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The Importance of Investment Diversification
by Greg Putnam, CFA®
Investment Portfolio Purpose
As a general rule, investment portfolios
exist to serve some quantifiable purpose.
For individual investors, funds are set
aside for retirement, college, or other
major life events. For institutional or
corporate investors, an investment
portfolio may be designed to fund a
pension for a large group of beneficiaries
(employees and retirees from a given
company), to meet the operating needs of a
university or charitable organization, to
earn a profit for an insurance company or
bank, or other business objectives.
In any circumstance, it is crucial for
investors to keep in mind the reason for
investing. If one is investing excess cash
for sheer speculation, then the portfolio
will be very different from one that is
designed to fund retirement or college
savings. Therefore, to some extent the
thought process should work backwards
from the eventual goal—knowing where
you hope to be 5, 10, 20 years in the future
will help you plan in he present for how to
get there..
So in many ways, investing is a two-sided
coin—the assets exist in order to fund an
anticipated expense or liability. If saving
for college, a family can estimate the cost
of attendance and the time until
enrollment, and set aside assets on a
regular basis to meet the liability.
Similarly, for an individual’s retirement,
one must save consistently over time in
order to have adequate funds to live on
after leaving the workforce.
Portfolio Diversification
Diversification is a common term among
professionals in the investment world, but
unfortunately it suffers from the same
malaise as many other business
buzzwords—overuse and misuse have
clouded its meaning. So, like “synergy”
and “outside the box,” the definition of
diversification can vary depending upon
the eye of the beholder. In the context I am
using here, diversification means that
investors should utilize a well-designed
asset allocation, including stocks, bonds,
and other asset classes or investment
strategies that may be available.
The goal of diversification is to dampen
volatility over time. (Volatility is a
measure of how much an investment’s
value might be expected to fluctuate over
time, and diversification can help to
smooth out those changes.) In other
words,
words, some assets will increase in value
as others decrease in value, and vice
versa. Putting together a good mix of
investments will hopefully smooth out
performance, and over a long period of
time improves results.
As an example of a large institutional
portfolio, a pension plan’s assets are set
aside to fund the retirement income of
thousands of current and former
employees. Pension plans must balance
the types of assets placed in the
portfolio—as
described
above,
a
combination of stocks, bonds, real estate
and other investments is required in an
effort to smooth out the portfolio’s
performance over a long period of time.
For example, stocks may do great in
certain years, like the S&P 500’s
performance in the 1990’s and the middle
part of the 2000’s. But we have also seen
that equities can have disastrous returns
in some periods, such as 2001-02, and
2008. Therefore, a pension portfolio may
require a significant amount of
diversification, which is achieved through
the use of a variety of investment
strategies and vehicles.
Individual Saving & Investing
The same logic for diversification applies
to individual portfolios—investors should
take into consideration the purpose or
need for the assets in question, and invest
appropriately. Most 401(k) plans offer a
variety of vehicles to choose from,
including:
Target Retirement Date Funds, which seek to
provide a diversified portfolio in a single
fund offering. Target Date funds are a
good choice for savers who want
diversification and simplicity, but may not
have the time or interest in choosing their
own asset allocation. Passive Funds, which
provide returns similar to a broad index,
such as the S&P 500 for equities or the
Barclay’s Aggregate Index for bonds.
Active Funds, which offer exposure to
investment managers whose goal is to
outperform the markets, often a
particular segment of the market, such as
US Large Company Equities.
Individual investors often also have
access in their personal investment
accounts (such as IRA’s and investment
brokerage accounts) to a seemingly
endless set of Exchange Traded Funds
(ETF’s), stocks, and mutual funds, which
can be used to build a diversified portfolio.
The Columbia Sun News February 2013
Greg Putnam, CFA®
Greg M. Putnam, CFA received a Bachelor of Arts Degree in Economics, cum laude, from the University of South
Carolina in 1992, and a Master of Arts Degree in Economics from the University of South Carolina in 1996. He has been
a CFA Charterholder since 2005 and is currently a senior investment professional with Abacus Planning Group, Inc.
Mr. Putnam has a broad financial background, with 15 years of experience in investment management, economics, and
trading. Immediately prior to joining Abacus, he served as Chief Investment Officer for a regional, South
Carolina-based company, overseeing $3.5 Billion in Pension and 401(k) assets. Mr. Putnam is an active member of the
University of South Carolina Honors College Alumni Association, and a Board Member of the SC CFA Society. He has
been a regular speaker and participant at conferences hosted by Institutional Investor and the Global Absolute Return
Conference, and has been published in Investments & Wealth Monitor.
Taking into consideration the intended use of the assets, individuals
and institutions should develop a meaningfully diversified portfolio,
in which the most important choice is not at the individual stock or
bond level. Individual securities matter, of course, but investors
should not have exposure to any individual stock or bond in such a
large proportion that it can significantly impact the overall portfolio.
The most important long-run goal for an investment portfolio should
be to maintain broad diversification both within and across asset
classes.