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One of the basic building blocks in portfolio management is buying a lot of different “stuff.” The financial industry uses a more refined noun — diversification — that rolls gently off the tongue but may seem equally vague. What does diversification actually mean? Is prudent application of diversification the same for every investor? Why or why not?

Within the context of an investment portfolio, successful diversification means combining broad baskets of assets that provide different patterns of return over different time periods. Doing so can help ensure that a portfolio participates in all markets — capturing returns provided by markets as a whole while reducing volatility (or turbulence) along the way.

But diversification matters outside of a portfolio, too. As discussed in the article ‘Life is a box of correlations. What’s in your box?‘, correlations surround our lives in complex ways, and we address those correlations — consciously or subconsciously — in a variety of ways. We buy insurance, hoping to lose our premium payments and never experience a catastrophe that destroys our house or takes our life. Oil-rich Norway is abandoning fossil fuel investments within its ~$1 trillion sovereign wealth fund to hedge against the risk of declining oil revenue in a more carbon-efficient global economy.

For professionals with skills, talents, and expertise wed to the technology sector, a portfolio tilt to so-called value stocks can make a lot of sense. Value stocks are broadly defined as cheap stocks with lower-than-average growth prospects; whereas technology stocks typically have characteristics that categorize them as growth stocks with (to no surprise) above-average growth prospects. The correlation concept here is no different. If your wages and earning power are tethered to the technology sector and you hold equity awards tied to your tech company’s stock — all else being equal, as an investor, you start from a concentrated position in one area of the investable market. Thus, if you don’t compensate for this concentration by tilting an otherwise market neutral, index portfolio to nontech areas of the market such as value stocks, suboptimal correlations may exist when viewed in the aggregate.

Additionally, apart from potential correlation benefits, value stocks (as a group) have historically provided meaningfully higher returns than growth stocks (as a group). For instance, over the last 20 years ended June 30, 2020, the Russell 1000 Growth Index produced an annualized return of 5.45% as compared to the Russell 1000 Value Index return of 6.32% over the same time period. The reason for this outperformance is that investors tend to systematically underestimate the ability of weaker companies to enhance revenue growth and profits, and they tend to overpay for companies with growth stories by extrapolating recent success too far into the future.

Despite these observations, the technology space has unequivocally been the place to be over the last decade. Since the bottom of the financial crisis on March 9, 2009, technology stocks (represented by the S&P 500 Information Technology Sector Index) have provided unusually high returns — up an annualized 23.39% through June 30, 2020. And for those working in the technology sector over that period, equity-linked compensation packages may have been an added bonus.

While tempting to put the proverbial pedal to the metal — work in tech, invest in tech; the prudent play is to hedge your bets. History tends to repeat itself and very expensive stocks tend to revert to more historical averages. For tech professionals, a portfolio tilt to stocks that are likely to do (relatively) well — if and when the technology sector stumbles — seems to make a lot of sense.

Filed under: Investing

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