Diversification is a commonly utilized strategy that seeks to minimize the risk of loss by spreading one’s investable assets amongst a variety of securities. The general theory is that the more diverse a portfolio is, the less impact one or several underperforming positions can have on the overall portfolio pie. Thus, the “safest” of portfolios will have more, rather than less positions spread amongst a variety of asset types, industries, market capitalizations, global and domestic geographic regions, etc…
Though the strategy helps to mitigate the risk of loss, it can also be a facilitator of lower returns, especially when we speak of equities. If a stock doubles in the course of a year, it can have a dramatic effect on overall return in a portfolio with a limited number of holdings. Yet as the number of holdings rises, that impact is incrementally diminished.
Due to their generally lower volatility, stated return of capital feature, and higher position in the capital stack, bonds don’t tend to be seen in the same diversification light as equities. There seems to be a general lack of necessity, even amongst those with capital preservation need, to be highly diversified in the fixed income realm. But is this a wise mentality?
How Many Is Enough?
As a proponent of diversification for the income investor, I’m inclined to think that one cannot have too many holdings, so long as one is able to competently keep track of everything. So pertaining to bonds, I would advocate more over less, so long as trading and tracking costs do not become burdensome.
Placing an exact number on the amount of individual issues to own is difficult. It is certainly conceivable that one could have 20 – five percent positions, 50 – two percent positions or 100 – one percent positions in a large bond portfolio. If we look at some of the pooled products available for purchase (ETFs, CEFs, open-ended mutual funds), many of them will hold thousands of positions, while others will hold a couple hundred. Thus, one multi-sector bond fund could conceivably be a better diversified solution than attempting to build an individual portfolio.
To some extent I believe the amount of needed diversification for the individual bond investor may be symmetrically related to the credit risk that is being taken. I would sleep much better at night owning only 10 AAA or AA rated corporate bonds than I would owning 10 B or BB rated issues. It’s certainly one of the reasons that bond funds are a good choice for high-yield investors. Instantly being spread amongst over a hundred lower credit entities takes away the risk of having a concentrated junk position fall into default.
Still, even though you are skewed towards investment grade fixed income, ten individual issues may be too low. But obviously the chances for default in companies like Microsoft or ExxonMobil is microscopic compared to JCPenney or other entities who are teetering on the verge of bankruptcy or have other near-term liquidity issues.
The bond market presents a variety of options for investors. But today, strategically speaking, it is difficult to position oneself for large-scale total return upside without taking excess credit and/or duration risk or trading near-term rate gyrations. With domestic yield depression and somewhat limited upside to bond prices, the general proposition is none too compelling for passive investors looking for robust returns.
Bond investors can look to diversify in international/emerging markets and sovereign debt which could present some credit upside and better yields. However, considering recent events in Crimea, the risks of political instability and capital downside may outweigh the potential value in doing so. Thus focused international diversification may not be appropriate for all investors.
In the end, fixed income investors must be introspective, creating portfolios that prudently and thoughtfully mix credit and diversity risk tolerance alongside yield and/or total return needs. Though implementation requirements will vary from investor to investor, the general benefits of diversification should always be considered, factoring highly in the portfolio building process.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.
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