Understanding Diversification

Pie Chart

Having a diversified portfolio is one of the keys to successfully managing your wealth. But while the idea of diversification may seem simple—putting all your eggs in one basket generally isn’t a good idea—it’s often misunderstood.

Simply having a lot of different investments doesn’t necessarily mean you have a diversified portfolio. Having a large number of stocks that are all in the same sector of the market—a lot of technology stocks, for example—doesn’t offer much diversification: if something happens to that sector, all of the stocks could decline at the same time.

Even having a large number of funds (which offer more diversification than individual stocks or bonds) doesn’t guarantee you’ll have a well-diversified portfolio. If all the funds have similar characteristics, they’re likely to all rise and fall at the same time. In other words, even if your eggs are in different baskets, it won’t do you much good if the baskets are all tied together.

So if the raw number of different investments doesn’t matter, what does? The goal of diversification is to lower the overall risk of a portfolio by putting together different investments that don’t all go up or down at the same time. A well-diversified portfolio will therefore have a mix of different asset classes, different stock sectors, different bond sectors, and different regions of the world. A portfolio that’s too concentrated along any one of these dimensions is not well-diversified, no matter how many individual investments in contains.

Avoiding the Low Volatility Trap

Stock market volatility—how much the market goes up and down on a daily basis—has recently been unusually low. Since July of last year the S&P 500 index of large US stocks has gone either up or down by more than 1% on only about 12% of trading days, compared to a historical average of more than 20%.

Stock Market Volatility

Such low volatility isn’t necessarily good or bad, although most investors probably appreciate not having the value of their wealth swing wildly on a day-to-day basis. But low volatility can also trick investors into making bad decisions that damage their long-term performance.

One cause of these bad decisions is regret. Low volatility typically occurs as markets rise: the recent tranquility has occurred in the middle of an almost 40% rise in the S&P 500 index since the start of 2013. When these kinds of bull markets occur, a natural tendency is to wish you had allocated more of your portfolio to stocks.

The effect of regret is compounded by recency bias, the tendency for people to predict what’s going to happen in the future based on what’s happened in the recent past. During periods of low stock market volatility, it can be easy to forget that stocks often move up and down quite a bit (at the nadir of the financial crisis in late 2008 US stocks rose or fell by more than 5% in a single day numerous times).

Regret and recency bias are normal, so it’s not always easy to fight them off. The result can be a low-volatility trap, where calm markets lull you into taking too much risk. The key to avoiding this fate is to honestly assess your willingness and ability to take risk, and then stick to a long-term strategy aligned with that risk tolerance. Sticking to your strategy may not always be easy, but it will increase your chances of achieving your long-term financial goals.

The Biggest Political Risk

China-US Diplomacy

We recently discussed the rise in political risk that investors have had to deal with over the past few years. But where is this risk most likely to have a meaningful impact on US investors? The answer, perhaps surprisingly, is East Asia.

That answer may seem odd given the political uncertainties in other parts of the world. Syria has been racked for years by a deadly civil war, Iraq’s government is trying to fight off an insurgency, Russian-linked separatists have been stirring up trouble in Ukraine, and military leaders have claimed power in countries such as Egypt and Thailand. But when it comes to global financial markets, these countries are bit players. Even Russian stocks comprise only about one half of one percent of the value of the global stock market. While it’s true that events in small countries can have an impact—trouble in Syria or Iraq could spread throughout the Middle East and affect global oil supplies, for example—political risks related to larger countries would be more consequential.

Since 2012, a diplomatic conflict has been escalating between China and Japan over a group of uninhabited islands in the South China Sea. China also has territorial disputes with other countries in the region, including Malaysia, the Philippines, and Vietnam. So far these conflicts have remained mostly diplomatic rather than military disputes, but there are routinely provocations that threaten further escalation. Last month China stationed an oil rig in territory claimed by Vietnam, leading to riots in Vietnam targeting foreign businesses.

A military conflict between any of these countries could roil financial markets: Japan is the second-largest country in the iShares MSCI All Country World Index ETF, while China is the ninth-largest. Furthermore, the United States could intervene in such a situation (the US has a security agreement with Japan), making the strife truly global.

The good news is that the probability of a large-scale military conflict is still very low. Yet even if the disputes remain the purview of diplomats, investors could feel some effects: trade between China and Japan has fallen substantially since their territorial squabble metastasized in 2012.

The Importance of Taking Inflation into Account

There are lots of reasons to try to grow your wealth, from retirement to education to starting a business. One thing these goals have in common is that the amount of money needed to achieve them doesn’t stay constant. The prices of almost everything change over time, which is why it’s important to take inflation into account when setting your financial goals.

The inflation rate (typically measured using the Consumer Price Index) reveals how much prices have risen (or fallen) on average for the things consumers spend their money on, such as food, rent, clothing, and medical care. If prices increase, your “purchasing power” falls, since the same amount of money can buy fewer items. Over long periods of time purchasing power can change dramatically: you would need almost $2,400 to buy the same amount of goods and services that you could have bought with $100 a century ago.

When “inflation” is discussed as a general concept, it’s referring to this average price increase. For specific items, however, price increases or decreases can be substantially different. According to the College Board, for example, since 1971 the average cost of college at a private non-profit four-year school increased by 2.1% per year more than the overall inflation rate.

College Costs

So how much inflation should you plan for when setting your financial goals? There’s no universal answer. The Federal Reserve, which controls interest rates to manage economic growth and inflation, aims for a 2% inflation rate. For a broad goal, such as retirement, this number is probably a reasonable assumption. For goals more focused on a specific purchase—such as funding a college education or buying a home—the right inflation assumption will depend on the details of the goal, and could be much higher or lower than 2%.

The Rise of Political Risk

One important trend in global financial markets during the last few years has been a rise in political risk, a concept referring to political changes that could affect the value of an investment. The number of events associated with political risk—such as elections, mass protests, and military interventions—has increased by 54% since 2011, according to a study by analysts at Citigroup. This kind of increase has a couple key implications for investors.

The first is that it can affect the relative performance of emerging markets versus developed markets. Interestingly, while political risk has historically been most closely associated with poorer countries, in recent years it has appeared in some of the wealthier emerging markets and even developed ones.

In emerging markets there have been protests in a wide range of countries, including Brazil, Russia, South Africa, Thailand, and Turkey. In developed markets, political posturing opened up the possibility that the United States government would default on its debt in the summer of 2011, and extremist parties opposed to the European Union did well in recent elections for the European Parliament.

A continued increase in political risk would likely hurt emerging markets more than developed markets, even if the risks aren’t isolated to emerging markets themselves. Investment typically flows from emerging markets into “safer” markets (such as the United States, Switzerland, and Japan) when perceived risk increases. This shift can take place even when the risk originates in the developed countries, as was the case when emerging markets were pummeled during the 2008 financial crisis.

A second implication of increased political risk is that it may lead to more divergence in the performance of stocks in different countries. This trend is already evident in some of the countries that have recently experienced notable political events. For example, Russian stocks have lost 8% so far this year (and at one point were down close to 25%) as the country became involved in territorial battles with Ukraine. Indian stocks, by contrast, have risen more than 20% this year as political power shifted in the country’s May elections.

EM 2014 Performance