Co-founder and CIO
15 March 2019
Editorial note: Our thoughts go to the families affected by the two recent plane crashes. We’re using this example solely to draw investment lessons that can illustrate how quickly and unexpectedly even a large, reputable company’s share price can drop, and how that can affect an improperly-diversified portfolio.
On 10 March, the Boeing 737 MAX aircraft flown by Ethiopian Airlines crashed near Addis Ababa, killing all 157 people on board. This comes less than 5 months since another Boeing 737 MAX aircraft plunged into the waters off of Indonesia. As investigators look to uncover root causes of these accidents, a growing number of aviation authorities around the world are grounding Boeing’s 737 MAX aircrafts. The debacle has sent Boeing’s share price down 14.8%, from $440 USD to $375.41 USD between 1 March and 12 March.
This example of a highly reputable company’s stock price plummeting with its planes goes to show the vagaries inherent with investing in single-name securities. Unexpected events can severely impact the value of a particular investment, negatively or positively. It’s not rare, and it’s unpredictable: for example, it happened last year to Facebook with Cambridge Analytica. The lesson investors can draw here is to have a diversified portfolio so they can sleep better not worrying about potential events within a company, such as plane crashes, a privacy scandal, a CEO affair, or about external impacts on a company, such as a sharp increase in oil prices.
Using what’s going on with Boeing to illustrate the importance of diversification, let’s compare the daily percentage change in the share price of Boeing against VTI, which is a Vanguard ETF that tracks the CRSP US Total Stock Market Index. The latter is a very broad representation of the universe of investable stocks in the US, and is made up of more than 3,500 companies. The benefit of diversification is very clear here: in Figure 1, we can observe that the swings in the Boeing stock price (orange line) can be as wide as +/- 7% per day. This volatility is significantly wider than that of the tracking ETF (blue line).
Source: StashAway, Bloomberg
Beyond smoothing out price swings, diversification also mitigates the problem of being exposed to event risks, such as companies being delisted or going bankrupt. It is simply too onerous and complex for an investor to track and analyse a large number of single-name securities to find winners and avoid losers.
Diversification is also not about simply having a large number of securities in a portfolio. Things become significantly more interesting when an investor starts including different types of asset classes into their portfolios. An effectively diversified portfolio would be invested across geographies, and strikes a good balance of allocations to growth assets (e.g. technology stocks, etc) and protective assets (e.g. government bonds, high-grade corporate bonds, gold, etc).
Defying all negative expectations, growth-oriented assets have reversed their doldrums in late-2018, and