Earnings reports, analyst notes, macroeconomic data dumps, notes read on the internet, unsolicited comments from friends, … investors contend with a seemingly endless sea of conflicting information. How do you deal with that? There’s one investing approach nearly all pros agree on: diversify your portfolio.

Determining what being diversified means depends on who you ask. A day trader in their 20s will have much different view of stock diversification than a retiree looking to limit risk. How you build and maintain a balanced portfolio will depend on your investment goals, age, risk tolerance and more.

There are many ways to think about diversification. It can be across asset classes — stocks, bonds, currencies, precious metals, real estate and so on. This is how a macroeconomic investor or financial advisor might think about it. Diversification is also achieved within a specific asset class. We are considered a hedge fund, holding stocks and cash. Diversifying within the equity asset class is what we focus on.

Before we dig in, here’s one way to think about balancing your stock portfolio: Spread your eggs (dollars) across many baskets (stocks) to avoid getting crushed if or when any one basket takes a hit. It’s a good starting point, but it’s still too simplistic. For one, that analogy doesn't talk about correlation. It should be closer to this: Spread your eggs (dollars) across many baskets (stocks) and make sure those baskets aren’t all stored in the same places (industries or sectors).

We’re breaking this tutorial into seven sections:

• Understanding correlations

• Getting a portfolio started

• Is S&P 500 truly diversified? Geography, market capitalization.

• Don’t diversify for sake of it

• How many stocks do you need?

1. Understanding correlations

Correlation is the key to diversification. Without getting into statistical formula, understand that stock correlation describes the relationship that exists between two stocks' price movement. Correlation is measured in a range of minus 1 to plus 1.

• A correlation of minus 1 means that two assets move exactly opposite to one another. 

• A correlation of plus 1 means they move perfectly in sync in either direction.

• A correlation of zero means there’s no direct connection.

Once you better understand correlation, you will understand why simply spreading your eggs (dollars) across baskets (stocks) isn’t enough. You might put your eggs in 11 baskets; but if all of those baskets are strongly correlated - think in the same car (industry or sector) - and that car were to drive off of a cliff — well, say goodbye to your eggs.

We need to consider the correlation between our investments. At a high level, we can say that stocks in the same sector will be more strongly correlated than stocks from different sectors. When investors rotate out of the technology sector, for example, stocks in the industries that make up tech — software, hardware, cybersecurity and so on — will often get hurt. They become more positively correlated. This is why our holdings need to be diversified across sectors and industries.

In addition to correlations, position size - the weighting of a stock within your portfolio - is also crucial. After all, if stock ABC and stock XYZ have a minus 1 correlation but 90% of your portfolio is in ABC and 10% is in XYZ, you’re not going to realize the benefits of diversification. Asset ABC is going to dictate the portfolio while any moves in XYZ won’t matter much.

2. Getting a portfolio started

The need to diversify across various sectors, and therefore reduce the correlation between your investments, is why we would suggest new investors or those who do not have the time to manage their own portfolio invest in S&P 500 index fund. That way, the investment is diversified across all 11 sectors of the S&P 500. We don't own index funds because we manage our own portfolio and we are trying to beat the index ourselves, but that's a different story.

Even if you own an S&P500 index fund and then want to add individual stocks, you don't want to go about buying any individual stocks. And of course, if you just want to invest in individual stocks, you have to consider how every new buy or sale will impact the makeup of your entire portfolio.

To better illustrate, let’s consider the current make up of the S&P 500. As of March 31, the end of the first quarter 2022, the S&P 500 weighting was as follows:

When you buy into an S&P 500 index fund, roughly 28 cents of every dollar goes into technology, while only 2.6 cents go into materials. From this example, we can clearly see that if we set the S&P 500 index as our core position and then go on tech buying spree, we’ll quickly lose any benefit of the diversification into materials, utilities, real estate and energy — all of which were relatively small to begin with.

Therefore, every new addition or subtraction from your portfolio should consider not only the target stock’s own attributes, but the impact it will have on your portfolio as a whole. The level to which you want to be diversified or concentrated is a matter of personal choice and risk appetite. We can’t advise you on those decisions, but can only explain how we think about our portfolio.

3. Is the S&P 500 truly diversified? Geography, market capitalization.

The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 of the largest companies that are listed on U.S. exchanges. When considering a position in an S&P 500 ETF, it’s worth noting this position will be missing some diversification, specifically relating to geography and market cap. Geography-wise, an investment in the S&P 500 will of course be strongly weighted towards the U.S. economy, lacking diversification with respect to other parts of the world, like an emerging market in South East Asia or a developed country in Europe. Market cap-wise, S&P 500 by definition only contain large-capitalization companies, therefore will not have small-cap companies.

According to FactSet, the geographic revenue breakdown of the S&P 500 is as follows:

Taking all this information together, an investor with all of their eggs in the S&P 500 basket may determine that new capital is better allocated to something with a smaller market cap — a foreign company or perhaps a U.S.-based name that operates in an undeveloped market.

Take India for example. The country is classified as an emerging market and we also don’t see much in terms of total S&P 500 revenue coming from India. India has a population of about 1.4 billion people — and according to data provider Statista, it’s expected to see gross annual domestic product growth of more than 6% through 2026.

To be sure, a position in the S&P 500 will provide a great deal of diversification and should be a solid starting point for most. We simply want to illustrate that there is more to diversification than simply an ETF that represents all sectors of a given economy.

4. Don’t diversify for the sake of it

Diversification simply for the sake of diversification is stupid.

You don’t want to simply buy something you don't have that has a negative correlation to your current holdings without considering the stock's own expected return. If someone asks “I’ve got this item for you to buy, it’s a loser but it’s going to add diversification to your portfolio,” would you buy it? Of course not. Our portfolio does not own any no-earnings, all-talk no-action, story stocks, and we will never own them.

Rather, the idea is to find assets that are not strongly correlated to your portfolio, but on their own must have strong underlying fundamentals. 

As an example, since the beginning of the year, as it became clear that inflation was going to pose a bigger problem than expected, especially with the rise in energy prices, we felt that our secular growth technology stocks would come under pressure as the bonds sell off and yields go up. We did not want to give up on secular growth names such as AMD, Apple or Microsoft, because who would bet against the Tim Cook, Satya Nadella or Lisa Su of the world. In order to keep these names, protect ourselves and dampen the portfolio’s overall volatility, we tried to offset these tech names which get hurt by inflation with names that benefit from inflation, specifically those in the energy sector. That is why we added energy stocks to the portfolio in the past few months, and to this day, our portfolio is 10% energy. This pair of oil/commodities versus technology is a good example of a hedge.

5. How many stocks do you need?

Ultimately, the goal of diversification is to enhance the risk/reward profile of your overall portfolio. For an equity portfolio, there’s no concrete rule as to how many stocks one should own. Whichever number you choose to go with, obviously you need more than one, but don’t need hundreds of stocks to be diversified. What you need are the right stocks. Also, make sure you are able to do at least one hour of homework each week per stock. 

Now, there are a couple more complicated points to discuss: 

• For the financial sector, we own both Morgan Stanley and Wells Fargo. You may ask, why not just own one, since both of them are in the financial sector and strongly correlated. The answer is that our investment theses in these names are slightly different. As much as Morgan Stanley move similarly to Wells Fargo, fundamentally, Morgan Stanley is a wealth management company, with stable, recurring revenues, traits that Wells Fargo do not necessarily have. On the other hand, Wells Fargo makes exponentially more money when interest rates go up, a trait that Morgan Stanley cannot compete.   

• There are times when you may may want to make a bigger bet on something. In that event, you might reduce diversification, increase concentration to a particular sector. Earlier this year, we continuously added to healthcare names like Eli Lilly, Pfizer and Danaher. Recently, we added United Health and Thermo Fisher. We want to own these healthcare names because we are betting that out of fears of economic recession, these names will see price appreciation because they are considered defensive, recession-proof.

6. Bottom line

There are may ways to think about diversification. The level to which an investor chooses to diversify is a personal choice that only they can make. While we never want to diversify for the sake of diversification, once we have identified a potentially attractive opportunity — based on its own merit — the next step is to consider how that investment will fit into our portfolio. By doing this — while also accounting for the weighting placed on the position and any correlations to other names — we can have a better sense of our overall risk exposure and how we can improve the overall risk-reward profile of our portfolio.