What is Diversification? How This Investing Principle Protects Your Portfolio

Typically, the best investment portfolio is a diverse one. A lack of diversification can cost investors untold millions – if not billions – in preventable losses every year. Properly diversified portfolios can generate returns regardless of the losses that individual stocks or asset classes might suffer. By harnessing the full power of the economy, diversification can reduce the risk inherent in investing.

Financial advisers can select diverse stocks and assets for their clients, or investors can sign up for low-cost robo-advisers that automatically take advantage of portfolio diversification benefits.

What is Diversification?

Investment diversification refers to an investing principle that reduces overall risk by picking stocks from different sectors.

• Examples of sectors include technology, healthcare, real estate, and energy.

The concept of diversification also applies to assets.

• Bonds, commodities (such as precious metals), cash, and alternative investments can diversify a portfolio outside of the stock exchange.

Why Is Diversification Important to an Investment Portfolio?

Diversification benefits include reduced risk balanced with the opportunity to take advantage of higher returns from riskier stocks. With a core of reliable investments, a portfolio may include a few investments that take on more risk.

There will always be some systemic risk in investing, meaning risks that affect the entire market. For example, a war, a pandemic, or a stock market crash can cause share prices to drop across sectors and asset classes. Diversification, however, can protect against the risk associated with a single stock or industry.

How Does Diversification Protect Investors?

Even stocks issued by blue-chip companies, like Apple or Google, can suffer losses. The stock market as a whole is not as vulnerable. That is why low-cost index funds that invest in a bundle of stocks – like the S&P 500 – are some of the lowest-risk investments on the market. Out of the 500 stocks the S&P tracks, a few will perform especially well, and a few might suffer unpredictable losses. The above-average gains of a few stocks should balance out the losses, and the investor will enjoy growth without taking on the risks associated with a single stock. 

Example: The Benefits of Diversification in 2020

Unpredictable calamities, like COVID-19, can result in plummeting share prices. Real estate is typically a reliable investment, but if investors overconcentrated in hotel real estate, they suffered huge losses following the global pandemic. But if portfolios that invested in hotel real estate also invested in Zoom, Etsy, and Moderna, their portfolio probably performed well enough to compensate for the bear market.  

Different Types of Diversification

Here are a few areas of diversification that every investor should consider:

Global Diversification

In addition to diversifying the type of assets in a portfolio, investors should also consider diversifying by buying international securities. Investing in U.S. stocks and bonds as well as securities based overseas reduces the risk that a single country’s tanking economy will result in devastating losses. 

Asset Diversification

Even if a portfolio has a variety of different types of stocks from different sectors, it may not be diversified enough. A Wall Street Journal article from 2008 illustrated that investors who had relied simply on diversifying their stocks had suffered greater losses than they would have if they had invested more heavily in commodities and bonds.

Liquid and Illiquid Stocks

Investors should also consider the maturity dates of their investments. Investments that attempt to profit from short-term volatility should balance out with investments that are designed to be held for longer periods. Younger investors have time on their side and may want to take advantage of illiquid investments that take 10+ years to mature but offer especially high returns.

Growth Stocks vs. Value Stock

Growth stocks have excellent prognoses for future share prices. A growth stock often comes out of the technology sector, issued by a company that dominates an emerging market. These companies do not yet have huge profits but are expected to in the future. For instance, Amazon operated at a loss for many years while it expanded its operations.

Value stocks are issued by companies that have been around for quite some time. The price of their shares is relatively low compared to their considerable revenue.

Why is Diversification a Recommended Investment Strategy?

Diversification is important because it can tailor the level of risk to an investor. Appropriate diversification may not look the same from one portfolio to the next. For instance, younger investors who are saving for retirement may want to take on moderate risk. Riskier investments may offer better returns, and the portfolio has time to recover. Older investors who rely on their portfolios for income should take on less risk. Both portfolios need to diversify, but brokers should be able to diversify portfolios to address individual needs.  

Diversification is Not Enough

Diversification does not justify every type of investment. For instance, an investment might technically diversify a portfolio, but could also introduce costs that negate potential returns. Low-cost index funds and ETFs make it possible to diversify without burdensome costs.

• Hedge funds add diversification but are not accessible to the average retail investor because of their prohibitively expensive buy-ins.
• Mutual funds can come with fees that make them unsuitable.
• Alternative investments are often overly complex and risky for retail investors.

Alternative Investments and Diversification

While alternative investments can add diversification to an investment portfolio, the risks associated with these complex investments can be hidden from investors. These kinds of products can also feature fees and tax implications that make it more difficult to calculate their benefits for investors.

Investors should make sure they understand how an investment is supposed to work before they purchase it. If the alternative investment might lose the principal investment, under Regulation Best Interest the financial adviser must determine if there is an investment on the market that offers similar benefits with less risk.

Master Limited Partnerships

Master Limited Partnerships might seem an attractive way to diversify with the potential for regular distributions. MLPs often form with the express intent of raising money for oil drilling. Drilling for oil is a speculative endeavor and overconcentration of this type of investment introduces huge risks. The SEC warns that concentrated exposure in Master Limited Partnerships can result in heavy losses following changes in gas prices, for example. Many investors find out too late that their brokers did not have their best interests in mind when they concentrated their portfolio in the energy sector.

Options Contracts

While options have gained popularity in recent years, the benefits to investor portfolios are not certain. At the most basic level, options trading allows investors to place bets on whether a stock price will increase or decrease. Speculation always comes with a high degree of risk and investors are likely to lose money on options contracts. Brokerage firms should only approve investors for options trading if they have a considerable risk tolerance.

Futures

Futures aim to correctly anticipate the price of commodities. Commodities are raw materials, like precious metals and oil.

Private Equity

Private equity firms buy companies with the express purpose of selling them. They may invest in companies that are struggling to turn a profit, taking over the management and taking steps to make the business profitable again.

Non-Traded REITs

Real Estate Investment Trusts (REITs) are investment companies that own real estate. Non-tradeable REITs do not trade on the stock market, are highly illiquid, and charge high fees. These factors can undo any tax benefits they are supposed to offer.

Dangers of Lack of Diversification and Broker Misconduct

If a portfolio lacks diversification, a stock broker or financial adviser may have violated FINRA Rule 2111, also known as the Suitability Rule. This rule requires brokers to exclusively recommend investments that suit an investor’s investing goals, financial needs, age, and tax status. The suitability rule also applies to the overall investment strategy – the selection of a stock must make sense in light of the rest of the portfolio.

FINRA states, “A recommended securities transaction or investment strategy may also be unsuitable if it results in a security or type of security that is inconsistent with the customer’s investment profile.” Failure to diversify may qualify as a type of broker negligence.

Failure to diversify a portfolio is also referred to as “overconcentration.” Overconcentrated portfolios suffer magnified losses when market forces cause share prices to drop. Investors who prefer moderate or low-risk investing strategies should be able to trust their brokers to choose diverse stocks. Overconcentration may indicate broker misconduct has occurred. Brokers may be tempted to overconcentrate an investor’s portfolio in investments that offer particularly high commissions.

Investors may wish to overconcentrate their portfolio if they believe that a particular stock will produce a spectacular return. These investors are taking a risky position, and they should only take on this type of risk if they can afford the potential loss. If a broker recommends overconcentration, they should make sure the investor understands the risk.

Lack of Diversification Examples

Lack of diversification often indicates that a broker or financial adviser has engaged in some type of misconduct. Brokers may be tempted to overconcentrate certain securities in order to earn higher commissions. In certain cases, investors have successfully utilized the FINRA arbitration process to recover losses. The following cases illustrate FINRA’s response to egregious cases of broker misconduct and a failure to diversify.

Overconcentration in High-Risk Investments

FINRA recently alleged that several Coastal Equities brokers over-concentrated their brokers in high-risk, illiquid investments. Allegedly, the broker earned $132,900 in commissions. One broker, for instance, allegedly recommended his customers buy $2.25 million in illiquid, alternative investments. “Illiquid” means that investors cannot withdraw their money without incurring significant fees. FINRA alleges some of these customers were seniors, making the investments especially unsuitable in light of their age.

The firm had a policy prohibiting investors from investing more than 35% of their portfolio in alternative investments. To get around this policy, one broker allegedly inflated his investors’ net worth.

This is not the only instance of a broker allegedly inflating his customer’s net worth in order to overconcentrate their account. In April 2022, a Morgan Stanley broker consented to the findings that he had inflated customers’ liquid net worth in order to place their portfolios in non-investment grade, fixed-income securities. As part of the terms of his agreement with FINRA, the broker consented to a 20-month suspension.

Brokerage Firms Fined for Overconcentration

Many brokerage firms have policies in place designed to prevent their customers’ portfolios from being overconcentrated in high-risk investments. The firms can – and should – create systems that flag accounts with high concentrations of high-risk investments. FINRA may fine a firm if it finds that it has not put adequate supervisory rules in place to prevent overconcentration.

For instance, in 2020, Moloney Securities consented to a $100,000 fine following allegations that the firm failed to maintain a supervisory system with respect to concentration in higher-risk products. According to FINRA’s allegations, a Moloney representative recommended that five senior investors concentrate their portfolios in risky oil and gas investments. These customers had specified that their investing goals included “preservation of principle/income.” Moloney’s surveillance system failed to flag these risky, over-concentrated investments. The AWC states that Moloney paid these customers restitution payments that totaled $195,500.

Diversification: Risk and Reward

The diversification rule derives from mean-variance theory, which determined that a stock’s risks should not be evaluated on its own, but in relationship to the rest of the portfolio. Diversification is not as simple as crafting a portfolio with different types of investments. The entire bundle of investments must complement one another.

As this article from the Wall Street Journal points out, a well-diversified portfolio should be able to generate a return in different markets. There should be investments that would fare well in a recession, as well as investments poised to take advantage of a boom. These can be complex calculations, which is why many investors rely on their financial advisers to guide their selections.

Changing market conditions may call for changes to an overall diversification strategy, and concentration does not necessarily indicate overconcentration. Some concentration might be called for depending on market conditions. As interest rates rise, a financial adviser may advise that portfolios shift to bonds, while a bull market may call for a concentration in stocks.

FINRA advises that investors rebalance their portfolios on an annual basis to ensure they take full advantage of the benefits of diversification.

Avoid These Types of Over-Concentration in Your Portfolio

Over-concentration can be more complex than simply owning too many shares of the same stock. FINRA has singled out different styles of over-concentration that can have dire consequences for investing portfolios.

Company Stock Concentration. Investors may be tempted to concentrate their investment portfolio in the employer’s stock, often out of a sense of loyalty to the company or confidence in the business’s potential. The collapse of Enron revealed the dangers of company stock concentration. The energy company employees placed the bulk of their 401(k)-retirement savings in Enron shares and in 2000, the 401(k)-retirement plan had $2.1 billion in assets. Following the discovery of executive fraud, the plan lost 94% of its value, gutting Enron employees’ retirement savings.

A 2001 article from the New York Times on the losses to Enron retirement funds states, “The loss serves as a grim reminder of the danger of relying too heavily on one investment.”

Concentration in Illiquid Investments 

Alternative investments are investments that do not trade on the stock exchange, such as non-traded REITs and private placements. The fact that they do not trade on the stock exchange is one of the factors that makes them especially risky. These kinds of investments are illiquid, meaning the investor is expected to hold them for an extended period. If an investor made it clear to their financial adviser that they may need to access their funds, their portfolio should not concentrate on these types of assets.

Concentration in Correlated Assets

Stocks and bonds are different types of assets, but they may be correlated, meaning they are affected by the same market forces. If your broker recommends a mutual fund or an ETF that tracks the technology sector as well as investments in individual tech companies, the overall portfolio will lack diversification.

Diversification Pitfalls

The Wall Street Journal article “When Diversification Doesn’t Spread Your Risks” points out that diversification does not work “when everyone diversifies the same way.” Investors may invest in different mutual funds, but if they all track the S&P 500, their portfolios will not enjoy the benefits of diversification. Different mutual fund and hedge fund managers may also follow the same investing trends. Collateralized loan obligations are increasingly popular among advisers, and investors may not realize that their portfolios are concentrated in low-quality loans.

There is also a phenomenon known “. With increased diversification comes an increased need for due diligence. Financial professionals do not always do their research before recommending an investment, resulting in investments that may suffer from over-correlation.

Funds that invest in a bundle of underlying stocks can help combat the problems of “diworsification.” Instead of evaluating a bunch of individual stocks, investors can choose investment funds that provide diversification. If one fund is a bond ETF and the other tracks the S&P 500, the portfolio will feature a wide variety of non-correlated assets without the investor or financial adviser needing to handpick a huge variety of stocks and bonds.

What Can I Do If My Broker Failed to Diversify My Portfolio?

Investors who suffered losses following a lack of diversification should speak with securities attorneys. If an investment contract comes with a pre-dispute arbitration clause, you may be able to recover losses via FINRA arbitration. Pre-dispute arbitration clauses prohibit investors from suing brokerage firms in civil court and require investors to recover losses using FINRA arbitration. FINRA provides a forum for dispute resolution and a supposedly neutral arbitration panel but does not offer investors legal advice.

Furthermore, the fairness of the proceedings has been called into question by the Public Investors Arbitration Bar Association (PIABA), which has called out FINRA for failing to provide sufficient transparency regarding arbitration panel members with industry ties. With an investment fraud attorney, you will have expert guidance as you navigate this niche area of law.

Contact our attorneys today for a free consultation. Kurta Law securities attorneys work on a contingency basis, which means we do not collect any fees unless you win your case. Call (877) 600-0098 or email info@kurtalawfirm.com