Don't confuse Diversification with Hedging

By Morningstar | Mar 31, 2023

Most investors accept guidance about diversification with a begrudging acknowledgement of its importance before largely ignoring the advice.

Mark LaMonica, Director of Product Management, Individual Investor, Morningstar Australia, tackles the confusion, the myth and tells us why he believes in it.

CONFUSION: Diversification is conflated with Hedging.

Diversification is often portrayed simplistically. We are told to not put all our eggs in one basket. This analogy has the appeal of being conventional wisdom. The beauty of conventional wisdom is that it allows everyone to interpret it as they please.

When pressed, many investors will say that a diversified portfolio contains assets that will go up in value when other assets go down in value. This fits well with a commonly held belief about shares and bonds. Many people think that when shares go up, bonds go down. And vice versa. The inconvenience of this view is that it is wrong. The latest example being 2022 when bonds went down significantly, and shares went down even more.

It is also not the point of diversification. Finding assets that are non-correlated – ones that move in opposite directions - is not the reason we diversify our portfolios. That is called hedging. And for most investors with a long-time horizon and high-return objectives, hedging is the opposite of what you want to do.

What most investors need is exposure to growth assets that will generate high long-term returns at the cost of short-term volatility.

MYTH: Diversification is for old people.

I hear this one a lot. A young investor will tell me that they understand diversification and plan to get to it once they are older and have more money. They assure me that since they are young, they can afford to take big risks.

It isn’t surprising that young investors have this attitude. It is consistent with the advice that young people are given in general – take risks now. Life advice is not good investing advice.

I’m currently 43. And $10k is worth less to me than it is to a 23-year-old. But it isn’t worth less because I make more money. It isn’t worth less because my portfolio is larger. It is worth less because the most valuable asset in investing is time. And the young have more time.

If that $10k is earmarked for retirement at 65 and you earn an 8% return it is worth just under $55k to me. It is worth $253k to the 23-year-old.

Being young isn’t an invitation to recklessly take on security specific risk.

FACT: Diversification is about achieving your goals.

All of investing starts with goals. And diversification is no different. If I want to retire in 20 years and I need an 8% per annum return to get there I need to make sure my approach to diversification is helping me achieve my goal.

The best way to achieve my goal is to avoid a catastrophic loss that makes it impossible to reach my desired investing destination. Volatility is ok. That is the price we pay for the returns we earn. For long-term investors, the market volatility is not a catastrophic loss.

We diversify to reduce security specific risk in our portfolio. That is the risk that something goes wrong with a particular company we own. The reality is that the future is unknowable. Companies are brought down by poor decisions that aren’t transparent to even the most diligent shareholders. They are brought down by new technology unimaginable a few years before. They are brought down by unexpected economic events and emerging rivals. They are brought down by well concealed fraud. These factors and countless others entail the security specific risk we are trying to diversify away.

How much we diversify away that security specific risk is up to each investor. We could diversify it all away by owning an index fund that includes every share. We could diversify some of it by owning two companies. Each individual share you add to your portfolio will move your security specific risk along the spectrum from putting all your eggs in one basket and owning the entire market. Owning the whole market or every share available means you are just exposed to market risk. And you will get the market return. You are now a passive investor.

Investing in other asset classes is also all about achieving your goals. We can use bonds as an example. A bond has lower expected returns and lower volatility than a share. Adding bonds to your portfolio will lower your expected future returns and it will lower the volatility of your portfolio. You may want to lower your returns because you don’t need that high of a return to achieve your goals. You may want to lower the volatility of your portfolio because a short-term drop would mean you don’t achieve your goal.

CHECKLIST: Starting point for investors who want to ensure their portfolio is diversified.

  • Mix between growth and defensive assets.

The driver here will be the return needed to achieve your goals and the length of time until your goal which may limit your ability to withstand volatility.

  • Determine your asset class, geographic and sector exposures.

The wider you diversify the less exposed you are to the specific risks associated with a type of asset, country or sector.

  • Diversify at the holdings level to remove security specific risk.

This can be done using ETFs of funds or by increasing the number of individual shares or bonds in a portfolio.

I don’t believe in diversification because everyone says it is the right thing to do.

I believe in diversification because I think it will help me achieve my goals.

I believe in diversification because there is a good chance my 20th best idea turns out to be better than my top idea.

I believe in diversification because I’ve made mistake of having positions take up too much of my portfolio and have those companies implode.

I believe in diversification because I realize that some of my decisions can go wrong.

Rethinking Asset Allocation and Diversification

5 ways to view Asset Allocation Differently

What no one tells you about Diversification

Diversification is always your friend

Add a Comment
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Nikhil Tamhane
Apr 1 2023 11:47 AM
Good Article
Shivani Sen
Apr 1 2023 11:33 AM
Good read.
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