When constructing an investment portfolio, it is important to include divergent investments and stocks. Divergent stocks refer to investments with different risk-return profiles and correlations. Including divergent stocks in a portfolio provides diversification benefits and reduces the overall portfolio risk. There are several ways stocks can be divergent: by company size, industry sector, geographic location, valuation, and growth prospects. Small-cap stocks tend to have higher volatility than large-cap stocks. Stocks in different sectors like technology, healthcare, utilities exhibit divergent performance patterns. International stocks diversify away country-specific risks. Value stocks offer steadier returns than growth stocks during market downturns. Blending together divergent stocks creates a more resilient portfolio that can better weather market turmoil. However, correlations between stocks rise during panics, so diversification benefits decline when needed most. Overall, astute investors should construct their portfolios with both convergent and divergent stocks to optimize risk-adjusted returns over time.
Market capitalization results in divergent stock returns
Large-cap and small-cap stocks have markedly different risk-return characteristics, making them divergent investments. Large-cap companies are well-established with steady cash flows, so large-cap stocks like Apple, Microsoft and Amazon tend to be less volatile. Small-caps are younger companies still gaining market share, so their future growth potential is accompanied by higher uncertainty. Academic research shows that small-cap stocks have outperformed large-caps historically, compensating investors for bearing extra volatility risk. However, large-caps tend to weather market downturns better. Blending large-cap and small-cap stocks produces a portfolio with smoothed out returns across the business cycle.
Sector preferences lead to divergent stock selection
Investors exhibit capital rotation across different sectors as the economic cycle evolves. During early cycle recovery, cyclical sectors like financials, energy, industrials and materials outperform. Late cycle, defensive sectors like healthcare, utilities and consumer staples shine as investors seek stability. The technology sector demonstrates divergent performance, flourishing during expansions but remaining resilient in downturns given its high growth prospects. Investors tilting their stock portfolios to favor certain sectors will achieve performance divergent from the overall market. However, many active fund managers fail to consistently time sectors right. Passive sector ETFs provide cheap exposure to sectors expected to outperform.
International stocks add geographic diversification
Investing globally across countries and regions enhances portfolio diversification since economic conditions diverge worldwide. Developed markets like the US, Europe and Japan exhibit lower growth compared to emerging markets in Asia and Latin America. Stocks in commodity-exporting countries like Australia and Canada fluctuate with the resource cycle. China’s economy follows policy directives from Beijing that often diverge from worldwide trends. An internationally diversified stock portfolio reduces exposure to any single country’s economic, political and currency risks. However, international investing also introduces new risks related to less transparency, weaker corporate governance and political instability in some regions.
Growth stocks and value stocks perform divergently
Growth stocks represent companies expected to achieve rapid earnings growth, often trading at elevated valuations. Value stocks appear inexpensive relative to their fundamentals like book value, earnings and cash flows. These divergent approaches tend to alternate in investor favor across the business cycle. Growth stocks drive returns coming out of recessions as the economy reaccelerates. Value stocks shine later cycle as the earnings yields of cheap stocks become attractive. Blending growth and value stocks produces a portfolio with balanced risk-return characteristics. However, even value stocks become correlated and fall together during panics, so their diversification benefits decline when most needed.
Divergent stocks with different market caps, sectors, geographies, and styles exhibit varying risk-return patterns. Blending them smoothes portfolio returns across market regimes. But correlations rise during panics, reducing diversification precisely when markets plunge. The solution is holding adequate cash and hedges to mitigate correlated crashes.