By: Joseph Goldy, CFP®
What is Diversification?
One of the most fundamental principles of investing is diversification. Diversification does not overload your portfolio into any investment but instead spreads the risk across different areas. Ideally, your portfolio is invested in several diverse types of investments, but as you'll see below, there is more to diversification than buying stocks, bonds, or funds.
At Highland, we make sure client portfolios are diversified across many broad categories. However, we feel proper diversification is done not just by asset class but, importantly, by company size, sector of the economy, and geographic region.
Diversification by Company Size
Diversifying by size is often referred to as a company's market capitalization. Market capitalization is simply a way to group companies by size and is calculated by taking the number of shares outstanding and multiplying it by a company's share price.
It's important to diversify by company size since the market will favor certain size companies over others at various times depending on factors such as where we are in the economic cycle and what the government is doing with fiscal and monetary policy decisions.
Below are the market cap categories by market value:
Mega-cap: $200 billion or more
Large-cap: $10 billion - $200 billion
Mid-cap: $2 billion- $10 billion
Small-cap: $250 million - $2 billion
Micro-cap: Less than $250 million
Diversification by Sector or Industry
The second way to diversify is by sector and industry. Below are the main sectors of the economy according to the Global Industry Classification Standard, along with an example of each:
Energy (ExxonMobil)
Materials (Southern Copper Corp.)
Industrials (General Electric, Boeing)
Utilities (PSE&G)
Healthcare (Johnson & Johnson)
Financials (JP Morgan Chase)
Consumer Discretionary (Nike, McDonald's)
Consumer Staples (Costco, Altria, Colgate-Palmolive)
Information Technology (Google, IBM)
Communication Services (Verizon, AT&T)
Real Estate (Simon Property, Public Storage)
Diversification and the Four Phases of an Economic Cycle
Although hard to sometimes predict accurately, the theory behind diversifying among sectors of the economy is that specific sectors do better or worse depending on what phase of an economic cycle we're in.
For example, if we're in a recession, generally, people are cutting back on consumer discretionary spending such as vacations and jewelry. However, if the economy is expanding and nearing a peak, some sectors that do well are financials, energy, and materials. This is due to increased business and consumer financing activity, people buying homes and cars, and higher energy use due to increased manufacturing.
You can see in the chart below which sectors tend to outperform relative to the economic cycle we're in.
Diversification by Geographic Region
The final way to view diversification is geographic. Geographically diversifying is one area that may not be as clear as it seems at first glance. That's because, over time, the percentage of the U.S. market's share of revenue generated from outside the country has grown and currently stands at almost 40%. The result is many U.S. investors are more diversified globally than they may realize.
Should I Diversify with International Stocks?
Take a look at some U.S.-based companies and their percentage of sales that come from outside the country:
Apple - 67%
Johnson & Johnson – 48%
Visa – 54%
Coke – 66%
Mcdonald's – 64%
Nike – 60%
Coca-Cola alone has 54 plants in India. When assessing how diversified your portfolio is, it is essential to understand that where a company has its headquarters based is mainly irrelevant.
Suppose you owned the companies listed above and thought you needed to add some international or emerging markets to your portfolio for diversification. In that case, you may add too much since the companies above would be operating in many of the same countries a foreign or emerging markets fund would be investing in.
In fact, in his book, "Bogle on Investing," the founder of Vanguard, John Bogle, went so far as to say you do not need international stocks in your portfolio due to the increased risk and the fact so much of the U.S. companies' revenue is already coming from around the world.
At Highland, we believe a portfolio has a place for foreign and emerging markets. Still, we monitor the correlation between the U.S. and international markets to ensure we get the desired diversification.
Diversification by Growth and Value Companies
We've discussed diversifying by size, sector/industry, and geographic region. Overlayed on all of these areas is diversifying by growth and value. Growth companies are expected to grow faster than the economy overall, rarely pay dividends, and are typically in tech or consumer discretionary sectors.
Value companies tend to be undervalued by the market currently and carry the expectation that the market will eventually realize their correct value and their shares will rise. Both growth and value are another way to view diversification.
Diversification Through Alternative Investments
Lastly, at Highland, we incorporate alternative investments into client portfolios. Alternative investments come in a variety of forms and across different industries. They require extra due diligence since many are private, but the benefit to an investor's portfolio is that they often do not move in the same direction as stocks or bonds, which is a benefit when markets are down.
My sons and I enjoy fishing and just recently went out on Father's Day, catching a few nice size bass (holding my hands up to show a fish much bigger than the ones we caught). Diversification is like fishing; the larger the net you cast, the more likely you are to capture opportunities for your portfolio that do well when another may not be doing so well.
How Highland Can Help?
If you want to learn more about how Highland Financial Advisors can help you diversify your portfolio, please contact us or use the button below to schedule a meeting with an advisor.
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.
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.