By now you've likely heard the news that some unlikely companies - GameStop, AMC, Blackberry, and others - have seen their stock prices suddenly skyrocket. GameStop saw a nearly 1,800% increase in January alone. Some of this activity appears to be tied to Redditors identifying the stocks as targets of short sellers. Other heavily shorted stocks, like Express, seem to have been affected by this dynamic in recent days as well.
Talking with friends who got in early on the action or seeing social media posts about people doubling or tripling their money in a week might leave you wondering, "Should I get in on the action?" As we continue watching this fascinating story unfold, here's a reminder about what diversification means for your portfolio.
The core objective of diversification is to reduce exposure to the risks specific to a company or industry and smooth returns over time. These risks include things like lawsuits, regulatory changes to an industry, strikes, poor management, and more. If you manage to entirely diversify away these company or industry risks, you'll be left with the market-level risks that diversification can't reduce.
There are effectively a limitless number of approaches to diversifying a portfolio; it's not a do-or-don't decision. Buying two stocks in the same industry provides a very low level of diversification, while using ETFs and mutual funds to invest globally across several asset classes would result in a highly diversified portfolio. When determining the extent to diversify your portfolio, consider your financial objectives, risk tolerance, strategy options, and tradeoffs involved.
While diversification is an almost universally suggested practice among financial advisors, there are of course tradeoffs. Namely, reduced returns - take the extreme example of GameStop's "to-the-moon" performance in January. I can't even begin to imagine a one-month run anywhere near that extent in even a moderately diversified portfolio. Evaluating the pros and cons before committing to an approach that strikes the right balance for you is crucial here, as with any other important financial decision you'll have to make.
Pros of Diversification
As mentioned previously, reducing risk is one of the key reasons to diversify your portfolio. While risk can’t be eliminated entirely, diversification can help manage your portfolio's overall risk level and minimize the probability of suffering large losses. When you put all of your eggs in one basket, you expose your portfolio to the effects of a single investment's rise and fall. If your only basket of eggs falls, it could be crushing to your long-term objectives and be very difficult to recover.
Spreading out your investments and diversifying tends to reduce volatility and smooth out returns over time, so you won't have to feel like your life savings are on a roller coaster. If you're a long-term investor, it better aligns your portfolio to your objectives by reducing the stress of short-term volatility. Even some people I've worked with who have well-diversified portfolios get stressed out when they see their portfolios rise and fall, because they worry about volatility threatening their probability of success. If that's you too, an undiversified portfolio that magnifies those ups and downs over even shorter time frames would almost certainly cause a lot of unnecessary stress and increase the likelihood of making bad decisions.
Diversification also has the ability to increase risk-adjusted returns - expected return per unit of risk. Modern portfolio theory considers maximizing expected return for a given risk level ideal; after all, why take more risk or experience more volatility for the same benefit?
Cons of Diversification
From the above, diversification may sound like a no-brainer, but the approach does come with potential disadvantages as well.
The main one is being unable to shoot for the moon. A friend of mine asked about "making Cayman GT4 money" last week. If they had thrown $9,000 into GME on January 4 and sold on January 29, they'd have their GT4 money, probably after taxes too. That simply won't happen in a diversified portfolio. Of course... if your timing was off, you'd have lost a third to half of your money in less than a week instead.
Diversifying a portfolio can be expensive. While many brokerage firms have eliminated transaction fees on stocks and ETFs, there's still the bid-ask spread on each trade, as well as mutual fund transaction fees. Managing costs is important to avoid consistently generating below-average returns. One way to address this is by using low-cost ETFs and thoughtfully constructing a rebalancing and trading strategy.
Overdiversifying can be a problem too. The concept of diminishing returns applies to diversification, and there's a point where continuing to diversify can be detrimental to the overall result. Adding more investments increases the chance of lower-quality stocks and bonds finding their way into your portfolio, incremental costs might be higher than the benefit, or it simply becomes not worth the time and energy to diversify further.
A Balancing Act
It's important to allocate your money according to your risk tolerance and goals. If you're expecting your portfolio to get you through retirement, it's probably not prudent to chase the next big investment win. But if you've got "play money" and wouldn't lose sleep over losing it all, there might not be harm in taking a big bet with it, as long as it makes you happy and doesn't threaten your financial stability and long-term goals.
My general investment philosophy involves investing globally in stocks and bonds primarily through ETFs, with the primary goal of landing on an asset allocation that will most effectively help you achieve your goals. But remember that diversification can be approached in many different ways: investing in individual stocks and bonds, using a mix of individual securities and funds, weighting asset classes differently or avoiding them altogether, etc. Your investment strategy has to be what works for you and gets you to where you want to be.
If you're still wondering whether or not to adjust your portfolio based on these recent events, speak with your financial advisor first, as they can help determine what's best for achieving your long-term financial goals. Or, feel free to send us an email or set a time to talk if you'd like to discuss your situation.