Diversification Works in A Crisis (But It Doesn't Work Miracles)

Wade Pfau

There are a lot of myths about diversification. Today, I want to address a pernicious lie floating around out there that diversification only works when times are good.

What Does Diversification Actually Do For You?

In the past, we’ve looked at how diversification actually works and what it does for your portfolio. But here’s a quick recap.

There are two broad sources of risk: unsystematic and systematic. Unsystematic risk is all of the company, or sector, or other risks that can be diversified away – the stuff that the market isn’t going to pay you for taking on.

Systematic risk is all of the stuff that’s left over in a diversified portfolio – the risk that is inherent in investing. This is the risk that the markets will pay you for holding. This is the stuff you want to build your portfolio around.

But it’s important to remember that it is still risk. You can’t expect the returns every year, or it wouldn’t be risk any more. There are going to be years where these risks are going to hurt you in the short term – just look back to 2008.

How Does It Work in a Crisis?

So how did a well-diversified stock portfolio do in 2008? Miserably. So clearly this means that diversification doesn’t work when the markets are collapsing, right?

Well, no. Diversification may be the only free lunch in finance, but it’s not magic.

When the markets are dropping like a rock (or shooting up), that systematic risk (the risk of the market as a whole) swamps the unsystematic risk (the risk of a particular company). A rising tide lifts all boats, but an ebbing tide still leaves all boats stranded on the shore.

During 2008, very few companies saw their share price rise. Blaming your portfolio’s poor performance on diversification when pretty much the entire market was tanking doesn’t fly.

That doesn’t mean diversification doesn’t work. It just means that systematic risk was dominating the company-specific risk, which is exactly the point of diversification.

For investors with well-diversified portfolios in 2008, it did that. They captured the “pure” market returns they built their portfolios around. They might not have been the returns they were hoping for, but that’s the catch with investing – it’s all about dealing with risk.

If you want the upside from investing (and you should – it’s been really good for disciplined long-term investors), then you need to be willing to accept the downside.

So How Do You Protect Your Portfolio?

If diversification isn’t the magic potion that will protect your portfolio when CNBC anchors are melting down, then what is? Your asset allocation. The amount of risk you put in your portfolio is the most important investing decision you’ll make.

Your split between stocks and bonds will determine how you do when the market is crashing, when it’s skyrocketing, and when it’s being boring.

If you take more risk, you’ll likely get higher returns in the good times, but you’ll get hit harder during the bad times. A more conservative portfolio means you won’t get the same highs, but you probably won’t see the same lows as your risk-loving friends.

How do you determine how much risk you should actually have in your portfolio? It’s not easy. And there’s no way to come to the exact right answer, either.

It involves focusing on two things: your risk tolerance and risk need.

You’ve probably heard of risk tolerance. The name is pretty self-explanatory. How much risk can you tolerate? When do you start losing sleep over your investments?

A good way to gauge this is to look at how you felt and what you did during tough times like 2008, or the Tech Bubble in the early 2000’s. Were you able to power through without jumping ship?

How about the flip side – how much upside are you comfortable giving up? Taking less risk protects you in the bad times, but it also means you’re missing out on returns in the good times. Your risk tolerance comes down to where this balance lies for you.

Risk need is more straightforward, but it’s also a lot more squirrely than risk tolerance. Risk need is how much risk you need to take to reach your goals.

It’s relatively easy to fire up a spreadsheet and figure out that you need a 4.8327% return per year to get where you want to go. The problem is, you can’t build a portfolio that will guarantee you 4.8327% return every year. But you can build a portfolio that, historically, has generated returns in that ball park (though it’s a pretty big ball park).

Now you just need to compare your risk tolerance and risk need. If they line up, it’s easy – just go and build that portfolio. If they don’t – which is pretty common – then something needs to give.

It’s generally better to move on your risk need rather than your risk tolerance. You can change the goals you are shooting for, try to save some more money, or plan on working longer. It’s a lot more difficult to change how you’re going to react when your portfolio just dropped by a third.

Diversification does not guarantee a profit or protection from losses in a declining market.

This article was written by Wade Pfau from Forbes and was legally licensed by AdvisorStream through the NewsCred publisher network.