There are few financial concepts as fundamental as diversification, but most of the people I speak with can’t really begin to understand what it means or why they might need it.
I get it! This stuff isn’t exactly intuitive.
At a high level, diversification is a way to control the level of risk in an investment portfolio. But I want to give you a functional understanding of this concept, so let’s talk through an example.
Imagine for a second that your portfolio is composed of just a single stock. When that stock goes up, so does the value of your portfolio. But that dynamic also works in the other direction, which is not particularly desirable.
Diversification’s Definite Benefit
We can clearly see the benefits of diversification when we add a second stock to the portfolio.
The first stock is up and the other is down, which means the value of the overall portfolio remains unchanged.
In practice, we rarely come across examples like this, because even though the two stocks may have fundamentally different characteristics, most of them perform similarly over short time periods. Diversification is excellent at ensuring that aberrant performance from any one stock – sometimes referred to as “idiosyncratic risk” – doesn’t detract too much from the performance of the overall portfolio.
But this protection has a limit.
That’s because some of the risk of investing in stocks is “systematic,” which is a fancy way of saying that it’s related more to financial conditions in the broad economy than the details of any particular company. Increasing the number of holdings in a portfolio cannot protect an investor from these systematic risks.
So if we imagine that the company behind Stock 1 is embroiled in a value-destroying scandal, it’s clear that an investor in a diversified portfolio would have a better experience than one that owned just that one company. But in the case of broader economic issues, all of the companies might wind up being affected similarly.
Diversification’s Diminishing Value
You don’t need a PhD in finance to realize that diversification can only provide a certain amount of protection.
The chart below shows that this benefit actually declines with each incremental stock that you add. So there’s a massive benefit from moving to something more diversified from a one-stock portfolio. But there’s no sense in just swallowing up every stock you can get your hands on in the name of diversification.
The chart above shows that there’s still significant incremental value in diversification until one’s portfolio holds more than a hundred stocks. But our flagship ethical growth strategy only has about twenty stocks in it.
Why is that?
For investment strategies like ours, which are predicated on strong investment beliefs and require a significant amount of fundamental research, diversification can be almost synonymous with value destruction unless it is managed incredibly carefully.
This concept is not particularly intuitive to people who haven’t spent their literal entire lives thinking about how to manage money ethically, so let me walk you through it in some depth.
In order to make it into our investment portfolio, a company must satisfy every step in our investment process. This includes a deep dive into the ethical concerns surrounding their products and conduct as well as a close examination of their financial prospects. So in effect, the composition and design of our flagship strategy is a response to practical constraints. We simply aren’t able to identify and monitor 100 companies that we think our clients ought to own.
Again, remember that diversification is just one way to manage risk.
The careful research we do also serves to significantly mitigate investment risk. Absurd or adverse consequences could result if we were to begin buying every ethical-sounding business that’s publicly traded. The extent to which this is true has really surprised me, and I wrote an essay a few months ago describing my intellectual evolution to this point which may be of interest to those who find this topic fascinating.
But I suspect the majority of our clients and community members are just trying to make a decision between a diversified portfolio and a more concentrated approach. So let’s steer right into those questions.
Do You Want a Diversified Portfolio or a Concentrated one?
There’s no perfect answer, but I can definitely help you peer inside of the way we manage portfolios here to identify what’s most important to you.
In the table below, I’ve enumerated several considerations that are relevant to clients choosing between our ethical growth strategy and the more diversified portfolios that we customize for their specific needs. To do this, we add external ETFs and mutual funds with aligned oversight practices. This allows us to broaden a client’s portfolio without diluting our other strategies, and can create a more balanced portfolio.
Both approaches have their advantages and drawbacks, so here is a table that can help you compare the two on three high-level criteria.
|All research and oversight are directly overseen by me, meaning we can manage ethical concerns with unusual precision.
|A portion of portfolios are managed by research teams at other firms. All of them have strong processes that align with our own, but we have significantly less control.
|Month-to-month performance will be more volatile, and may diverge from popular stock indices for long periods of time.
|Performance is still inherently volatile (it’s the stock market, after all) but is likely to be more similar to popular stock indices.
|All research and portfolio management is included in our standard fee.
|Additional fund-level costs which may vary from .10%-2% a year are imposed by the Mutual funds and ETFs selected to add diversification. We do not receive any of these fees.
With all this said, I’d be a silly goose if I didn’t mention that there’s no reason to navigate this alone.
If you’ve read this far and still aren’t sure which path is more appealing, you should probably click here to book a call with us. We love helping kind people design investment strategies that help them maximize the probability of realizing their financial goals, so please don’t hesitate to use us as a resource.