Diversification. You've undoubtedly heard the word. You probably even know what it means, and in what context it gets used most often. Yes, diversification is used most commonly when speaking about investment strategies.
So in the previous post, we discussed a rough approximation of how you can get to $10 Million in savings. The ways we can drive revenue to put into our savings account will be discussed in future posts, and mainly focuses around developing passive income strategies. But it is also important that we know how we will be deploying that passive income in our savings vehicles.
That is where the concept of diversification comes in. As much as we'd like to find one stock that will go up 10,000% in the next 20 years, there is almost an infinitesimally small likelihood we will be able to do that. Unforeseen events and competitors make that unlikely. It's more likely that something bad will happen to the stock over that time span, and we will lose a chunk of our investment. That is why we diversify. It is a much better idea to spread our risk over various stocks and asset classes, and simply count on the benefits of capitalism, economic growth, and interest rates to help us in the right direction. So spreading money across many stocks can help prevent the fallout if one stock fails. But what about market-wide, or sector-wide declines, like the '00 Internet Bubble/Crash, the '14-'15 Oil Crash and the '09 Housing/Financial Crisis? How do we mitigate their affects? The same way we do for an individual stock. We diversify across different sectors and different asset classes.
What does that mean? It means that you don't put all your money in one stock, and you generally don't put all your savings in only one type of stocks. You spread it between big and small stocks, growth and value stocks, US and international stocks, bonds, REITS, commodities, cash, etc.
What does this diversifying do in a nutshell? It lowers the correlation within your investment portfolio. That means that one component does not act like another. If one sector like Retail stocks goes down, another like Utilities, may do better. If stocks as a whole under-perform, bonds may be more likely to outperform. If stocks go down, real estate may keep going up. These aren't certainties of course, but we seek to hold assets that react differently to different situations.
There are long run benefits to this as well. We don't just do it to protect our money. It acts to increase returns in the long run. For example, ETF.com wrote an article on correlation and has an illuminating quote:
"The most dramatic impact in the portfolio comes when adding commodities as the seventh asset class. This multi-asset portfolio was comprised of large U.S. equities, small U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities—each asset class having a portfolio weighting of 14.3 percent. The seven-asset portfolio had the highest return (11.25 percent), the lowest standard deviation of return (8.67 percent), the lowest aggregate correlation (.128), the smallest maximum one-year drawdown (-10.2 percent) and a zero frequency of a 10 percent loss (as measured by IRR) over one-, two- and three-year periods. (The -10.2 percent maximum portfolio drawdown is, by necessity, calculated differently than IRR).
... The key point here is that highly diversified portfolios with low aggregate correlation tend to avoid losses, which essentially negates the need for a high recovery probability. In sum, the probability of recovery from a 10 percent loss within three years is slightly lower in the more diversified portfolios, but the frequency of 10 percent or higher losses is nearly eliminated."
So there you can see the benefits of lowering correlation by diversifying among asset classes, sectors, and definitely beyond individual stocks. We minimize huge losses, and therefore don't have to do as well to recover.
Did you notice something else? Just by diversifying between these asset classes, we have almost achieved one of our goals of 11.5% annual returns (see our second blog post). This is the number that we needed to achieve to reach our $10 million dollar goal!
So there you have it. A diversified portfolio is essential to reaching our goal, so is there any other reason not to do it? Tune in next week for further discussion on Asset Class Allocation.
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