By Jeffrey J. Brown, MD, MBA, CFA®, CFP®
Diversification is a popular investment strategy, and with good reason, as it is one of the golden rules of investing. But why? It all comes down to maximizing your expected return for a given level of risk.
Here is a cautionary tale that shows what can happen without diversification. Let’s say that you are fortunate enough to land a job at America’s Most Innovative Company. At least, that’s what Fortune magazine has been calling it. You’re thrilled with the opportunity and pour your heart and soul into your work. As an employee benefit, they offer a retirement plan that allows you to invest in your own company’s stock. It would be crazy not to invest in the country’s most innovative company! By age 50, your accounts have surpassed $2 million and you’re starting to plan an early retirement.
Unfortunately, this dream scenario turned into a nightmare for many employees of this company, which as you may have surmised, was Enron. In the aftermath of the Enron accounting scandal, many employees lost not only their jobs, but their life savings as well.
Systematic vs.Unsystematic Risk
The Enron story highlights the risk of having too much of your investment capital and human capital associated with one company. The beauty of diversification is that it eliminates company-specific and industry-specific risk, both which are forms of unsystematic risk. The goal of diversification is remove unsystematic risk so that you are only exposed to systematic risk which cannot be diversified away, as illustrated in the following quote:
“There is a reward for bearing risk, but not just any risk. It’s the risk of doing badly in bad times. It’s that central societal risk that in an efficient capital market is going to be rewarded with higher expected returns.” –William Sharpe, Nobel laureate, Professor Emeritus, Stanford University
Invest Across Asset Classes
Broad diversification within U.S. and international stock markets is an effective way to reduce unsystematic risk. You can achieve further diversifcation benefits by investing in additional asset classes whose returns are not closely correlated with the equity markets.
Bond returns have a low correlation with equities and can therefore serve as an effective porfolio diversifier. Bonds also are less volatile than stocks, which can help dampen the volatility of portfolio returns over time.
Real estate is another good portfolio diversifier with a relatively low correlation to the stock market. A convenient way to invest in real estate is with real estate investment trusts (REITs), which allow you to diversify broadly across different classes of commercial and residential real estate. REITs are required to distribute 90% of their taxable income to their shareholders each year and, as a result, they should only be held in tax-advantaged accounts, such as IRAs or 401k accounts.
Commodities can also provide diversification benefits and may serve as an inflation hedge in some situations. Although some investors prefer to invest in a single commodity, such as gold, we generally recommend a more diversified approach that includes a broad range of natural resources (such as precious metals, crude oil, etc.) and agricultural products. Investing directly on the commodities exchanges typically involves a high degree of leverage, however, ETFs and mutual funds provide an opportunity to invest in commodities in a less risky, unleveraged manner.
Famed economist, Harry Markowitz, revolutionized the field of academic finance when he discovered that portfolio diversification can reduce risk without sacrificing expected returns, a phenomenon he referred to as the only free lunch in economics. We at Shearwater Capital, LLC can help you build a broadly diversified, tax-efficient investment portfolio tailored to your time horzon, risk tolerance, and unique circumstances, and help you work toward achieving your financial goals. Schedule an introductory phone call online or contact us at (314) 434-4750 or firstname.lastname@example.org to get started.
Jeffrey Brown is principal and chief investment officer at Shearwater Capital, LLC, a fee-only fiduciary financial advisory firm helping physicians and their families attain financial security using a scientific, evidence-based approach. Jeff has been a practicing radiologist for over 30 years and is currently chair of the Department of Radiology at Saint Louis University School of Medicine. He earned his bachelor’s degree from the University of California, Irvine and his medical degree from the University of California, San Diego. He has been named one of St. Louis’s Top Doctors every year since 2011 in St. Louis Magazine. Jeff saw a need for physician-tailored financial services and earned an MBA from Washington University in St. Louis, going on to found Shearwater Capital, LLC with fellow MBA classmate and radiologist, Dr. Eric Malden. Jeff is a Chartered Financial Analyst (CFA®) and CERTIFIED FINANCIAL PLANNER® (CFP®) practitioner. Learn more about Jeff by connecting with him on LinkedIn.