You’ve probably heard the old saying “Don’t put all your eggs in one basket”. It’s one of the essential components of financial advice, which over the years has been simplified to: “Diversify your portfolio”. But not everyone explains why, how, or even if it’s good advice.
What is Portfolio Diversification?
Diversification is a strategy designed to spread your money across different asset classes and investment types. The goal here is to protect your portfolio from concentrated risk.
Diversification can get complicated with the many different choices that come with its own advantages and disadvantages.
So what is the right way to diversify a portfolio?
Well, there is no one single way. Quantitative portfolios may use mechanisms such as portfolio construction to reduce overall volatility. Discretionary portfolios may spread their allocations around several different asset classes, and also within each individual asset class.
For you, assuming you are a discretionary investor, let’s focus on diversifying within a particular asset class that you are familiar with.
For the typical private investor the three main asset classes are: stocks, bonds and cash.
Asset Class | Typical Volatility | Long-term Return |
Stocks | Highest | Highest |
Bonds | Moderate | Moderate |
Cash | Lowest | Lowest |
If you are a short-term trader, chances are you will alternate between holding cash and trading stocks.
Bonds are typically reserved for longer-term investors.
At WiseTraders, we focus on short to medium term stocks (and options) trading. So let’s take a look at how you can diversify your portfolio focusing on stocks.
Diversification With Stocks
There are three factors to consider when diversifying with stocks: industry or sector, market cap, and type of stock.
Industry or Sector
If you are comfortable with – and good at – trading with momentum, then it’s likely that you will not diversify much between the different sectors or industries. This is because your trading style will be latching onto the big movers.
There is nothing wrong with this. Indeed the quickest money is made when you are successful at catching trends in a concentrated way. But you have to aware that is what you are doing, and you have to be agile enough to get in and out quickly and ruthlessly.
At the beginning of this article we posed the question whether diversification was even a good thing? It depends on the context. For short/medium term momentum traders, it really doesn’t matter so much … indeed it could be counterproductive.
Business cycles and economic cycles will affect different industries and sectors in different ways. If you aspire to achieve a balanced portfolio, you are likely to benefit less from momentum. Again, that’s fine, but you need to be aware of your strategy from the outset and make sure your trading style is consistent with that strategy.
If you hold ten stocks all from differently behaving sectors, the impact of any one stock dropping is reduced because there are other stocks that offset the loss. Similarly, the impact of any one stock gaining significantly will have less impact on the portfolio, assuming that is the only stock behaving in that way.
Let’s say you work for an oil and gas company and decide to invest in the company stock because it’s a good company and you know it well. Then, say you hear about another company that does something similar but in a different part of the world, so you invest in that stock as well. A few weeks later, oil prices suddenly drop by 40%. The value of both companies would likely drop significantly due to their high exposure to oil prices.
Now imagine what happens if you also invested in companies from other industries, such as drugs and healthcare — which may have very little exposure to oil prices. The losses from your investments in oil and gas will be offset by gains from other companies in sectors that perform better during this period, thereby reducing volatility in your portfolio.
Market Cap
Most of us may have heard the term “market cap”. But what does it mean, really?
Well, the proper wording is “market capitalization”, and it is simply a measure of a company’s value using this formula:
# shares x price per share
Think of it as a company’s size. Larger companies have higher market caps (values) than smaller companies.
One way to look at market cap is in tiers:
- Mega cap: > $200 billion or more
- Large cap: $10 billion – $200 billion
- Mid cap: $2 billion – $10 billion
- Small cap: < $2 billion
Be very careful to avoid generalisations.
Some people may suggest that mega-cap companies will have lower growth potentials, but we have seen many lower-end mega-caps escalate quickly into the higher end of that bracket.
At WiseTraders we have an expression which says “Trade What You See”.
Now, that might not be the only time or place where you’ve seen that expression, but our interpretation of it is clear, precise and unique to us.
We specifically look for evidence of ‘Big Money’ interest in the stock, and we have several specific markers that we look for. Those Big Money Footprints are what we are aiming to see before we get interested in making a trade.
So, ultimately it doesn’t matter to us if a stock is a large-cap or a mega-cap. We want to see evidence that Big Money might affect the demand and supply for a company’s shares, thereby causing the share price to move.
Type of Stock
Stocks come in three main varieties: growth, quality and value. Quality stocks are not talked about much in retail investor circles, so we’ll focus here on growth vs. value.
Growth stocks (often associated with tech) are companies that are expected to grow at a faster rate than the overall market. Investors are willing to pay a premium for growth stocks because they expect these companies to grow faster than their rivals, producing higher returns on their investments.
Value stocks, on the other hand, are companies whose shares are unloved and appear undervalued. These companies may be out of favor with investors or have fallen out of fashion and have been punished with lower stock prices. In theory, value stocks offer greater potential for long-term capital gains because you can buy them at a discount.
Growth stocks and value stocks typically perform differently from one another. Growth stocks tend to outperform value stocks when markets are doing well. On the other hand, value stocks tend to shine when markets are choppy. Investing in both means that any losses in one asset may be offset by the gains in the other.
There are several reasons behind this difference in performance between growth and value stocks. Ultimately it boils down to the drivers of supply and demand for the shares.
Those drivers may be economic, cyclical or purely based on sentiment. For example, the immediate impact of Covid-19 shattered travel stocks while boosting internet stocks.
The aftermath of Covid-19 and its delayed shock on the world economy (plus other factors) sent energy stocks into overdrive, while internet and tech stocks plummeted.
You can benefit by combining growth and value stocks in our portfolio so that you use diversification to dilute your exposures to specific factors. The goal of such diversification is to balance high growth potential with conservative investments that offer stability and income.
There’s no perfect formula for mixing growth and value stocks in your portfolio — it all depends on your personal trading goals, time horizon and risk tolerance.
The truth is ...
Diversification can help you reduce risk and exposure to volatility. For longer time horizon portfolios it’s a sensible strategy, combined with different exposures to other asset classes.
For more aggressive growth however, you’ll discover you’ll tend to be focused on particular sectors at particular times as your time horizon is shorter.
At WiseTraders, we tend to focus our discretionary trading activities on that shorter term time horizon where we are looking to profit from momentum.
Our trading plan is what helps us navigate volatility by ensuring we remain in stocks trending in our favour, and exiting stocks quickly when they violate our stop levels.