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Diversification. For generations, investment professionals have stressed its importance as a means for stock investors to manage risk while capturing long-term growth. But what does this actually mean? How can you assess whether you are adequately diversified? In this primer, Fisher Investments will share some basics on how we view diversification—and some common pitfalls we see regularly in investors’ portfolios.

In our experience, many investors think the word “diversification” means simply owning more than one security or a few securities. This is partly correct, but it is incomplete—and oversimplified, in our view. Owning more than one security is a benefit—it reduces the risk that a single company’s specific issues greatly harm your investment results. It can also mean you have a greater chance of including good-performing stocks in your portfolio.

But diversification isn’t limited to this, in our view. Fisher Investments thinks you should also view diversification at the country and economic-sector level. Consider: If you own three Energy companies, you may reduce the risk that a company-specific factor (accounting issues, a scandal, an industrial accident or something similarly troublesome) hits your portfolio hard. But what if the entire sector faces headwinds? Our research indicates that, most of the time, stocks in the same industry will perform similarly because they respond to similar drivers. In the Energy sector, our research shows oil prices are the chief driver. When they are weak and appear likely to remain weak based on supply and demand trends, Energy stocks tend to perform poorly—with very few exceptions.

Take 2020 for an example. This year’s economic lockdowns and travel restrictions have hit demand for gasoline and other Energy products hard. Meanwhile, oil supply is elevated, tied to vast increases in American production in recent years. At 2020’s outset, Brent crude oil—the blend used to approximate global prices—traded at $67.77 per barrel. After lockdowns shuttered the global economy, it hit a low of $9.12 on April 21. Economic reopening has helped—Brent prices finished October at $36.33.

The damage to stocks in the sector was acute. Through October’s close, the MSCI World Energy sector was down -48.8% this year—the worst of the 11 broad equity sectors. Energy felt that pain broadly. Of the sector’s 54 constituent companies, 50 were down year to date as of October 31. Moreover, 48 were down more than -20%. In this timeframe, 33 Energy stocks’ returns fell within 10 percentage points (plus or minus) of the sector’s return. So while blending together different Energy firms in your portfolio could have helped you find some that fell less than the overall sector, most were down pretty significantly and you were highly unlikely to find stocks that rose. A mid-November rally in oil prices provided some relief, but the sector remains far behind global markets.

In Fisher Investments’ view, this highlights the importance of owning companies across the array of stock market sectors. Technology stocks, for example, have no material connection to oil prices and are up notably on the year. We think it can be useful as a guide to break down a broad index like the MSCI World by sector. (Index-provider MSCI provides factsheets showing this data, that are updated quarterly and available online.) That way, you have a reference point to understand how big (or small) that sector is. This can help you determine whether you have enough—or too much—exposure. This doesn’t mean you need to mimic the index’s sector weight perfectly, in our view. It is merely a starting point.

This reference point can help you avoid the common pitfall of ignoring some sectors while owning too much in others. In our experience, investors often do this unwittingly because stocks in one category they own are doing well while others aren’t. That performance differential alone can swell certain sectors’ share of your portfolio. Furthermore, some investors sell the laggards and chase the better returns. Maybe that sounds sensible, but we think it actually adds risk. No sector is permanently in favor, and you could suffer if leadership rotates. Diversifying properly, in Fisher Investments’ view, means owning things that are both in and out of favor. That may seem unpalatable at times, but it is vital.

Another common error we see often is people owning way too much of a single company’s stock. Some do this because they used to work there, are fans of its products and services or they are otherwise emotionally attached to it. But unless you are legally restricted from selling the stock for employment or other reasons, in our view, this is a problem worth rectifying immediately. We have unfortunately encountered many retirement investors whose portfolios were devastated by owning too much stock in a single firm—and having something go terribly wrong.

So spread your assets around. Own more than one company’s stock. But don’t ignore sectors and countries as you do so. In Fisher Investments’ view, this is a key step toward building a sound retirement portfolio.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.

[i] Source: US Energy Information Administration, as of 10/15/2020.
[ii] Source: FactSet, as of 10/15/2020. Brent crude price on 01/01/2020.
[iii] Ibid.
[iv] Ibid.
[v] Source: FactSet, as of 11/04/2020. MSCI World Energy sector return with net dividends, 12/31/2019–10/31/2020.
[vi] Source: FactSet, as of 11/04/2020. Total return of MSCI World Energy sector constituent equities, 12/31/2019–10/31/2020.
[vii] Source: FactSet, as of 11/04/2020. Statement based on MSCI World Information Technology sector returns, 12/31/2019–10/31/2020.

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