Why Could Portfolio Diversification Be a Way to Minimize Your Risk of Loss?

You have heard the old saying during particularly volatile securities markets: “Don’t put all of your eggs in one basket”. In particular when all of the eggs in that basket are going up and down in value together. Instead, it can potentially be less risky if you invest your eggs in multiple baskets and then you watch them very carefully to make sure they are performing the way you expect them to perform.

In theory, if one basket is performing poorly it only impacts a portion of your assets. Even better, there can be other baskets that are producing positive returns that offset the losses that are being produced by the first basket.

Needless to say, if you knew the best performing basket in advance you might be inclined to put all or a significant portion of your assets in it. However, this is a very risky strategy when you don’t know the best-performing basket in advance.

Since the future is uncertain, and no one has an accurate crystal ball, you are better off using a diversified strategy so poor performance has the potential to only impact a small portion of your assets.

Want to know more? This article will cover the following topics:

What is the role of diversification?
What are asset classes?
What is the opposite of a diversified portfolio?
What is the best investment environment for bonds?
What are alternative investments?
What is stagflation and how does it impact your investment strategy?
Which businesses are hurt the most by stagnation?
Which businesses produce the best results during periods of stagflation?
Why does demand for financial advice increase during recessions?

What is the role of diversification?

A primary role of diversification is to minimize your risk of large losses.

You could own a diversified portfolio of individual stocks or an Exchange Traded Fund that invests in 200 stocks. Or, you could own a balanced portfolio that includes a blend of stocks, bonds, and cash equivalents.

In a 10-stock portfolio, each investment could represent 10% of your assets. On the other hand, in a 50-stock portfolio, each investment could represent 2% of your assets. This reduces the impact of a bad investment.

You could be even more diversified by owning a combination of 50 stocks, 10 bonds, and other types of assets – for example, three income-producing real estate investments.

What are asset classes?

At a high level, stocks and bonds are two very distinct asset classes. Stock prices are impacted by the earnings of companies. Bond prices are impacted by changes in interest rates.

If we drill down a little further, domestic stocks and foreign stocks are two types of asset classes. The definitions of foreign and domestic vary based on where companies are headquartered and where companies derive most of their earnings.

It is also possible to divide stocks into additional asset classes such as small, mid, and large capitalizations or blue chips, dividend-paying stocks, value stocks, and growth stocks.

What is the opposite of a diversified portfolio?

The opposite of diversification is concentration. An example would be you hold ten stocks that are all in the technology sector. This is a very risky strategy because one economic event could simultaneously impact all of the stocks in that industry group. For example, several stocks in that sector announced lower earnings.

Concentration may be used by younger people who have an extremely high tolerance for risk. Or, in some cases, a high percentage of their net worth is impacted by one stock – the stock options of the company that they work for.

What are alternative investments?

Stocks, bonds, and cash equivalents (CDs, Money Market Funds, and T-Bills) are three primary asset classes. Then there are other asset classes that include: Real Estate Equity, precious metals, commodities, foreign currencies, collectibles, private equity, and others.

Diversifying into alternatives can be a two-edged sword. On the one hand, you are diversifying away from asset classes that fluctuate based on earnings outlooks and interest rates. On the other hand, you may be investing in asset classes that you know very little about.

It pays to obtain knowledgeable, experienced advice when you invest in alternatives.

How does inflation impact investing?

High inflation rates can be the precursor for a recession when businesses react to higher expenses by reducing their costs and increasing prices to maintain their margins.

Inflation is particularly destructive when it erodes the purchasing power of most Americans’ assets – for example, the assets being used to fund retirements.

You might say inflation has a double impact because it damages the profitability of companies and the purchasing power of consumers. This can be particularly destructive when it triggers a destructive wage/price spiral by consumers and companies.

What is a recession?

A frequently accepted definition of a recession is two consecutive quarters of a decline in Gross Domestic Product of the U.S. Or, a recession just needs to be a contraction in the economy that includes shrinking production, lower consumption, and rising unemployment as companies layoff employees to reduce their expenses

There is also the spiral effect when industries start laying off employees due to reduced demand for their products or services. Their suppliers experience reduced demand when they reduce their purchases so they also start laying off workers and cutting other costs.

A depression may be described as a severe recession that is more global in its impact and can last for longer time periods.

One of the most visible characteristics of recessions and depressions is a substantial rise in unemployment rates. The loss of jobs will also impact the buying habits of the unemployed – they will do whatever it takes to reduce their costs.

Who gets hurt the most during periods of stagflation?

Stagflation is a period when the economy is contracting and prices are rising. This is the ultimate double whammy. Consumers are buying less because the prices of goods and services are increasing. Companies are laying off employees to reduce their expenses.

The businesses that are impacted the most produce discretionary items that are easy to defer. For example, instead of buying new cars in 2023 consumers choose to defer these purchases until 2024 or later. These deferrals impact the car companies and all of their suppliers.

Which industries are impacted the least during periods of stagflation?

Consumers still need to buy food, use electricity, and have a place to live so these industries are impacted the least by stagflation.

For example, many rental agreements of apartment complexes have inflation protection clauses in their service agreements. Consequently, their prices rise with every uptick of inflation.

Some businesses that produce lower-cost products, can also flourish during periods of inflation, recession, and stagflation.

Why does demand for financial advice increase during recessions?

Just about everyone benefits when the stock market is going up. In fact, some DIYs (Do It Yourselfers) begin to believe investing is easy. On the other hand, a declining stock market can be intimidating when the market values of assets in 401ks, IRAs, and personal accounts are declining in value. At some point, these investors may turn to professional help.

Investors who are comfortable in rising markets may want decidedly more contact with their financial advisors in down markets. There is a certain amount of comfort when your assets are managed by financial professionals who have experienced many different market cycles.