Navigating Economic Disruptions: The Role of Diversification
May 28, 2020
At Ronald Blue Trust, we offer strategies and concepts to help our clients navigate through all of life’s seasons, including periods of economic disruption. We believe diversification is a foundational concept that can be key to reducing volatility during times of market movements. As part of our “Navigating Economic Disruptions” series, we discuss the important role of diversification in your portfolio and how it can help during uncertain times.
When experiencing a difficult market environment, economic hard times, or perhaps even a geopolitical crisis, it’s always good to remind ourselves that we have tools to help navigate these periods. Diversification can be one of the most valuable tools an investor possesses. How should we think about diversification and how can it help?
Diversification at its core means investing in many things rather than only a few. Investing in that manner makes sense because we live in a world that is uncertain. If uncertainty implies we will never know what the future holds, diversification offers a way to spread our investments around so that we can better withstand whatever environment or scenario may unfold.
The Goal of Diversification
If uncertainty drives the NEED for diversifying, then our GOAL is to reduce the fluctuations in potential returns that we might experience. Large swings in portfolio returns (volatility) can be unpleasant for an investor, and diversification means no single asset class, geographic region, industry sector, or single company will have a disproportionate impact on our overall portfolio returns. Some might say that diversification falls short in extreme market events or disruptions and admittedly that can be true to some extent. However, over time, returns will typically begin moving independently rather than all together as they commonly do in the initial days and weeks of a market drop.
If the benefit of diversification is reduced portfolio volatility, is there a cost? We would say that diversification has implications, which at times can feel like a “cost.” Concentrating wealth in a single asset is one way wealth can be created. For example, over many years a business owner might build an enterprise that results in significant net worth. However, that business owner was not diversified. The owner’s wealth was concentrated in one highly appreciating asset: the business. If that enterprise is sold and the proceeds are invested in a diversified portfolio of marketable securities, what is the implication? The owner’s future wealth is not likely to grow in the same manner as he or she experienced with the business. However, the former business owner is more likely to preserve or maintain that wealth because he or she is diversified. The range of possible outcomes or future returns has been narrowed through diversification. That may feel like a cost, but it may be exactly what that former business owner desires if it fits with his or her financial goals going forward.
The Manner of Diversification
Diversification means more than just having multiple investments, and the manner in which one diversifies is crucial. To truly receive the benefits of diversification, an investor’s portfolio needs to be diversified by asset class (stocks, bonds, and/or cash), geographies, industries, and companies. Varied investments move differently in shifting market environments, and that variety of return experiences can offset one another when a portfolio is diversified appropriately. In addition, it’s important that a portfolio is rebalanced back to its initial allocation or strategy so the portfolio doesn’t become skewed to investments that have appreciated.
Diversification is a beneficial and useful ally for the investor who wants to see their portfolio experience an appropriate and tolerable degree of fluctuation in value. A diversified portfolio should provide a smoother ride for an investor compared with portfolios that are concentrated in just a handful of investments, limited to a portion of the overall financial markets, or skewed to just one asset class. However, a diversified portfolio will never outperform the single best-performing asset class or performance leader. Over a long-term investment time horizon, a diversified portfolio can temper losses and help investors realize the benefits of compounding. Consistent and steady can be a rewarding approach, and a diversified portfolio can help an investor achieve and maintain that posture when investing, no matter how uncertain the future may be.
If you would like to speak to a Ronald Blue Trust advisor about diversifying your portfolio, please call 800.987.2987 or email [email protected].
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