insights

The importance of investment diversification

Investment Portfolio Purpose

As a general rule, investment portfolios exist to serve some quantifiable purpose. For individual investors, funds are set aside for retirement, college, or other major life events. For institutional or corporate investors, an investment portfolio may be designed to fund a pension for a large group of beneficiaries (employees and retirees from a given company), to meet the operating needs of a university or charitable organization, to earn a profit for an insurance company or bank, or other business objectives.

In any circumstance, it is crucial for investors to keep in mind the reason for investing. If one is investing excess cash for sheer speculation, then the portfolio will be very different from one that is designed to fund retirement or college savings. Therefore, to some extent the thought process should work backwards from the eventual goal—knowing where you hope to be 5, 10, 20 years in the future will help you plan in he present for how to get there.

So in many ways, investing is a two-sided coin—the assets exist in order to fund an anticipated expense or liability. If saving for college, a family can estimate the cost of attendance and the time until enrollment, and set aside assets on a regular basis to meet the liability. Similarly, for an individual’s retirement, one must save consistently over time in order to have adequate funds to live on after leaving the workforce.

Portfolio Diversification

Diversification is a common term among professionals in the investment world, but unfortunately it suffers from the same malaise as many other business buzzwords—overuse and misuse have clouded its meaning. So, like “synergy” and “outside the box,” the definition of diversification can vary depending upon the eye of the beholder. In the context I am using here, diversification means that investors should utilize a well-designed asset allocation, including stocks, bonds, and other asset classes or investment strategies that may be available.

The goal of diversification is to dampen volatility over time. (Volatility is a measure of how much an investment’s value might be expected to fluctuate over time, and diversification can help to smooth out those changes.) In other words, some assets will increase in value as others decrease in value, and vice versa. Putting together a good mix of investments will hopefully smooth out performance, and over a long period of time improves results.

As an example of a large institutional portfolio, a pension plan’s assets are set aside to fund the retirement income of thousands of current and former employees. Pension plans must balance the types of assets placed in the portfolio—as described above, a combination of stocks, bonds, real estate and other investments is required in an effort to smooth out the portfolio’s performance over a long period of time. For example, stocks may do great in certain years, like the S&P 500’s performance in the 1990’s and the middle part of the 2000’s. But we have also seen that equities can have disastrous returns in some periods, such as 2001-02, and 2008. Therefore, a pension portfolio may require a significant amount of diversification, which is achieved through the use of a variety of investment strategies and vehicles.

Individual Saving & Investing

The same logic for diversification applies to individual portfolios—investors should take into consideration the purpose or need for the assets in question, and invest appropriately. Most 401(k) plans offer a variety of vehicles to choose from, including:

Target Retirement Date Funds, which seek to provide a diversified portfolio in a single fund offering. Target Date funds are a good choice for savers who want diversification and simplicity, but may not have the time or interest in choosing their own asset allocation. Passive Funds, which provide returns similar to a broad index, such as the S&P 500 for equities or the Barclay’s Aggregate Index for bonds.

Active Funds, which offer exposure to investment managers whose goal is to outperform the markets, often a particular segment of the market, such as US Large Company Equities.

Individual investors often also have access in their personal investment accounts (such as IRA’s and investment brokerage accounts) to a seemingly endless set of Exchange Traded Funds (ETF’s), stocks, and mutual funds, which can be used to build a diversified portfolio.

Taking into consideration the intended use of the assets, individuals and institutions should develop a meaningfully diversified portfolio, in which the most important choice is not at the individual stock or bond level. Individual securities matter, of course, but investors should not have exposure to any individual stock or bond in such a large proportion that it can significantly impact the overall portfolio. The most important long-run goal for an investment portfolio should be to maintain broad diversification both within and across asset classes.

This article originally appeared in the February, 2013 issue of Columbia Sun News.