The Benefits of Diversification – Part 1

By Schultz Collins Investment Counsel on August 29, 2022

Given the recent increase in stock market volatility, it is important to revisit The Benefits of Diversification. Put simply, diversification is the way investors reduce risk by owning many different assets instead of just a few. Although that may sound simple, diversification is more complicated than that. Yes, diversification can reduce risk, but when done right, it can also help investors efficiently trade risk for return. A well-constructed portfolio goes beyond buying 50 to 100 stocks or even a broad array of investment funds. Let’s look at how Schultz Collins helps investors understand the pitfalls and benefits of diversification through a series of portfolios that become more and more diversified.  

Let’s imagine an investor who owns all the large company stocks in the US stock market. This portfolio is depicted as the circle on the righthand chart of Figure 1. He wishes to reduce his risk, therefore he allocates 20% to bonds. Bonds are depicted as the triangle in the chart. Doing so would reduce his exposure to risk, but also his expected returns. A naïve investor would think that buying a mixture of both stocks and bonds would result in expected risk and return levels somewhere along the black line connecting the two investments. However, this is not the case. 

Figure 1 

The 80/20 portfolio is depicted as the square on the chart. The square lies above the line, indicating a higher level of returns than our naïve investor would expect.  

The top left pie chart shows the allocation of the portfolio to stocks and bonds. The bottom left column chart illustrates the historical risk and return characteristics of the allocation. We’ll use these charts to illustrate how an investor can try to increase the diversification of their portfolio and how those attempts can affect the risk and return of the portfolio.  

One way to diversify the portfolio further is to buy different types of bonds. The chart on the right of Figure 2 illustrates the historical risk and return for various bond maturities. The red bars represent standard deviation, a measure of risk. Shorter maturities offer the lowest risk, but also the lowest return. Let’s assume our investor wants to reduce risk further, and so opts to split his 20% bond allocation into 15% short-term bonds and 5% intermediate-term bonds.  

Figure 2 

Another way to diversify is to own companies all over the world, rather than just in the United States. The chart in Figure 3 shows three curved lines. The curves represent different time periods and show historic risk and return data along continuums of allocations between U.S. stocks (as depicted by circles) and international stocks (as depicted by diamonds). The squares represent portfolios of 80% U.S. and 20% international stocks. These line charts show that sometimes US stocks outperform international stocks, but sometimes they don’t. However, there appears to always be some reduction in risk to a portfolio that invests in both stock markets, as indicated by the black squares. We’ll assume our investor allocates 50% of their portfolio to large company stocks in the US and 30% in international stocks. This change reduces the risk and return of the portfolio further.  

Figure 3 

Our investor can further diversify by buying stocks in smaller companies. The chart on the right of Figure 4 shows various groupings of stocks with the largest stocks on left and progressively smaller stocks to the right. Historically, small company stocks have come with expectations of higher risk and returns.  

Let’s assume our investor allocates half of the stocks to small companies and half to large companies, both in the US and internationally. The inclusion of small stocks increases the portfolio’s return, but also its risk.  

Figure 4 

We will consider one more addition to our portfolio: “value” stocks. Simply stated, these stocks are considered relatively cheap compared to their expensive counterparts, called “growth” stocks. The chart on the right of Figure 5 shows returns for growth stocks and value stocks compared to a large company stock index. Historically, value stocks outperformed growth stocks and the large company stock index over the 1973-2021 period. Let’s assume our investor allocates 50% of US stocks to value stocks, across both large and small companies. The result is a portfolio with higher returns but – surprisingly – slightly lower risk.  

Figure 5 

Let’s compare these allocations by recapping the progression of the portfolio from the simple U.S. stock and bond portfolio to a well-crafted and well diversified portfolio. First, we started with our simple 80/20 portfolio seen in Allocation #1 of Figure 6. We then diversified our bond holdings to include a mixture of short-term and intermediate-term bonds, as shown in Allocation #2. In Allocation #3, we increased the portfolio’s diversification by adding international stocks. Allocation #4 layered-in small companies to our US and international stock allocations. Finally, Allocation #5 incorporates value stocks in the U.S. stock portion of the portfolio.  

Figure 6 

Finally, let’s compare the performance statistics along each step of our diversification example by examining Figure 7. The data show diversification can reduce risk, as seen in the addition of short-term bonds and international stocks in Allocations #2 and #3. However, diversification may also increase expected returns with modest increases in risk, as seen with the addition of small companies in Allocation #4, or even reduce risk, as seen with the addition of value stocks in Allocation #5. In summary, diversification is not just buying more assets to lower risk. Diversification may also provide a warranted exchange of higher risk and potential return.  

It is important to note that this article is just an example of how we help investors diversify. We haven’t discussed other important assets investors should consider, like real estate and international bonds. Furthermore, these allocations are not recommendations, nor would we recommend any prefabricated allocation to our clients. Each person is unique, and we can help determine the allocation that best fits each investor’s needs and risk preferences.  

Figure 7 

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