A recent article in The Economist by Buttonwood asks the question: “Should you put all of your savings into stocks?” The piece is motivated by the recent surge in the US and Japanese stock markets.  The S&P 500 index of big American companies is up by 5%, having passed 5,000 for the first time.  In February, Japan’s Nikkei 225 passed its own record set in 1989.

The report included studies by Anarkulova, Cederburg and O’Doherty who make a case for a portfolio of 100% equities through a review based on data going back to 1890. Ayres and Nalebuff of Yale University even argued for a strategy of borrowing by young people in order to buy stocks, before diversifying and deleveraging later in life.  However, an even longer view by McQuarrie dating back to the late 18th century showed decades when bonds outperformed stocks.

Of course, this view is contrary to mainstream belief that a good mixture of stocks and bonds works best for the regular investor. The US and Japan equity indices may be at all-time highs, but for how long? The stock concentration argument is based on the very long run. And in that same period, we are all dead unless we are blessed with the magic of one famous centenarian politician.   The gyration of the markets still supports a more balanced perspective.

It is true that the potential for high return exists in equity, but it comes with an equally high level of risk and volatility.  Stock prices can be unpredictable, influenced by various factors like economic conditions, geopolitical events, and company performance.  Prices can fluctuate significantly in a short period, and one may experience substantial losses. It could jeopardize financial stability, especially if access to savings is an exigency for the short term.

Diversification involves spreading your investments across different asset classes and securities to reduce risk and enhance the potential for returns.  Different asset classes such as stocks, bonds, real estate and cash equivalents have unique risk and return characteristics. By allocating across various classes, the benefit is when assets perform differently under different economic conditions. When stocks face a downturn, bonds or real estate may offer stability or even appreciate. In China today, for example, young investors have been buying gold as a refuge from local property and stock market mayhem.

Statistics play a crucial role in assessing the effectiveness of diversification. Modern Portfolio Theory (MPT) developed by Henry Markowitz is a statistical framework that formalizes the concept of diversification.  MPT uses statistical measures like expected return, standard deviation, and covariance to optimize portfolio allocation.

Standard deviation is a measure of dispersion of returns from the mean. When combining assets with different standard deviations, the overall portfolio standard deviation may be lower than the weighted average of individual standard deviations. This is the “diversification effect” where a well-constructed portfolio can achieve a more favorable risk-return tradeoff.

The key to achieving the “diversification effect” is correlation, which measures the degree to which returns of two assets move in relation to one another.  Diversification benefits are maximized when assets have low or negative correlation because they are less likely to move in the same direction at the same time.

Other statistical tools are models like Monte Carlo simulations which are employed to assess potential outcomes and risks under various market conditions.  The concept of the Sharpe ratio, a measure of risk-adjusted return, helps investors evaluate whether the additional risk taken on is compensated by higher returns.

Moving on from asset classes, further diversification can be achieved by selecting a mix of equity companies of different sizes, industries, and geographical regions.  Similarly in the bond market, diversification can be across different issues, maturities, and credit qualities. Industry diversification considers distinct economic cycles, regulatory environments, and risk factors. Spreading investments across various sectors can provide a buffer against downturn in any single industry.

Other considerations include the length of time an investor plans to hold the investments.  Risk tolerance is also a critical factor because each investor has unique ability to tolerate risk influenced by factors like age, financial goals and personal circumstance.

Despite the surge in recent times that provides temptation to put all money in stocks, particularly in the US and Japan, and the study citing the superiority of a pure equity approach in the very long run, this concentration approach is fraught with dangers.  Do not put all your eggs in one basket. Better still, choose baskets that exhibit low correlation.

The tried and tested rule of diversifying your investments across a range of assets can help manage risk, increased potential returns, and create a more resilient portfolio. Regular portfolio monitoring and rebalancing are essential for maintaining effective diversification.

The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.


Benel Dela Paz Lagua was previously EVP and chief development officer at the Development Bank of the Philippines.  He is an active FINEX member and an advocate of risk-based lending for SMEs. Today, he is independent director in progressive banks and in some NGOs.