Thinking differently about diversification

Hedge the inherent risk involved in investing in your favorite stock

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By Acred99 (Own work) [CC BY-SA 3.0 or GFDL], via Wikimedia Commons

ou want to invest, and you figure the way to do it is to (somehow) pick the best stock out there and load up. What’s the best stock out there? Right now, some people will tell you it’s Apple, some people will tell you it’s the marijuana industry company Canopy Growth Corporation, some people will tell you it’s Berkshire Hathaway, and they’ll all have their reasons why.

For the sake of our discussion, it doesn’t really matter what that one stock is, let’s just pretend that you’ve picked your one stock and you’re going to put your money into that stock because you believe it’ll produce the highest return. After all, what’s the point of diversification if you’ve identified the best stock currently in existence? It’ll only dampen your returns, right?

Well, besides the reality that you can’t predict the future, there are a host of threats your investment continuously faces. Through diversification, you can hedge your risk of investing in that single high-flying equity alone. Utilizing broad-based, poorly correlated assets in a well-balanced lazy portfolio minimizes your risk to each individual stock, protecting you from the possibility of an outright loss. And rest assured, there’s an immense amount of risk out there to mitigate.

long the way, all sorts of things can happen to your darling company and its stock, some directly influencing it, some indirectly: another party may sue them for patent infringement; a competitor may come up with a more revolutionary product, making their products less appealing; the company may lose its innovative and inventive edges; management may change for the worse; legislation may be passed that negatively impacts growth plans or product sales.

To hedge the risks posed to your company, then, you decide to put your money into a fund that tracks the particular index that describes your company, like technology, finance, consumer goods, etc, figuring that if your company is doing well, probably others in the index are doing alright, too. You trade the outperformance that you expect your stock can deliver for the safety in numbers that investing in more than one company provides, but still, there are risks.

Legislation that affects your company, for instance, may impact the whole sector. Or, the sector may be subject to paradigm shifts that change the way we live or buy things — think brick-and-mortar bookstores in the face of e-books and digital reading devices. Whole sectors can be negatively affected by a host of things. Clearly OPEC letting the fuel flow in the past hurt the entire energy sector, to say the very least. And natural disasters can send insurance company stock prices scurrying.

Given these additional risks, you decide to protect your investment in your company not with an index fund based on just your company’s sector, but with an index fund based on all equities. You’ve determined that if your company or its sector face any headwinds (even temporary ones), other companies and sectors in the vast universe of investing may not. They may actually do well when your company and its sector are not doing so hot, increasing your chances for positive return and decreasing the hit you might take if something negatively impacts your company’s equity performance or the performance of its sector.

Yet still, wouldn’t you know it, there are risks: the equities markets may face downturns for any number of reasons; hedge funds, with large holdings in your company and others, may collapse if they get burned by one of their bets (the Swiss Franc changeup in Jan of 2015, for instance); the banking system may falter as a result of derivatives trades gone wrong; financial firms may be the victims of injurious cyber attacks; the Federal Reserve may mismanage the interest rate environment; troubles abroad may give investors the jitters at home as everything is globalized. These things and more can bring down the domestic markets as a whole, including your company’s share price.

Hence, you decide to put a portion of your money in the broadest based international equities fund you can buy, to go along with the broadest-based domestic equities fund you can buy, to further cut your risk exposure. Somewhere in the world, you reason, there are likely to be a few countries’ companies and their corresponding equities that are doing well even if the ones at home are not. However, given today’s immense intertwining of financial markets around the globe, the interactions of trade and currencies and business partnerships and so on, this move only affords you a smidgen of extra insurance as equities markets all over the world often move in tandem; i.e. if there are major problems in the markets of developed countries, that can bring all markets down.

So, finally, you buy bonds in order to further hedge your position in your favorite company, its sector, your domestic equities markets, and worldwide equities markets at large. And not just any bonds, but the broadest-based bond fund you can buy, at least the US specific one anyway, to go along with the broadest-based equities funds you can buy. Why? The performance of bonds is generally poorly correlated with the performance of equities. Therefore, bonds tend to go up when equities are going down due to flight-to-safety responses on the part of investors. Vice versa, when bonds are going down and equities are going up, it is said that market participants have an increased appetite for risk.

At this point, you’ve finally diversified in a manner sure to earn the approval of many passive and lazy investment practitioners, and some would argue that you’ve now protected your initial investment in your favored company as much as anyone can expect to.

there more you can do? Sure. Studies have shown, for instance, that a very small investment in a commodities fund (or in gold in particular) is worthwhile, especially as the performance of these assets tends to be poorly correlated with stocks and bonds. This reality may give you added protection and return potential. Yet others would instead say that the benefits are marginal at best. At any rate, note again that we are discussing how the returns of the different investments are or are not correlated. That’s what really matters and can save you in a pinch; it’s not about how much of a return they can each earn you according to the historical record.

What no expert would deny is the powerful risk mitigation capacity of the broad-based equities/bonds combination above all else, although many continue to chase the dragon in their pursuit of outperforming the market. The recent crypto craze comes to mind, of course. However, that’s gambling, not investing, and a subject for another time.

After all is said and done, what have you accomplished, then? You are invested in your favorite company, but you are also invested in many others as well as bonds, and this helps you protect your original investment. Don’t think of lazy or passive investing as the slow path to your goals, think of it as the reasonable path to your goals. Indeed, consider it the most secure way of hedging the risk involved in investing in those cream-of-the-crop companies out there.



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