Probably since before you made your first dollar, you were told about the importance of investing in the stock market – about the wonders of compounding returns over time that can transform a lifetime of savings into a car, a house, and a comfortable retirement. The amount of money that these goals require certainly seems unattainable for the average person to accumulate by putting their savings under their mattress. Chances are that if you stumbled across this article, this is not news to you. So you know the ‘why’ of investing, next comes the ‘what’. A quick Google search about stocks will reveal that there is no shortage of people, businesses, articles, and TV personalities that are ready to tell you about the next hot stock tip. But of course you have heard about diversification too, likely accompanied by an idiom about a basket of eggs, so you know not to invest all of your money in one place. How many stocks do you need then?
To say that the world of equity investing can be daunting for the amateur investor is a bit of an understatement. While stocks are not the only asset class that can make up a portfolio, most portfolios with the goal of growing over time will have some portion invested in the stock market. Historically stocks have been an excellent tool for investors with long time horizons to grow their wealth, but the conundrum at the heart of investing is that the level of return goes hand-in-hand with the level of risk. The principle of diversification can help mitigate some of that risk, however. At its core, diversification is the principle that combining multiple stocks that move in less than perfect tandem with one another will create a portfolio that is less risky than the average of its parts. The lower correlation two stocks have with one another, the greater the diversification benefit. In an effort to find a collection of stocks that share a low correlation with one another, we at Parsec think about diversification across a number of different attributes.
The first method of diversification is to invest in companies across different economic sectors. The market is typically divided into 11 sectors, such as financials, energy, healthcare, and technology. Within each sector there will be stocks that do well and stocks that do poorly, but the prices of companies within a given sector typically move together closely in the short to intermediate term. There is sound logic behind this effect; from a fundamental standpoint, stock reflects the ownership of a company, and therefore the price of a company’s stock should follow the level of earnings. In turn, the earnings of all companies with a similar focus should be affected similarly by the economic climate. For example, within the consumer discretionary sector, even seemingly dissimilar companies such as Royal Caribbean Cruise Lines and Amazon have a greater than 70% correlation, as they are both affected by the economic cycles that influence the level of consumer spending. Each sector has its own unique drivers of performance, which often causes correlations between companies in different sectors to be lower than that of two companies in the same sector. Despite our views of the relative attractiveness of each sector, we refrain from putting too much weight on any one of them, and instead maintain broad diversification across all 11.
Another way we think about diversifying our exposures is by investing in companies from all over the world. Many large corporations often derive revenue from many different countries. Exxon Mobil for instance is a US-based oil company, but it earns greater than 60% of its revenue from outside of the US. Some argue that the geographical diversification gained from investing in large multinational firms based in the US provides all the diversification benefits of adding foreign stock into a portfolio. At Parsec, we believe that international companies do provide unique sources of return that distinguish them from US-based stocks, and for that reason, that they can reduce a portfolio’s risk.
One of the main differences is fluctuations in currency value. Through a financial innovation known as American Depository Receipts, US-based investors can use their dollars to buy company stock such as BMW, which is a German car company with shares denominated in euros, and a bank middleman will take care of the currency translation behind the scenes. While a physical exchange of currency doesn’t take place, an investment in BMW is both an investment in the company, as well as an investment in the euro. Currency investment is a challenging topic, but a simple example is exchanging dollars for euros at the airport kiosk one day, and then switching your money back to dollars the following day. If during the night that you hold the euros, the euro appreciates against the dollar, then when you go back the following day you will get more dollars in return than you started with. Incorporating this into our BMW example, if BMW’s share price increases 10% on the Frankfurt Stock Exchange, and over the same time frame the euro appreciates 5% against the dollar, then the US investor would realize a 15% return on their investment. A depreciation of the euro is equally possible, however, and that would serve to reduce the investment’s return. Currency fluctuations are difficult to predict, and even if one predicts the correct direction of currency moves it is nearly impossible to forecast the timing. The benefit then is not in trying to improve returns by making currency bets, but to provide another unique factor into the portfolio that further diversifies risk.
The last dimension we think of in our diversification strategy is by company size, or market capitalization (market cap). Market cap is simply the combined value of all of a company’s shares, and typically the stock market is broken down into large-cap, mid-cap, and small-cap companies. Unfortunately, there are no hard and fast rules about what the size cutoffs are for each category, but without splitting hairs over definitions it is important to note that about 80% of the whole stock market is made up of “large” companies. Furthermore, the typical indexes that usually serve as a proxy for the stock market’s performance such as the S&P 500, and the Dow Jones Industrial Average are made up of 100% large companies. Because small and large companies have different characteristics, an allocation to small-cap stocks can cause portfolio returns to significantly diverge from the returns of the traditional market benchmarks, for better or for worse. Throughout history, small companies have offered a higher return than their blue chip counterparts, but with significantly greater risk. This effect is intuitive: small companies have greater opportunities for growth, but will likely not have the financial stability of large companies during challenging economic conditions, which creates a wider range of potential outcomes. Due to the less than perfect correlation with large-cap stocks, however, a small allocation to small-cap stocks can actually serve to reduce the overall riskiness of a portfolio while also providing a higher potential for return. We maintain a small, well-diversified allocation to small-cap stocks to capture that diversification benefit.
By creating and managing portfolios on an ongoing basis that are diversified among sectors, countries of origin, and companies of different sizes we seek to reduce risk and improve risk-adjusted returns for our clients.