Stocks have rebounded significantly in recent weeks, with major indices rallying roughly 10 percent since the June low.
Given the combination of 2022’s predicted uptick in market volatility, the latest equities bounce, this week’s FOMC monetary policy decision, and the potential for additional price swings going forward, this could be another opportune time for our periodic review of the importance of diversification, particularly when it works, and when it does not. Indeed, diversification in its simplest form is akin to the old adage “do not put all of your eggs in one basket,” because investing all of your money in a single stock means that your wealth will depend solely on the performance of that one asset.
Doing this could provide excellent returns for a while if the stock happens to outperform the overall market. However, this would also expose you to the idiosyncratic risks associated with the company, e.g. industry-specific problems, new competition, currency fluctuations, bankruptcy, etc., all of which have the potential to more than wipe out any unrealized gains. Diversification, therefore, requires that a basket of uncorrelated investments is constructed so that one can still benefit from strong performance but limit the exposure to the risks associated with any single holding. Many retirement investors likely understand this concept and will therefore try to invest in a handful of companies that they are familiar with.
Too often, though, such asset mixes chosen by retail investors will still be inadequate for a properly diversified portfolio. For example, the total number of investments could again be too small, or the portfolio weightings may be too high in one or more assets (a problem even for some ETFs). For the former, it is important not to think that the goal should be to own as many different equities as possible because research has shown that the benefits of diversification start to diminish after only a few dozen stocks as a portfolio’s returns and risk profile begin to converge to that of the entire market (index). Investors must also understand that there are times when even a well-diversified stock portfolio may not provide a lot of protection.
Such a situation can arise whenever uncertainty reaches extreme levels and scared investors rush for the exits all at once. This behavior can cause stock correlations to spike, i.e. equities that normally would not trade similarly suddenly move in lockstep, and such price action has arguably been exacerbated by the rise of automated, high-frequency trading systems. Put simply, spreading your money across a wide variety of stocks can help reduce the risks associated with any particular company or industry but exposure to a broad market selloff will not always be eliminated. For additional protection, a retirement portfolio must therefore be diversified not just in stock allocations but also asset classes.
More conservative instruments like bonds can sometimes act as such a hedge since this asset class often performs well when equities are under pressure. This is especially true for U.S. Treasury, the “global safe-haven,” when markets are in a “risk-off,” “flight-to-safety” mode. Of course, if you do not plan to hold everything all the way to maturity then even government bonds can be a risky investment, particularly during a rising interest rate environment. Real estate investment trusts (REITs) and other alternatives exist to help provide further portfolio diversification but one should not forget about cash. Indeed, leaving some money on the sidelines, or in highly liquid cash-like instruments, can help one take advantage of market corrections by providing the means for picking up shares of great companies at a discount.
Like most investing issues, though, diversification is not an exact science, meaning there is no single formula for constructing a “well-diversified” portfolio that everyone should follow. This is because what is right for one person may not be appropriate for another since unique factors like risk appetite, tax situation, and nearness to retirement must be taken into consideration. Altogether, it is very difficult to completely eliminate risk from a portfolio, but it is possible to reduce one’s exposure to many “known unknowns.” Utilizing mutual funds and other innovative financial products can often help simplify the process, but for many regular investors even these selections can seem intimidating, which is why consulting with a professional advisor may be worth considering.
What To Watch This Week
Monday
- Chicago Fed National Activity Index 8:30 AM ET
- Dallas Fed Manufacturing Survey 10:30 AM ET
- 2-Yr Note Auction 1:00 PM ET
Tuesday
- FOMC Meeting Begins
- Case-Shiller Home Price Index 9:00 AM ET
- FHFA House Price Index 9:00 AM ET
- Consumer Confidence 10:00 AM ET
- New Home Sales 10:00 AM ET
- Richmond Fed Manufacturing Index 10:00 AM ET
- 5-Yr Note Auction 1:00 PM ET
- Money Supply 1:00 PM ET
Wednesday
- MBA Mortgage Applications 7:00 AM ET
- Durable Goods Orders 8:30 AM ET
- International Trade in Goods (Advance) 8:30 AM ET
- Retail Inventories (Advance) 8:30 AM ET
- Wholesale Inventories (Advance) 8:30 AM ET
- Pending Home Sales Index 10:00 AM ET
- EIA Petroleum Status Report 10:30 AM ET
- Survey of Business Uncertainty 11:00 AM ET
- 2-Yr FRN Note Auction 11:30 AM ET
- FOMC Announcement 2:00 PM ET
- Fed Chair Press Conference 2:30 PM ET
Thursday
- GDP 8:30 AM ET
- Jobless Claims 8:30 AM ET
- EIA Natural Gas Report 10:30 AM ET
- Kansas City Fed Manufacturing Index 11:00 AM ET
- 7-Yr Note Auction 1:00 PM ET
- Fed Balance Sheet 4:30 PM ET
Friday
- 10-Yr TIPS Settlement
- Personal Income and Outlays 8:30 AM ET
- Employment Cost Index 8:30 AM ET
- Chicago PMI 9:45 AM ET
- Consumer Sentiment 10:00 AM ET
- Baker Hughes Rig Count 1:00 PM ET
What To Watch Next Week
Monday
- 2-Yr Note Settlement
- 5-Yr Note Settlement
- 7-Yr Note Settlement
- 20-Yr Bond Settlement
- PMI Manufacturing Final 9:45 AM ET
- ISM Manufacturing Index 10:00 AM ET
- Construction Spending 10:00 AM ET
Tuesday
- Charles Evans Speaks 9:00 AM ET
- JOLTS 10:00 AM ET
Wednesday
- MBA Mortgage Applications 7:00 AM ET
- ADP Employment Report 8:15 AM ET
- 3-Yr Note Announcement 8:30 AM ET
- 10-Yr Note Announcement 8:30 AM ET
- 30-Yr Bond Announcement 8:30 AM ET
- Treasury Refunding Announcement 8:30 AM ET
- PMI Composite Final 9:45 AM ET
- Factory Orders 10:00 AM ET
- ISM Services Index 10:00 AM ET
- EIA Petroleum Status Report 10:30 AM ET
Thursday
- Challenger Job-Cut Report 7:30 AM ET
- International Trade in Goods and Services 8:30 AM ET
- Jobless Claims 8:30 AM ET
- EIA Natural Gas Report 10:30 AM ET
- Loretta Mester Speaks 12:00 PM ET
- Fed Balance Sheet 4:30 PM ET
Friday
- Employment Situation 8:30 AM ET
- Baker Hughes Rig Count 1:00 PM ET
- Consumer Credit 3:00 PM ET
