Understanding Diversification: Strategies for Better Portfolio Management

As the saying goes, you shouldn’t put all your eggs in one basket. You shouldn’t put all of your investments in one place either. Diversification involves spreading your investments across various assets to minimize risk and maximize potential returns. It's a fundamental strategy that can help safeguard any portfolio against market volatility.

In this episode of Capital Conversations, CERTIFIED FINANCIAL PLANNER™ professional Colin Day and portfolio manager Ryan Potts discuss the principles of diversification, its benefits, and explore practical ways to implement it in your investment strategy.

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Below is a transcript of our most recent podcast, “Understanding Diversification: Strategies for Better Portfolio Management”

Colin Day: Welcome back, everyone, to another edition of Capital Conversations. I'm Colin Day, CERTIFIED FINANCIAL PLANNER™ professional, and with me today again is Mr. Ryan Potts, our portfolio manager. Ryan, welcome back.

Ryan Potts: Thank you, Colin, for having me.

Colin Day: You're welcome. Thank you for accepting the invite.

Ryan Potts: Yes.

Colin Day: Today we are going to be chatting about diversification. It's something your advisor likely preaches. And if you've never heard of that term, there's lots of ways that we can swing the conversation of diversification. We're going to talk about at least a couple versions of diversification today, I believe.

But Ryan, why don't we start there? Most advisors preach diversification in many different ways across client portfolios. But if you were to maybe dumb this down for a layperson like myself, how would you describe diversification to the broad masses?

Ryan Potts: Diversification, or what most people know as broad diversification, is simply just owning a wide basket of all kinds of different assets. I think the easiest analogy is probably within stocks, because most people think of it that way.

One might argue that true diversification or complete diversification might be the S&P 500. That's 500 individual names, all kind of packaged inside of one index. You buy the index, you now are broadly diversified amongst 500 different names. You can blow that picture up even more if you want to say the Russell 3000, which is an index that's encompassing of the 3000 largest US stocks. You buy that index, you own 3000 different names.

Simply put diversification is a methodology of covering all the bases when it comes to exposures. Owning everything, not necessarily picking, one over the other, but simply broadly owning everything that's available to you.

Colin Day: Right. And I think if we want to stick on the S&P 500 just for a moment, that's equally weighted, right? Those 500 companies – that spreads out your risk evenly across all 500, right? So for an argument for broad diversification, what's wrong with that?

Ryan Potts: Well, there's a lot of things wrong with it. No, I'm kidding.

Colin Day: Including what I just said.

Ryan Potts: What you just said was not accurate in the sense that the S&P 500, and this is actually a great talking point, because most people I think have misconceptualized what this looks like. The S&P 500 is not equally weighted. It's market cap weighted.

Colin Day: Gasp. So what's market cap weighted?

Ryan Potts: The difference between equally weighted and market cap weighting – again, sticking with the S&P 500 – I'll say 100 names in a broadly diversified basket, equally weighted might be 100 names weighted at 1 percent across the board. That would be equally weighted.

Market cap weighted, however, says the largest companies in that index are going to have a larger weight relative to smaller companies in that index.

What does that turn into? Well, we have a situation right now in May of 2024. We maybe have 10 names in the S&P 500, so 10 of the 500 names are greater than 40% of the weight in the index. So owning the S&P 500, yes, you might be broadly diversified, but you also might have some concentration built into that diversification.

Colin Day: And is there a particular market sector that this weighting might be – again, because it's cap weighted – towards a particular kind of industry? So, for example, like, we might call them the Magnificent 7.

Ryan Potts: For those who are familiar with the Mag 7, you can really think of all these technology stocks. And so the S&P now has almost turned into a NASDAQ-like index in the sense that the NASDAQ is mostly tech companies. If you look at the S&P 500, you own different sectors. Right now, predominantly, it's technology.

Colin Day: Right.

Ryan Potts: So again, you're getting concentration in the fact that you have ten names at the top or 7 in the Mag 7 that are concentrated in weight, but then you also have concentration in select sectors. So you're not getting broad sector exposure either.

Colin Day: Right. So I think what we're explaining here is that when your advisor thinks about diversification across investments, just investing in an index might not be enough because again, depending on how the index is set up, you might be actually concentrated, accidentally thinking you're more diversified than you actually are.

So when we think about diversification as part of our portfolio management, what kind of diversification are we striving for?

Ryan Potts: We look for more efficient diversification. And why is our diversification more efficient than maybe the S&P 500? As some might argue, or as we can use as the baseline.

Well, ultimately we say that there is concentration built into just broadly diversifying. Also, we might be buying assets now, kind of looking at a broader picture, we might be buying stocks and bonds in a portfolio. As of recently, really like the last five years, stocks and bonds have kind of moved in lockstep with each other. And so their diversification isn't what it used to be. Another way this is put is correlation. The correlation between the two is positive, and skewing closer to one than ever before.

So, we could argue that if you're broadly diversified, you're getting a correlation between assets that isn't really helping your portfolio, which means that they're just going up and down together.

What we're trying to accomplish with our efficient diversification is identifying assets, asset class sectors, etc… that maybe move in less correlation between one another. And the goal there is, maybe one sector is up and the other one's down, but in the inverse situation, that same sector that was down, and the same asset class that was down, might be up now, and the one that was up might be down.

So it's kind of, “How do we balance out the risk and return risk reward profile of a portfolio?"

Colin Day: Yeah. And I think the overall object is to diversify in a way that reduces the market volatility in the accounts, because especially for many of our clients that are very close to or in retirement, that kind of market volatility doesn't bode well for them. The majority of the questions that we get from portfolio management side, at least personally from a financial planning perspective that, are “Hey, what are we doing?” So when the market is up, they were capturing all the gains, but then maybe when the market is down, maybe we're not experiencing the lowest of the lows and then everything in between there.

Because as Ryan's pointing out with the correlation, if everything goes up at the same time, stocks, bonds, all the different market sectors, well, that's good when things are going up, but it also means we're capturing all those losses on the other end.

Ryan Potts: Yeah. And I think back to – I think it's always fun to wrap in our older conversations – but the bucket approach and the way that we talk about kind of your midterm and long term bucket of money and your short term bucket and how they're all invested in a slightly different way. I think a lot of that has to do with correlations between the buckets as well and saying that, “Hey, your short term bucket, we want little to no correlation to the public stock market because we know in your growth bucket, you're going to have a lot of correlation to the public stock market.”

The reason you want that is again, we can always refer back to the year of 2022, where stocks were down double digits, bonds were both down double digits. We're sitting there like the only thing that was really safe or secure was alternatives or cash. And in your short term bucket, you were hopefully sitting in cash and not alternatives because you might not be able to get out.

Ultimately that's the goal and that's how it implements into the way we speak of efficient diversification. We're doing it through the bucket approach and we're looking at saying, “We want to own assets that are uncorrelated or that have negative correlation and they can protect our clients on both the down and upsides in the market.”

Colin Day: Sure. So explain that a little bit more. Maybe provide an example if you can of what efficient diversification might look like for our clients. What is the kind of research you're doing? What are you looking at on the back end to make sure that our clients are experiencing that level of diversification as opposed to the “I bought the index. I'm diversified, or at least I think I am”?

Ryan Potts: Yeah. You can look at efficient diversification in a lot of different ways, and I think it depends on, are you talking about at the portfolio level? Are you talking about at the strategy level? Are we talking about just broadly, how are we diversified as a firm, even, in different asset classes?

The conversation can get different, and the reason that's important to talk about first is, at the portfolio level, right now, we might say that bonds are actually providing an attractive, uncorrelated exposure to the public markets. This might be occurring because interest rates are up significantly compared to where they have been in the last decade, and we're finally feeling like we're getting the buoyancy in the portfolio that we've been looking for in the sense that we feel, because there is a higher yield being generated from bonds, we have some downside protection in the event that the market were maybe to go south.

We haven't had that over the last 10 years. So advisors who typically maybe preach the 60/40 allocation as the perfect diversification – we've seen advisors moving away from the 60/40. I think that we've actually taken the stance that where the markets are at, we feel like we are getting some downside protection in bonds, so we're maybe kind of floating back into the 60/40 allocation. That's a portfolio level.

From a strategy or an asset or sector allocation perspective, I think – this is the one that I always refer to. Again, going back to the S&P 500 – a lot of people recognize that one. You look at the S&P 500, you own 500 names, but really 40% of that exposure is derived from 10 names. So I always argue to people, you don't really own 500, you maybe own 10, you own 10 quite a bit, and then you own the rest maybe a little bit. Our argument is that you can go out and buy 30 to 40 individual names, and maybe have a neutral sector weighting to the S&P 500 and get the same level of diversification benefits out of the 30 to 40 names that you would get from buying the 500 names in the S& P 500.

Colin Day: Yeah. When we coined this – well, not us personally, but whoever coined this – efficient doesn't mean that we have to spread out our eggs amongst 500 different companies per se. We can still accomplish the same types of things with a limited menu. And so you might look at it and say, “Well, how terribly efficient is that?” Again, as long as it's spread out across kinds of market sectors, market caps, whether it's domestic, international, whatever, we can still achieve that without having to flood the portfolio with a bunch of names.

Ryan Potts: Broad diversification that has no strategy involved whatsoever.

Colin Day: Right, right. And that 60/40 portfolio that Ryan was mentioning, just a level set for everybody, if you're not familiar, 60/40 is just referring to the exposure to equity and fixed income.

So 60% in equities or stocks, and then 40 percent generally in bonds. That's a pretty traditional pre-retiree or retiree portfolio. So thinking about the diversification and how we play with that, that's ultimately what Ryan was referring to there.

So Ryan, what have we touched on with the efficient diversification or what haven't we touched on that you want to make sure that people know about before we let them go?

Ryan Potts: So the way that I look at it, you have broad diversification again, which is just owning the market or the index, whatever you might be trying to get exposure to. Efficient diversification is taking more of a strategic approach to it. Really digging into the weeds and doing the research and the underlying analysis and due diligence to figure out, “How can I get calculated exposures with efficient diversification.” And maybe it's by doing it with less names than the S&P 500, or maybe it's by looking at different asset classes like alternatives or fixed income relative to the equity markets.

Being a little bit more targeted, being a little bit more deliberate with the analysis and the research is what we try to strive for in our efficient diversification.

Colin Day: Got it. All right. Right. Thanks for educating us today. Appreciate it.

Ryan Potts: Absolutely. Thank you for having me.

Colin Day: All right. Until next time, thanks everyone for joining us on Capital Conversations. We'll catch you next time.

The opinions expressed in this program are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. It is only intended to provide education about the financial industry. To determine which investments may be appropriate for you, consult your financial advisor prior to investing.

As always, please remember investing involves risk and possible loss of principal capital. Please seek advice from a licensed professional. Correct Capital Wealth Management is a registered investment advisor. Advisory services are only offered.

Capital Conversations | Correct Capital Wealth Management

True diversification goes beyond simply spreading investments across various assets and involves strategically selecting the right mix to balance risk and return effectively. If you don't have the time, interest, or knowledge to handle your assets and investments efficiently, a financial advisor can help you navigate these complexities and tailor a diversification strategy that fits your unique needs and goals. To learn more about how a financial advisor can support your financial journey, give us a call at 877-930-4015, contact us online, or schedule a consultation with a member of our advisor team today. It only takes 15 minutes to understand if you're a good fit.