A failure to understand diversification can result in loss and reduce the probability of meeting your goals.
According to Anna Lusardi’s 2019 paper on financial literacy, risk diversification is one of the top three misunderstood personal finance concepts. People have difficulty understanding risk.
I see why. Risk diversification is abstract. I’ve been investing for eight years and reading about investing for over a decade, and I still find it hard to structure this post.
This post helps you reduce investment risk while retaining the same investment returns.
Table of Contents
Any securities mentioned in this post are for educational purposes. I am not recommending these investments. Before making investment decisions, you need to know if you are ready to invest and what your risk tolerance is.
Diversification: The Only Easy Returns
Diversification is the act of holding multiple assets across various businesses, sectors, and geographies. With such an approach, you reduce the risk of one specific investment failing and can reduce risk without reducing expected returns.
This is why Burton Malkiel calls diversification “the only free lunch” in his book A Random Walk Down Wall Street – one of my favourite investing books.
Plus, markets do not reward investors for taking on risks that can be quickly diversified away.
Index funds allow investors to quickly diversify away these “uncompensated” risks associated with specific businesses, sectors and countries.
With an index fund, you can maximize diversification for stock and bond asset classes. They are also inexpensive to own, with annual fees of less than 0.1% of your total investment amount.
How Diversification Reduces Risk Exposure
I aim to have a diversified life. To build such a life, I consider the following important: fitness, my human capital, solid relationships, Wealthy Corner (this blog), and my day job.
How does this protect my life from downside risk?
You can take away my day job, and I’ll be fine. I have built the human capital to find another job (or start an advisory firm).
Likewise, say I get injured and can’t lift weights or cycle. That’s okay. I will shift that energy to writing more aggressively for this blog.
What if I lose everything? At least I’ll be left with my values and human capital that cannot be taken away: self-discipline, integrity, knowledge, skills, and the capacity to influence people. This is the ultimate form of diversification.
Diversification can help you lead a wealthy life by reducing downside risk. It can make you more resilient, which is pretty cool.
Enough about life. How does diversification apply to stocks and bonds?
Diversification: Investment Risk With Stocks and Bonds
I don’t care if one company I own (by holding its stock) fails. This is because I own over 6,000 stocks worldwide with low-cost index funds. If one company fails, I have 5,999 others that may do well.
It works this way for bonds too. A bond is a loan to a company or government. If one company fails, I may lose the bond’s principle and the regular interest payments tied to the bond.
But I don’t worry about that, because I own a bond fund with 1,137 bonds.
When it comes to stocks and bonds, diversification protects you from downside risk. You can look at diversification at a few scales:
- Company diversification
- Sector diversification
- Geographic diversification
Company Specific Risk, Forecasting and Hindsight Bias
Let’s take a look at two risks that could not have been forecasted by investors for two specific companies.
On 20 April 2010, the Deepwater Horizon oil spill occurred in the Gulf of Mexico. Over the next three months, BP’s stock plunged by over 50%.
Similarly, you may remember that the entire fleet of Boeing 737 Max aircraft was grounded after two planes crashed in 2019. Boeing’s stock price proceeded to fall by 23%.
What do these two examples have in common?
Even the best investor could not have predicted these events. If they could, it wouldn’t be a risk! Risk is defined as uncertainty in future outcomes.
Our pattern-recognizing brains are good at lacing together explanatory stories. The BP and Boeing events may look predictable in hindsight; welcome to the hindsight bias.
Owning a pool of stocks and bonds across multiple companies can reduce downside risk without reducing future expected returns.
Sector Specific Risk
The US tech sector was down 35% in 2022, as measured by the ETF QQQ that tracks the NASDAQ 100.
For reference, the total US stock market was down only 19.2% as measured by the Vanguard Total Stock Market Index Fund VTI.
There are 11 sectors as measured by the Global Industry Classification Standard (GCIS). These sectors are shown in the infographic below from the MSCI site.
If oil prices tank, the energy sector may take a hit. But there are 10 other sectors to keep you afloat. Perhaps strong performance in the health care sector neutralizes the oil sector downturn.
Diversifying your investments by holding stocks and bonds from companies in all 11 sectors can reduce sector-specific risk.
For example, take a look at the globally diverse index fund (of funds) VEQT. The 13,600 stocks in this ETF are spread across the various sectors as shown below. VEQT was only down 11% in 2022.
Diversification across various sectors can reduce sector-specific risk without compromising your expected returns.
What if all your assets were concentrated in the Japanese stock market in 1990?
It would not be pretty. It’s 2023 and the market still has not recovered to 1990 highs. Before 1990, the Japanese stock market was the best-performing market in the world.
Strong stock markets like the US market suffer a survivorship bias. Past performance is no guarantee of future performance. You can read this post to see the Japanese market example and better understand US survivorship bias.
So, how do you diversify globally?
Many index funds exist that hold 1000’s of stocks around the world. To keep the same example, let’s look at the 100% stock index fund VEQT.
VEQT is a fund of funds. It holds four underlying stock index funds. The first two index funds contain stocks in the US and Canada.
But the third FTSE Developed All Cap Ex North America Index holds stocks in multiple European countries, Japan and Australia.
Holding stocks across many countries can save you from downside risks without sacrificing your expected returns.
Risk Factors For A Single Company
The risk associated with a stock or bond held with one company is driven by risk factors which can affect the company’s earnings.
A stock’s price reflects the expected future earnings power of the business (see where stock returns come from). Risks like natural disasters or crashing planes reduce a company’s future earnings. Therefore, the risks translate directly into the stock price.
Risks that affect a company’s earnings power can lead to bankruptcy; this correlates with risk to corporate bonds (credit risk).
Here are some risk factors that can impact a company’s future earnings:
- Incompetent management (company specific)
- At-risk supply chain input (company/sector specific)
- Workforce strike (company specific)
- Legal problems (company specific)
- Competitors (company specific)
- Localized natural disasters where the company operates (geo-specific)
- Changes to regulations that affect one company or sector (company/sector specific)
- Economy or turmoil in the country where the business operates (geo-specific)
- Changes in Interest Rates (all companies)
- Global Inflation (all companies)
- Global Pandemics (all companies)
- Global Recessions (all companies)
- Global supply chain shocks (all companies)
- World Wars (all companies)
The risks listed first can be quickly diversified by investing across various companies, sectors and geographies. But things get interesting when you look at the bolded risks.
Risks in bold apply to all companies. They cannot be diversified away! Such risks are called systemic risks.
Let’s cover these topics in more detail.
Idiosyncratic Risk: Risk You Don't Get Paid For
The risks associated with individual companies, sectors and countries are “Idiosyncratic risks.” I try to avoid big words at all costs, but I’ll keep this one since it’s an important concept.
You may ask, “why is this a problem? Doesn’t more risk equate to more returns?”
The answer is no.
Markets do not compensate investors (you) for risks that can be quickly diversified away.
An index fund diversifies away the following risks with the click of a button:
- Individual company-specific risk
- Sector-specific risks
- Geographic Risk
Why would you take additional risk without any expected benefit?
Personally, I see no need to take on a risk that does not provide an expected benefit.
You are not compensated for increasing idiosyncratic risk because it can be quickly diversified away.
Risk that applies to all companies is called systemic risk. This is the compensated risk – the risk you get paid to take.
I like to think of systemic risk as risk that applies to the entire “system.” In the case of stocks, the system is the global economic system.
Such systemic risks include large-scale war, climate risk, interest rate changes, inflation, global pandemics, and global recessions.
In the case of bonds, the systemic risk includes interest rate risk (duration risk) and credit risk.
You can learn more about systemic risk factors in this Corporate Finance Institute article.
Systemic risks impact all companies. It cannot be diversified away. You are compensated for your exposure to systemic risks.
The total risk of your portfolio is the systematic risk + the non-systematic risk. The picture below shows that diversification reduces total risk. After sufficient diversification, your total risk equals your systemic risk.
At this point, all you are left with is the risk that can’t be easily diversified away.
Please note the green line is not to scale. It’s just to illustrate the concept.
Why is Idiosyncratic Risk Uncompensated?
Let’s assume markets are efficient, meaning all available information is priced into every stock and every bond. (Read my post on the Efficient Market Hypothesis to see that markets are indeed pretty efficient).
In an efficient market, all assets are fairly valued. There is no room to earn higher returns by finding “undervalued” stocks.
In this situation, only the market return can be expected from any given stock. Any returns above the market return can only come from events that can’t be forecasted (luck). The luck can be good luck or bad luck.
Investors can only expect the market return from a single stock in an efficient market, but the single stock is exposed to the idiosyncratic risk factors above!
Therefore, the stock has far more risk than the broad market, with the same expected return as the broad market.
Owning multiple stocks (diversification) reduces risk, while retaining the same expected return (the market return).
As you continue to diversify, the total risk approaches the systemic risk. At this point, all risk is compensated risk.
More Systemic Risk: More Returns
Assets with higher systemic risk have higher expected returns. This is a core component of the Capital Asset Pricing Model.
The risk-return relationship is why stocks have historically beaten bonds, and bonds have traditionally beaten treasury bills.
The higher risk of stocks is the reason for the higher returns of stocks over bonds.
To see why stocks are risker than bonds, consider what happens when a company goes bankrupt. The bondholders are paid back first. Stockholders are the last priority for payment.
You can learn more about the systemic investment risk for index portfolios in my post Investment Risk for Stocks, Bonds and Cash. This post explores uncertainty in returns from the following asset classes:
How to Diversify: Total Market Index Funds
Diversification has never been easier. Anyone in Canada or the US can access thousands of stocks and bonds around the world with low-cost index funds. These are available through brokerages, either as index mutual funds or index ETFs.
I’m specifically talking about total market index funds that hold all stocks in a stock market. This includes large-cap, mid-cap and small-cap stocks spread across the 11 market sectors.
Globally diversified total market index funds eliminate nearly all idiosyncratic risks associated with specific companies, sectors, or countries.
The risk remaining is primarily systematic risk, thereby maximizing your risk-adjusted returns.
Not All Index Funds are Diversified
Not every index is diversified. Consider the S&P U.S and China Electric Vehicle Index. It holds 50 EV stocks in a narrow sector, with substantial idiosyncratic risk that you are not paid to take.
This idiosyncratic risk materialized between 2021 and present, where the S&P U.S & China Electric Vehicle Index fell by over 50%. This is a reminder that exciting companies are not always good investments.
Risky Business: Holding Employer Stock
Your human capital is concentrated in the company you work for. By holding a lot of stock in that same company, you concentrate your financial and human capital.
That’s a lot of idiosyncratic risk!
If the company fails, you take a massive hit to your financial capital and your earnings.
Financial and human capital can be diversified in the following two ways.
First, you can shift your investments away from your work sector. For example, an oil worker would hold fewer stocks in the oil sector, and more stocks in the other 10 sectors.
Second, you can build a diverse skill sets. For example, a munitions disposal operator will have a harder time finding employment than a project manager if their employers go bankrupt.
The power of diversification extends beyond investing. It also applies to your human capital.
In an efficient market, you do not receive higher expected returns for taking on the additional risk that can be easily diversified away.
Risk that can be easily diversified away includes risk associated with individual companies, sectors or countries.
Therefore, you get the best returns for a given amount of risk with a global stock/bond portfolio that is aligned with your unique risk tolerance.
Diversification is “the only free lunch in investing.”