the losers in their investment portfolios?
The difficulty lies in the fact that proper diversification means not every investment owned should be up at the same time.
Most investors, including myself think: why am I holding these losers? Imagine if all the investments were in the one(s) that are up!
How does an advisor explain to a client the need to hold International stocks when the US market is doing so well?
Beyond the standard, “don’t put all your eggs in one basket” there a couple other important reasons:
1. In a properly diversified portfolio: todays losers should be tomorrows winners when todays winners are tomorrows losers.
2. And, most importantly: because of #1 above, diversification is a FREE LUNCH! One can get larger gains with lower risk!
Let me explain:
The classic example of diversification is of a portfolio of an investor who owns the stock of 2 companies: an umbrella company and a sunscreen company. The idea is that whether it is sunny or raining, one of the companies is making money for you. This is represented in the graph below.
By owning the 2 stocks an investor has less ups and downs (volatility). This seems obvious. What is not obvious is that the lower ups and downs lead to better returns over time.
For example. If the investor had $100 invested in umbrellas only and they went down in value 50%, the new value of the investment would decrease to $50. But if the investor had split his investments into $50 umbrellas and $50 sunscreen as shown in the graph above, then the 50% decrease in the $50 umbrella value leads to a $25 decrease in value of umbrellas. At the same time the sunscreen has a 50% gain of $25, negating the loss of the umbrellas.
But if the gains are always negated by losses, as in the above example, then how does a portfolio grow? The answer is that most investments go up over time, and over time, the gains outweigh the losses.
Now for the free lunch: let’s look at an example of 3 portfolios over a period of 6 years. All three portfolios have an average return of 5% over the 6 year period. But, portfolio B experiences 10% more volatility each year than portfolio A; both in the up and down years. Portfolio C experiences 25% more volatility than Portfolio A.
$100 beginning balance:
Portfolio A B C
Year 1 +5% +15% +30%
Year 2 +5% – 5% – 20%
Year 3 +5% +15% +30%
Year 4 +5% – 5% -20%
Year 5 +5% +15% +30%
Year 6 +5% – 5% -20%
Average return +5% +5% +5%
Ending value $134.01 $130.39 $112.48
The portfolio with the least volatility (gained through diversification) but with the same average returns, results in higher long term growth of the portfolio.
In a well diversified investment portfolio there should always be some investments that are down while others are up.
The development of diversified portfolios are part of what is known as Modern Portfolio Theory (MPT).
Most advisors have the ability to help investors create diversified portfolios that will try and give the investor the most return for the least amount of volatility.
Note: the above example is from the web site of: