Diversification is a fundamental concept of investing. Brought to light as the result of the groundbreaking, Nobel Prizewinning research of Harry Markowitz in the 1950s, diversification is the concept of not placing all of your eggs in one basket, but rather spreading your investment dollars into different types of securities in an effort to increase portfolio returns while mitigating risk.
Diversification may include exposure to different sectors and types of ETFs, mutual fund holdings such as the stocks of large-cap, mid-cap and small-cap sized companies. This may include exposure to growth stocks such as strong companies believed to have excellent prospects for the future, as well as value, like the stocks of companies that are distressed, or that may be out of favor. Diversification may also include exposure to U.S., international or emerging market economies. Within fixed income, investors can diversify across U.S. government bonds, corporate bonds or the bonds of foreign governments or corporations.
Most investors are likely well acquainted with the concept of diversification as portfolios are globally diversified across many different asset classes. Through this level of diversification, most investors are hopefully better positioned to reach their long-term goals while risk is mitigated to the extent possible.
In addition to traditional diversification, the concept can also be applied to “factor investing.” Simply stated, “factors” are sources of returns that are available in the capital markets, and historically, they have been sources of greater returns.
So how do you think of diversification within the framework of factor investing, and how might it benefit investors? Academia has identified different factors that offer the potential for greater returns over time. However, it’s important that investors remember that while factors may provide benefit over the long run, a given factor may or may not offer a greater return in the short run.
Additionally, even if a factor is in favor at a particular point in time, depending on the time period in question, it may be to a greater or lesser degree, thereby contributing more or less to the portfolio returns accordingly.
For example, even though there’s a premium over time for investing in value stocks, growth stocks have periods where they have outperformed, and there will be periods when they will outperform in the future.
Similarly, despite the greater return opportunity of small cap stocks, large company stocks can outperform their small company counterparts.
Likewise, a set of stocks with positive momentum may seem like a good bet today, but unforeseen, problematic events could cause the stocks’ momentum to be interrupted tomorrow, or perhaps reversed entirely.
The point is, just as investors can’t predict which types of stocks and/or bonds might outperform in any given time period, they also can’t predict if, when, or to what degree a particular factor may come into play and provide greater returns for portfolios.
By diversifying across multiple factors, however, investors have a greater opportunity to profit from those that may be in favor and that may be demonstrating strength at a particular point in time.
Eide Bailly strives to be a market leader in factor-based investing by translating academic research into sophisticated portfolios. Our portfolios are broadly diversified and strategically allocated, with the flexibility to accommodate a wide variety of investor needs, goals and risk comfort.