Return to:Previous Page
Morningstar.com's Interactive Classroom

Course 503
Diversification

Introduction

You've decided on your investment objectives and you’re ready to begin building your portfolio. But what asset classes should you include, and in what proportion? Ah, the process of diversification. There are two levels. One level addresses which asset classes--such as stocks, bonds, real estate, venture capital--should be part of your portfolio. The second, more specific level addresses what kinds of securities--from conservative to aggressive--you should hold within each asset class. This process may seem like a hassle, but it's worth it.

Diversify a Little, Diversify a Lot

The answers to these questions--which assets you should own and in what proportion--lie in your objectives and constraints. Return, risk, time horizon, liquidity, and taxes all play a role. A diversified portfolio will be made up of asset classes that are not correlated with each other--meaning as one asset class rises or falls, the other asset classes will more than likely not move in the same direction. This multi-asset, risk-conscious approach gives the portfolio resiliency in different market environments. College-bound high-school seniors all worry about what college they’ll get into, but they can practice very different application strategies. Some fill out just a few applications, but labor over each; all forms are neatly typewritten and every essay is carefully crafted. Other students take a different approach, feverishly sending out applications to 15 good colleges. These students can't spend as much time on each application, but they hope that by spreading their bets around, some admissions officer, somewhere, will give them the nod. Here’s the parallel to the investing world. On the one hand are investors like Warren Buffett and Marty Whitman, who believe that focus is key to success. Research particular investments meticulously, they counsel, and when you find one you like, load up. If you know--really know--that an investment is great, there’s little risk in devoting a huge chunk of your portfolio to it. Overdiversifying, in this view, just leads to shoddy work. On the other hand are investors--including most financial planners and academics--who believe that diversification is the best, if not the only, way to reduce risk. The more efficient that you think securities markets are, the more you’ll lean toward this view. (Efficient-market theory says the more quickly information comes to the marketplace and the more rapidly it’s reflected in market prices, the more highly efficient is the market.) After all, if markets price stocks and bonds correctly, it’s rather foolish to waste time looking for just a few great investments. But no matter what your view is on market efficiency, you can still argue that widespread diversification is the best policy. The human ego being what it is, it’s all too easy to convince ourselves that we’re little Warren Buffetts, able to find great investments. Humility counsels us that no, we’re not that good, and that we’re better off hedging our bets through diversification.

The Best Approach

Who’s right? Well, the answer depends on the investor. Think back to the college applications. There’s no right answer as to whether it’s best to write a few polished applications or mail out a dozen or more. For students who know where they want to go and can add value to their applications by spending time on them, the first option is better. For those who would be happy at any of a number of good schools and who can churn out quality work en masse, the second option is probably the best. Both sets of students may be pursuing their highest-return, lowest-risk option, given their desires and abilities. Likewise in investing. Assuming an investor has the time and knowledge to do research, it makes sense to focus on building a small portfolio of (potentially) great investments. Others may feel that finding those great investments is not worth the effort (or that it might be impossible to do so) and therefore choose to spread their investments far and wide. And, of course, there’s the whole range of positions in between. Keep in mind, though, that no matter how good a stock-picker you may be, a small portfolio will be the riskier course. Even a great focused investor such as Buffett can't elude risk. In March 2000, Buffett's Berkshire Hathaway was down nearly 50% from its early 1999 high. Eventually, it comes down to your risk and return trade-off and how much confidence you have in your stock-picking abilities. For the equity portion of an account, studies have shown that as few as eight to 12 stocks, whose returns are not highly correlated with each other, would reduce the portfolio risk to the risk level of the market. These studies are based on the average past performance. When looking forward, those portfolios with just eight to a dozen stocks will have results that are not as predictable as those of a portfolio made up of many more stocks.

Quiz 503
There is only one correct answer to each question.

1 Which best describes the multi-asset, risk-conscious approach to investing?
a. Many different asset classes are employed in a portfolio with no thought given to how they will affect the risk and return objectives of the portfolio.
b. The portfolio balances risk and return and includes many asset classes, thus offering the most flexibility to respond to different market environments.
c. Losses in one asset class will doom the entire portfolio.
2 What does the efficient-market hypothesis explain?
a. The more quickly information comes to the marketplace and the more rapidly it's reflected in market prices, the more highly efficient is the market.
b. An efficient market is one in which public information is never reflected in the market price of an asset.
c. The more slowly information comes to the marketplace and the more gradually it's reflected in market prices, the more highly efficient is the market.
3 Name the first two steps of diversifying a portfolio:
a. First, randomly pick asset classes with the highest expected return, and then pick the riskiest securities within those asset classes to maximize the portfolio return.
b. First, pick individual securities to hold in the portfolio. The total amount that's held in each asset class will already be decided based on how much was purchased in the first step.
c. First, decide which asset classes to include based on objectives and constraints, and then determine what kinds of securities, from conservative to aggressive, to include within each asset class.
4 What's the best justification for holding a concentrated portfolio of only a few securities?
a. It's easy to keep track of.
b. By meticulously researching securities and then investing in the select few that are worthy of being included in the portfolio, you will have no need for further diversification.
c. Diversification only increases the risk of the portfolio, so the fewer the holdings, the better.
5 Which is the best approach to building a stock portfolio?
a. Owning eight to 12 stocks that don't behave alike.
b. Owning dozens of stocks.
c. It depends on the investor and his or her objectives.
To take the quiz and win credits toward Morningstar Rewards go to
the quiz page.
Copyright 2006 Morningstar, Inc. All rights reserved.
Return to:Previous Page