Category: Investment Education

Why Does a Diversified Portfolio Matter?

A wooden table with scrabble tiles spelling out the word, "Investment." The tiles are white with black letters and are in all CAPS. In the post, Why Does a Diversified Portfolio Matter?

Why does a diversified portfolio matter? Put simply; it helps reduce the risk that you’re taking with your investments. You’ve probably heard the saying, “Don’t put all of your eggs in one basket.” That saying is speaking directly about diversification.

What Does a Diversified Portfolio Look Like?

Let’s say that you have $10,000 to invest, and you’ve decided that you want to invest in electric vehicles. Investing in electric vehicles could mean a lot of things. It could mean buying shares of Tesla. The price of Tesla shares is notoriously volatile. If you invest $10,000 in Tesla and the following day, the market price is up 3%. Then you have a nice $300 gain practically overnight. Although, if the market price of Tesla is down 3% the day after you invest, then you lose $300 practically overnight.

Diversifying Your Investments

Suppose now, rather than investing the entire $10,000 in Tesla, you invest half in Tesla and half in another car company. They also happen to make electric vehicles but have other products and do not have a polarizing and vocal CEO. The second car company also has a stock price that tends to be less volatile. Potentially because it also has other products and does not have a vocal and polarizing CEO. On the day after you purchase your shares, Tesla shares go down 3%, and the shares in the other company go up a modest .5%. In this case, your portfolio would be down $250. If Tesla shares were up 3% and the second auto company was down .5%, then your portfolio would be up $250. Your potential gain was reduced, but so was your potential loss.

“Either way, if something happens that affects the auto industry as a whole, your portfolio is likely to decline in value, and neither stock would likely reduce the effect.”
Kellly Ennis – Financial Advisor & Founder of Infinity Financial Strategies

A series of transparent glass jars sit in a row. A white complected hand enters the frame to drop coins into the first jar - which is currently empty. The next three jars increase in wealth and size. They also have a what begins as a small seedling, and grows to a full vibrant green branch. In the post, Why Does a Diversified Portfolio Matter?

Now assume that you’ve decided that you also want to invest in something that everyone needs. You choose a company that makes toilet paper (we all learned a lesson during the pandemic) and other products that are considered consumer staples. Allowing that you split your $10,000 evenly between each of the three companies. If the consumer staple company has many products and many ways to earn money, there’s a good chance that its stock price doesn’t move too wildly. Many consumer staple companies have pretty steady stock prices.

Having this stock in your portfolio can help you have a steady base in your portfolio. Think of it as ballast in a ship. It helps mitigate the ups and downs when the ship hits large waves. This doesn’t mean that the stock price doesn’t go up and down. It just doesn’t usually move as drastically as the more volatile stocks. This helps reduce the risk in your portfolio because it isn’t particularly volatile. It also isn’t likely to move in lockstep with auto industry stocks.

The Long Haul of Diversified Portfolios

Over the long haul, the market tends to go up. The problem is that we don’t know how long the long haul has to be. There will be times when the market is down even though the long trend is upward. If we could stay invested for “the long haul” and our investments could roughly reflect “the market,” then we should expect investment gains over a long period of time. It will take quite a few positions in a portfolio to roughly reflect the entire “market.” There are stocks for roughly 2800 companies being traded on the New York Stock Exchange alone. That doesn’t include NASDAQ and other exchanges.

The bronze statue, Charging Bull, near wall street is quite famous. This image displays only a glimpse of the ready for battle bull's right eye, ear and massive horn and muscular shoulders. In the post, Why Does a Diversified Portfolio Matter?

Take Advantage of Market Tendencies

If we can spread out the risk in an investment portfolio, we could potentially have stocks that tend to move in opposite directions. We could add in bonds, which frequently (but not always) move in the opposite direction to stocks. And bonds give an additional income source that is not dependent on the stock price. Which is another form of a diversified portfolio. In addition, we should consider international stocks, both in developed markets and emerging markets. Business cycles often occur with different timing in other countries. This means some economies will be in a growth period while others may be plateauing or even in a recession. Portfolios with a good level of diversification would be able to rely on the market’s upward trend. This would then drastically reduce the risk at the same time.

"Fearless Girl" is a bronze statue of a small girl with her hands on her hips legs apart in a prepared and bold stance with the streets of New York city behind her. In the Post, Why Does a Diversified Portfolio Matter?

Diversified Portfolios Matter

If the CEO of Tesla makes a comment online that causes the stock price to decline precipitously, and your entire portfolio is invested in Tesla, the value of your portfolio will also decline precipitously. To be fair, the reverse is true as well. If the CEO of Tesla makes a brilliant comment or the company exceeds its target number of vehicle deliveries, causing the stock price to climb steeply, then the value of your portfolio would climb steeply as well. The question is, can you stomach these wild swings? Holding shares of multiple companies and investments with differing characteristics can reduce the wild swings in your portfolio value.

In short, diversified portfolios matter a lot when reviewing the full picture of your financial health and portfolio health.

This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

Should I Keep an Eye on the “Dow”?

Any investors listening to the morning radio or turning on television during the week have heard the performance of the Dow Jones Industrial Average. The investing media pundits seem to go into a wild panic whenever it falls and rejoice whenever it rises. A popular question, though, is why?

The Origins of the DJIA

To understand what the Dow Jones Industrial Average (DJIA), which is known to many simply as “the Dow”, means, first, you have to know what it meant back when it began. The precursor to the Dow Jones Industrial Average started in 1896, and its purpose was to provide a measure of how the industrial economy was performing. To do that, it started with 12 companies.

The American Cotton Oil Trust, which dominated the cotton oil industry, is now part of Unilever. American Sugar, which was the main producer of sugar for the United States with plantations in Puerto Rico and other Caribbean nations, was bought by Domino Sugar. American Tobacco, which was broken up by the SEC into multiple companies. Chicago Gas, which has now become Integrys.

Distilling and Cattle Feeding, which oddly enough produced whisky and had nothing to do with feeding cattle. General Electric, still exists today but was removed from the Dow in 2018. Laclede Gas was and still is a natural gas company in Missouri. The North American Company was a holding company with interests practically everywhere. National Lead, which was the biggest company in the lead-smelting industry. Tennessee Coal, Iron, and Railroad, which was a major mining and transport company. U.S. Leather was dissolved after antitrust lawsuits, and U.S. Rubber, jumped from owner to owner until it was bought by Michelin in 1990.

These dozen companies spanned nearly the entire industrial sector of the United States, and that was the goal–to ultimately sum up the industry of the United States with an average. As companies fell apart, and new companies rose through the ranks, the Dow added and removed companies. In fact, none of the original 12 companies are on the current Dow, which is now comprised of 30 companies.

The Wall Street Journal

A more modern incarnation of the DJIA was first published in the Wall Street Journal in 1916. That index included 20 stocks–eight from the old index and 20 new stocks. In 1928, the index expanded to 30 stocks.

Today the Dow isn’t necessarily the most important measure of the stock market and the economy. With the rise of more indices, both broader and more specific, there are more ways to quantify the performance of the stock market and, more importantly, your own portfolio. The S&P 500 is an index of 500 stocks spread across the entire nation in various industries, and there are countless indices for specific sectors of the economy.

Does the Dow Do a Decent Job of Diversifying?

Throughout the entire economy of the United States, it is very difficult to create a thorough and complete picture of the economy with only 30 stocks. If your portfolio was heavily based in the automotive and oil industries, then the Dow wouldn’t really reflect your portfolio; the Dow does not currently include any stocks in the automotive or oil industries. Similarly, if your portfolio is based in companies outside of the United States, the Dow couldn’t represent your portfolio; all of the stocks in the Dow are based in the United States. That being said, almost all of the companies represented in the DJIA do have a worldwide business and could be affected by political factors.

The Dow

Ultimately, it is important to realize that the Dow, in most cases, doesn’t represent your portfolio. If you wake up one morning and see that the Dow has dropped 8%, your portfolio won’t match that exactly unless you are solely invested in a Dow Jones Industrial Average Fund. Because the Dow only represents 30 companies, the change in the price of one stock can drastically change the value of the entire average, while in indices like the S&P 500, it would take a much larger change in one stock to sway the entire average.

Noteworthy

Also worth noting, the Dow is what is called a price-weighted index. This means that the stocks with a higher trading price are weighted more heavily than the stocks with a low trading price. For example, Caterpillar(CAT) is currently trading at around $287.57, while Walt Disney Co (DIS) is currently trading at around $86.30. Even though the market capitalization of Disney is actually higher than the market capitalization of Caterpillar as of July 28, if the prices of both stocks were to increase by 2%, Caterpillar would have an impact on the index worth about three times Disney’s impact on the average. (Market capitalization is the value of all of a company’s shares of stock outstanding, and different companies have different numbers of shares of stock outstanding.)

Charles Henry Dow's portrait. A grainy black and white image of a man with a thick full dark beard. He is wearing a smart suit and large tie with a high white collar. Dark gazing eyes away from the camera. He appears to be thinking as he has his portrait commissioned. — Charles Dow

A Black and white man's portrait. He has a large curled mustache, receding hair-line, and a high white collared shirt under a heavy, fine suit. — Edward Jones

Who Created the Dow Jones?

And why is it called the Dow Jones Industrial Average? The index was first compiled and reported by two financial reporters, Charles Henry Dow, and Edward Davis Jones, who founded a company called Dow Jones & Co. The DJIA was only one of the indexes they created around that time; they also reported on an index comprised of 20 railroad companies which would later become the Dow Jones Transportation Index.

The NASDAQ

To sum it up, the Dow Jones Industrial Average has a really interesting history (if you’re into that sort of thing), and it gives an indication of the performance of a carefully curated selection of companies in the U.S. economy. However, it includes only 30 of the approximately 2800 companies trading on the New York Stock Exchange and 3300 companies on the NASDAQ. In addition, the DJIA only includes large company stocks. What does this mean to you as an investor? A large swing in the Dow probably doesn’t mean that your portfolio increased or decreased by the same percentage as the Dow. But, a large swing in the Dow is often indicative of significant events on the world stage.

Dow Dow Jones Finance Interest Rates Investment Education

What is Index Investing

You’ve probably heard of index investing. In fact, if you’ve heard of Jack Bogle and Vanguard, you’ve almost certainly heard of index investing. Jack Bogle was the founder of the Vanguard Group, which created the first index mutual fund.

A wooden table with scrabble tiles spelling out the word, "Investment." The tiles are white with black letters and are in all CAPS.

Why Does This Matter?

Index investing allows investors, including individual investors, to get broad market exposure at a relatively low cost. With index investing, a fund holds the components of a predefined investment index.

The manager of the fund is responsible for ensuring that appropriate amounts of the index components are held in the fund rather than being responsible for choosing what securities to hold. An investor then buys into the fund. This allows investors to have exposure to each of the components of the index without having to actually purchase and hold shares in each of the companies that make up the index. As an investor, you could choose to invest $10,000 into an index fund even if purchasing single shares of every company in the index might require a $20,000 investment.

What Exactly is an Index?

An index is a collection of investments that have some factor in common distilled down to a number that represents the aggregate performance of the component pieces. Examples of indexes are the Dow Jones Industrial Average (DJIA), the S&P 500, and the Nasdaq 100 index, which are broad-based indexes often used to gauge the performance of a broad market. Then there are indexes intended to provide information on the performance of certain segments of the market, such as the Russell 2000 Index, which includes small-cap stocks, or the PHLX Semiconductor Index (SOX), which tracks the performance of companies that produce semiconductors.

The calculation of the value of the index varies from index to index. For instance, the DJIA is a price-weighted index meaning that the value is computed based on the price per share of each of the components. On the other hand, the S&P 500 index is calculated based on the market capitalization, the total number of shares outstanding multiplied by the price of the shares of each of the components. Some indexes use a combination of price, market capitalization, the aggregate market capitalization of all securities in the index, and other factors. Since the calculation of these indexes varies widely, it often makes more sense to pay attention to the change and direction of change of an index rather than the index value itself.

Who Creates an Index?

Indices can be created by anyone. However, the most well-known and followed indexes are often created by fund managers, investment banks, or brokerages. See our recent post about the history of the Dow Jones Industrial Average. The creator of the index defines the concept behind an index and the rules that will apply to the index, including how component securities will be chosen and the calculation of the index value. Then, the index provider will start calculating and communicating the index according to the method and rules they have established.

Periodically, the index may need to be rebalanced to bring it back in line with the established methodology due to events like mergers, spin-offs, stock splits, etc. Ultimately, the index provider makes money on their index by licensing their indices to portfolio managers who may build products like ETFs and mutual funds from the index. In addition, the index providers can license the index to media that report the value of the index in real time.

What’s the Benefit of Index Investing?

One of the benefits of index investing is that it removes stock-picking and market timing from the picture. If you buy into an index fund, you will be gaining exposure to the components of that index based on the weightings established by the index at the current price. There is no waiting for the price of a particular company’s stock to reach a certain level, and there’s no guessing when to sell a particular stock because it might be at its high. All of the buying and selling of individual securities occurs based on the rules of the index.

A painted modern abstract background in colors of whites, blues, golds, and grays anchors the image. The foreground holds a blurred deep slate gray table upon which, a small transparent glass jar holds a large amount of coins of varying worth. Out of the top of the glass cup sits a green plant signifying growth.

It provides broad exposure to a segment of the market at a relatively low cost. To buy just one share of the 10 largest companies in the S&P 500 index would cost you at least$8000. Or, you could get exposure to 500 companies with just a small investment by purchasing shares in an S&P 500 ETF or mutual fund.

And the index acts as a benchmark. You would think that all funds based on the S&P 500 would have the same performance, but you’ll find that isn’t necessarily true. One reason may be due to the difference in expense ratios charged by different funds. Another reason may be due to the timing of trades when the fund ensures alignment with the index. And there may even be a difference depending on the pricing that a large broker-dealer who provides a fund can get versus a smaller fund provider.

Are There Drawbacks?

There’s always a balancing act when deciding to let someone else choose your investments. Both ETFs and mutual funds have fees associated with them. Part of those fees go towards marketing those funds and paying for the folks who keep the funds compliant with regulations and reporting requirements, as well as the actual traders. But another part of those fees pays for the licensing of the index being used by the fund.

In some cases, the portfolio manager itself is providing the index and managing the fund. This can work out in their favor or the investor’s favor depending on the licensing fee being paid for the use of the index. With a widely-used index, there are many licensees paying the fee for the license, and therefore, it is likely a lower fee. With indices without a broad-based following, you may see the portion of the fee going to the licensing company is rather large.

Another potential drawback is that indices generally have rules regarding the timing of additions and deletions from the index and when the index is reconstituted. This could mean that a company that you feel is a poor investment is still in the index when you might have sold that stock if you managed the funds yourself. This is part of the price you pay for broad exposure for a relatively low cost.

Is Index Investing the Answer?

As usual, the answer is “It depends.” It depends on the question you’re asking, and it depends on your goals and available resources.

Index investing does take the emotion out of investing, for the most part. You may still try to time the market when buying into a particular sector, but you won’t be trying to time the market regarding a particular company. Index investing does allow investors to gain exposure to a large number of companies without needing the capital to buy actual shares in each individual company. But, you do give up a degree of control in exchange for using the funds that depend on predefined indices.