Diversification is a risk management strategy used in investing. It is a portfolio allocation technique which enables investors to combine multiple assets potentially across multiple asset classes within a single portfolio. The objective is to reduce the risk of the portfolio as measured by the volatility of returns. Diversification achieves this reduction by limiting exposure to any one single asset. Losses of one asset should theoretically be offset by gains made in other assets. For this reason, the overall return of the portfolio is not necessarily increased, but the return achieved is done so with less volatility in the observed returns.
A common turn of phrase often associated with diversification is “Don’t put all your eggs in one basket“. At such time that the investments are unwound, for example, as the investor approaches retirement, diversification would have reduced the chances of the portfolio having a zero value. Whereas all eggs placed in one basket would increase this probability. A single investment in a single stock which turns bad could wipe out the entire portfolio.
Reducing Risk with a Diversified Portfolio
Risk can be divided into two parts.
- Systematic risk – risk that is inherent in the system
- Unsystematic risk (also known as specific or idiosyncratic risk) – risk that is specific to an asset
Systematic risk, such as broad macro events cannot (often) be diversified away as these risks are inherent in the system affecting all assets. However, diversification can lower the effects of idiosyncratic risk from a single investment or stock. A biotechnology company for example will have little in common with a utility company. the specific risks to these companies will not be related. Adding further assets of this nature will negate any negative effects on the return of the portfolio as it is unlikely not all risks will prove to be negative for all assets at the same time. As always, there IS a caveat to adding additional investment which is discussed in the next section.
Stocks or assets that are subject to their own specific risk at different time will exhibit a correlation score that is less than one. In other words, they are not perfectly correlated. Because of this, their returns are able to offset each other over time. Assets that are expected to have a FUTURE correlation relationship with the existing portfolio may be a good investment for the portfolio in terms of risk management. (NOTE:- A historical correlation relationship may not necessarily continue). Therefore, the trick is to find an investable asset with the desired expected return that fits with the existing portfolio. Although we have specifically mentioned stocks, this new asset could be in the form of
- All assets can be considered including, Bonds, Commodities, FOREX (including cryptocurrency), Private Equity and Alternative Investment options for example.
- Moving on from this, despite increased globalization, many parts of the world may be at different stages of their own economic cycle. This produces opportunities for diversification within a single asset class. For example, a portfolio of stocks in the USA may be diversified with stocks that have exposure to Latin America.
- Even within a specific market, an individual investment strategy, such as an event driven investment approach using merger arbitrage may produce diversification.
In terms of stocks, academic research suggests a portfolio consisting of between 15-30 investments should be sufficient to realize the benefits of diversifying. If chosen accurately, as few as 10 stocks may be sufficient. Adding different assets classes could reduce this number further. The rise of sector and style ETF’s such as an index fund has reduced the number of investments and the time and effort required to construct a portfolio. Coupled with reduced trading commissions, it means most investors have diversification possibilities within easy reach.
There is no limit, other than the individual investors own mandate to the potential range of additional assets which can diversify a portfolio. Additionally, the weightings given to each investment will also effect the level of diversification achieved. UCITS compliant funds use this approach with their 5 10 40 rule. Negative weightings however, or short selling an asset can be used as a risk management tool or as a pairs trading or relative value trading strategy but is not generally considered an element of diversification. Regardless, asset weightings can still produce an infinite number of possible portfolios and outcomes.
Problems with Diversification
put all your eggs in one basket, and then watch that basket*If an investor of fund manager has a high conviction idea, the weighting given to the investment may be reduced simply because the investor believes they should “diversify”. Diversifying in this instance may cause the return of the portfolio to suffer as well as diverting attention away from the focus of the portfolio. Therefore, without having a solid investment rationale for doing so, will not add value to the portfolio.
*later updated to “to put all good eggs in one basket and then watch that basket“
