Recently I have had a conversation with many client’s regarding the news that stocks in some unlikely companies - GameStop, AMC, Blackberry - have suddenly soared. In fact, the New York Times claims amateur investors are "Beating Wall Street at Its Own Game" with shares in GameStop skyrocketing 1,700 percent by end of day Monday, Jan. 25. In part, some of this activity appears to be tied to social media users on Reddit.1 Other heavily shorted stocks, like AMC, Blackberry and Express, have been affected by this dynamic in recent days as well. To me this is reminiscent of the dot-com bubble when speculation money was flowing into names like pet.com and crossed the line of investing.
Seeing social media reports about amateur investors doubling their money can leave one wondering, "Should I be reallocating my investments?" As we continue to watch this story unfold, here is a reminder about what diversification means for your portfolio.
Diversification has been called the only free lunch in investing. Research has shown that diversification, through a combination of assets like stocks and bonds, could reduce volatility without reducing expected returns compared to those individual assets alone.
A highly diversified portfolio of global stocks and bonds are readily available to investors at a comparatively low cost. A global portfolio can hold thousands of positions from multiple countries around the world and in many different currencies.
Building on the Basics
What do we already know about the science of investing? It begins with these core principles2:
• Asset Allocation: To increase expected returns while managing related risks, build a low-cost, globally diversified portfolio. The allocations should reflect your personal goals and risk tolerances.
• Low Correlation: Diversify your investments across different sources of returns to seek a smoother “ride” and more consistent results. For this, you want to combine sources that have exhibited low correlation with one another.
• Efficient Implementation: Use portfolio managers and funds who manage their solutions in a low-cost and tax-efficient manner.
When determining the composition of your portfolio, consider your own personal investment objectives, preferred risk tolerance and strategy goals. As with any important financial decision, you want to first make sure you consider both the advantages and disadvantages of each approach before making a final decision.
While diversification is a routinely suggested practice among investors, as one might guess, there are pros and cons to the approach.
Pros of Diversifying Your Portfolio
As mentioned previously, reducing risk is one of the key reasons you might decide to diversify your portfolio. While risk can’t be eliminated entirely, diversifying your portfolio can help you manage your overall level of risk and minimize your chances of losing large sums of money over time. When you don’t diversify among your asset classes, you become even more exposed to market risk.
To go along with reducing risk, diversification also allows you to hedge your portfolio, which is an automatic benefit of refraining from putting all of your eggs in one basket. By investing in a variety of companies, sectors, and countries you even out your chances of getting positive and negative returns, as opposed to purely negative.
An alternative to capital appreciation, capital preservation is another benefit of diversification. Instead of focusing on your rate of return, capital preservation is all about protecting the money you already have. Because diversification involves investing in a variety of stocks, and bonds, it may make it easier to protect the wealth you’ve already saved and accumulated.
Cons of Diversifying Your Portfolio
While diversification sounds like a dream come true, there are certain disadvantages that accompany this popular investment approach. While investment professionals often recommend the approach for its ability to reduce risk and volatility, it could also minimize the level of returns generated. The more positions you have to keep track of, the more likely you’ll fall behind on managing them, or at least being aware of where they stand. What investors may not realize is that when you have too many assets in your portfolio, it essentially turns into an index fund, which can be invested on its own entirely to reduce transaction fees. When it comes to costs, transaction fees, as well as high mutual fund fees, may result in below-average returns.
Finding a Balance
When it comes to proper diversification, it’s important to allocate your money according an investment strategy, not some overly-hyped Wall Street formula, a Reddit blog or changes in the news.
The unusual activity we're seeing with these heavily traded stocks like GameStop, AMC and Blackberry are creating big headlines in the news, but that doesn't necessarily mean it's cause for reallocation within your own portfolio.
If you're still wondering whether or not to adjust your portfolio based on these events, speak with your investment advisor first, as they can help determine what may be best for addressing your long-term financial goals.