By: Gary Hirsh, CPA, CFP®
I’ve been asked numerous times throughout my career about the importance of diversification in a portfolio. After all, why not just buy the “hottest stocks” or the hottest sector, as evidenced most recently by the “Magnificent 7” (Google, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) This portfolio would have had a 1,3- and 5-year annualized return of 20.9%, 46.22% and 37.98% respectively.
The question may be, after a 51.25% return in 2021, would most of us have the nerves or foresight to sit tight through a 49.72% decrease in 2022?
Toward the end of 2022, would many have bet the Magnificent 7 portfolio would more than double in 2023?
The father of diversification was Harry Markowitz, an economist, who at the age of 24 wrote an article that traced the relationship between returns and the variability of returns. In short, Markowitz advocated “not putting all your eggs in one basket.” Markowitz saw that investors cannot look at items in isolation.
Holdings needed to be evaluated in terms of the relationship between them. The extent to which holdings move together can determine how much risk you may reduce. Markowitz argued that by diversifying investments with different risk and return profiles, investors could minimize the risk without sacrificing returns.
Perhaps like today’s Magnificent 7, I learned about the 1960s-70s stocks thought to be stable with high valuations. I know my dad advised me with one of his rhymes. “Don’t be a jerk, Buy Merck.” While some of the names have done well (American Express, Coke, Disney, Pepsi, Procter & Gamble), others, such as Polaroid, JCPenney, Kodak, Digital Equipment Corp., Sears, Xerox, and Joseph Schlitz Brewing, are hardly household names now. These examples emphasize that there is no sure deal in investing and that one is better off owning many stocks and asset classes.
Diversification means different things at different points in one’s life. For example, for a grandchild account or those investing in 401(k)s in their 20s, why not maximize the returns with close to a 100% stock portfolio? This allocation may be appropriate for those with a 40+ or more year time horizon.
However, as one faces “adulting,” it becomes more prudent to sacrifice returns for stability for big-ticket items like cars, homes, colleges, etc. Investors need a safety zone where, regardless of the market returns, they know the volatility associated with equity returns will be diminished in investments such as treasury or high-rate bonds. Note that there are years, such as 2022, in the face of interest rate increases, where even the US Aggregate Bond Index lost 13%.
At HIGHLAND, we further diversify away from the traditional stock and bond asset classes using alternative investments such as private credit, private equity, and private real estate. The conclusion is that while diversification may limit “home run” gains, the more balanced approach reduces risk and mitigates market volatility.
The foregoing content reflects the opinions of Highland Financial Advisors, LLC, and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions, or forecasts provided herein will prove to be correct.
Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses, which would reduce returns.
Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful or that markets will act as they have in the past.
The above article was written with the assistance of artificial intelligence (AI).