As the saying goes, do not place all your eggs in one basket. This is perhaps one of the most important lessons when discussing investment management and retirement planning. (This post will solely cover diversifying stock positions and we will be releasing a post targeted towards bonds and miscellaneous investments in the coming months.)
Before we dive into the various diversification options, lets cover what this strategy means. Overall, diversification means to purchase various investments to create a risk-managed blend. By purchasing multiple investments, you spread the risk across multiple companies or multiple funds. The more investments you hold, the less risk you will incur but this will be accompanied with less potential as well.
Owning 100 stocks is safer than owning 1 stock, but you will experience less growth if that 1 stock really takes off. This is due to the fact that the owned companies will only be 1/100th of the size in a diversified portfolio. If you are going to focus on only a few ideas, it is best to make sure you are confident in those choices because while there is more upside potential, the downside risk is just as great. On top of simply purchasing more positions to diversify a portfolio, there are also other characteristics to consider.
We do feel the need to address the concern of overdiversification. Having your investments spread too thin will severely hinder the potential for substantial growth. It is important to focus on the companies and areas that will outperform and decrease exposure to those that are expected to underperform. As Warren Buffet once said, “Wide diversification is only required when investors do not understand what they are doing.”
There are multiple different sectors that are included in the overall stock market. These sectors include Technology, Healthcare, Financials, Energy, Utilities, Industrials, Consumer Staples, etc. Obviously, purchasing only one sector relies heavily on that specific industry. We believe that a blend of sectors is appropriate in any environment, but the correct blend depends on the state of the economy. Some industries perform better in an expanding economy and some perform better in a contracting economy.
For example, Energy is based strongly off of the price of oil and economic production. If there is a slowdown and the economy weakens, corporations will not be purchasing as much oil, travel will decrease, and this industry will suffer. On the other hand, Consumer Staples includes toilet paper and laundry detergent suppliers. These companies are always in demand since these are essential items for human life, but these companies will also not experience much growth if the economy is expanding. Staples are very consistent through various economic stages. Technology also performs well in a growing economy since companies are spending more money on their technological research and design advancements. Utility companies perform well during slowdowns since individuals and businesses still need to pay their monthly bills. Financials perform well in an expanding environment because companies and individuals are able to afford more debt and banks earn the interest on the loans they issue. These are just a few examples, but every sector has a preferred economic environment in which it thrives compared to other industries.
Now that we know the basics to sector diversification, how do we apply this to a portfolio? It depends on the stage of the economy. As described above, aggressive sectors normally perform better in growing economies and conservative companies usually perform better during economic slowdowns. Aggressive sectors also usually see more swings in their stock price and defensive sectors typically provide the benefits of dividends to shareholders. This is precisely why we utilize a rotating sector strategy with our in-house portfolios. Depending on your personal risk tolerance and time horizon, your preferred blend may vary from others’. Active management allows us to buy and sell our preferred sectors while a long-term buy-and-hold strategy may potentially benefit the most from a blend of various sectors.
Market Capitalization refers to the size of the investable company. Typically, these are referred to as Small Cap, Mid Cap, and Large Cap companies. Smaller companies are usually considered more aggressive positions because they do not have the history nor size to withstand large financial strains. Large companies have more assets, more revenues, and normally a longer track record as well. Therefore, large companies are considered safer investments. And of course, medium sized companies fall right between their small and large competitors.
Investment Objective refers to the company’s internal goals. These are very similar ideas to the market capitalizations listed above. Included in these objectives are Growth, Value, and Blend. Growth companies are typically focus on increasing revenues, profit, and their share prices. Value companies focus heavily on maintaining consistency in their business operations and preventing negative fluctuations in their stock price. Value companies also often tend to provide dividends to shareholders. Blend companies try to balance both growth and value. Like we mentioned, investment objectives often align with the market capitalization. Small companies usually focus on growth and large companies usually focus on providing stable value. Medium sized companies often fall into the blend category.
So, now that we have discussed the different types of factor diversification, how do we apply this to an investment portfolio? Well, of course, it all depends on the individual investor and their personal goals and objectives. Those who are more aggressive and do not care about wild swings in their account balance, could focus on small-growth focused companies. Individuals who want to protect their account balance and want to invest in strong, household name companies could focus on large-value companies. For those in the middle, medium-blend focused companies may be the best fit. With this being said, we do believe that a mixture is often the best move. Small-growth companies perform best when the economy is growing rapidly. Large-value companies are best when the economy experiences a slowdown. By holding both, you are potentially able to position yourself appropriately for whichever direction the economy moves.
If you have any questions about taxes, your individual investment portfolio, our 401(k) recommendation service, or anything else in general, please give our office a call at (586) 226-2100. Please feel free to forward this commentary to a friend, family member, or co-worker. If you have had any changes to your income, job, family, health insurance, risk tolerance, or your overall financial situation, please give us a call so we can discuss it.
We hope you learned something today. If you have any feedback or suggestions, we would love to hear them!
Zachary A. Bachner, CFP®
Robert L. Wink
Kenneth R. Wink
James D. Wink
Summit Financial Consulting