Portfolio diversification is one of the most important concepts to focus on when creating an investment portfolio. Having a well-diversified investment portfolio that supports your investing goals and reflects your risk tolerance is key in order to be a successful investor.
Portfolio diversification matters, a lot. It’s no surprise that diversification is a mantra in the world of investing.
If done properly, portfolio diversification allows you to reduce the overall risk of the investment portfolio given the same level of returns (yes, it’s the closest thing to the famous “free lunch” in the financial world).
Although the concept is easy to understand, the actual implementation can be daunting. Creating the right mix of investments according to your situation and future goals is vital in order to keep investing and avoiding mistakes.
This article will cover the main reasons why portfolio diversification works and how and why you should be diversifying your investment portfolio so that you can sleep well while your money works for you.
What Is Portfolio Diversification?
In the world of finance and investments, diversification is the practice of allocating capital across a variety of securities and asset classes reducing the exposure to any one of them in order to reduce the risk.
It’s a strategy to manage and reduce portfolio risk that can either lead to higher returns for the same amount of risk or lower risk for the same amount of return.
Why Portfolio Diversification Is Important
Your investment portfolio should be a vehicle to reach your financial goal(s).
To create this vehicle, portfolio diversification is extremely helpful to structure an investment portfolio that matches your risk tolerance and time horizon properly.
A large number of investors out there forget about those two things and allow their emotions to make investment decisions both when the market is exuberant and when a crash occurs, with disastrous results.
Portfolio diversification offers a practical way to significantly reduce the risk of your portfolio protecting you against volatility. This is good news for investors because you can protect yourself in the case of a market crash and keep investing in every financial and economic scenario.
There will always be market crashes and unexpected situations, the ability to keep investing no matter what happens in the market will supercharge your chances of being a successful investor.
Furthermore, if you are in for the long run, will allow compound interest to do its wealth-creating job.
Unless following a thorough analysis and a strong investment rationale, investors shouldn’t put all the eggs (your investments) in the same basket (specific security of market segment) because it would imply a high level of risk.
The idea behind diversification is combining several securities and different types of investments into an investment portfolio, taking advantage of the fact that not all the asset classes or securities move together.
The result is that on average, a portfolio that holds a variety of investments yields higher returns and has a lower risk compared to any individual investment within the portfolio.
Correlation – How Portfolio Diversification Works
In creating a diversified portfolio, investment risk is the probable dispersion of returns, that is, the chance that expected returns will not materialize during the holding period.
Nobody knows for sure what future returns will be, but a security whose returns are not likely to depart that much from the average is considered less risky than a security whose returns from year to year tend to be volatile (e.g. bonds are generally less risky than stocks).
Different investments have different levels of volatility and by taking a closer look at the investment opportunities out there, they can be grouped into broad categories known as asset classes.
The main asset classes are:
- Real estate
- Cash & cash equivalents
Not only different asset classes have different levels of volatility, they are affected differently by market conditions. In other words, they don’t go up or down in the same way and at the same time.
Portfolio diversification works because different asset classes don’t always move completely in parallel.
The correlation coefficient plays a crucial role.
If your entire portfolio reacts in the same way at a particular market scenario (all investments have a high correlation among them), diversification won’t be very helpful in reducing the risk of your portfolio.
On the other hand, if you created a mix of asset classes with low or negative correlation among them, chances are that when one goes down others go up, balancing fluctuations therefore reducing portfolio volatility (risk).
A simple example will make everything clearer.
How Portfolio Diversification Reduces Risk – Example
We have already pointed out that the reason why portfolio diversification works is that prices of the securities within different asset classes don’t always move in tandem.
The following example to illustrate the concept of diversification and correlation is taken from the book A Random Walk Down Wall Street by Burton G. Malkiel, a book that every investor should read and study.
Suppose that you have an island economy that only has two businesses: a beach resort and an umbrella manufacturer. It’s clear that weather affects both businesses, in fact the first business will do great during the sunny season while the second business will do great during the rainy season, and vice versa.
Here’s the hypothetical returns of the two businesses during the two seasons:
On this island, the distribution of season is on average 50% sunny and 50% rainy.
An investor has $2 and decides to invest all the money into a single company. These are the returns that an investor can reasonably expect if he buys a share in only one of the two businesses:
- Umbrella manufacturer: half of the time earns 50% return; half of the time -25% return. The average expected return is 50%*0.5 + (-25%)*0.5 = 12.5%
- Beach resort: half of the time earns -25% return; half of the time 50% return. The average expected return is + -25%*0.5 + 50%*0.5 = 12.5%
Although the frequency on which sunny and rainy seasons show up is 50%, there could be several sunny or rainy seasons in a row, therefore the results are variable.
By investing only in one company, the investor can’t be sure to get a 12.5% return on his investments.
If the investor decides to buy both companies however, diversifying his portfolio, results improve and while risk reduces.
By spreading $1 in each company, during the sunny season $1 invested in the beach resort would produce 50 cents and $1 invested in the umbrella manufacturer would lose 25 cents. The total return would be 25 cents (12.5% on $2). The exact same things happens during the raining season if you invert the names of the companies.
Through diversification, the investor can obtain a return of 12.5% each year no matter what happens with the weather. The investor is sure (risk reduction) to get this return because the weather affects both businesses in a different way (low correlation).
How To Diversify A Portfolio
In the real world, there are thousand of different securities and several sectors and industries. Keep in mind that most companies move together with the economy and companies in the same sector have a closer correlation.
A perfect negative correlation, like the case of the example above, would completely eliminate risk.
As far as we know, there are not two investments that are perfectly uncorrelated (correlation coefficient = -1) but the good news is that perfect negative correlation isn’t necessary to get the benefits of diversification.
As long as there is less than perfect positive correlation among investments, portfolio diversification can reduce risk.
Now, here’s a thing to keep in mind: buying a large number of securities doesn’t automatically imply diversification.
Let’s say you are a stock investor and you bought an index fund that tracks the S&P 500.
Although investing in a large portfolio of stocks is likely to be less risky than investing in one single company, it doesn’t mean that you are diversified. In fact, you would be 100% exposed to corporate America.
If that’s the risk-reward balance that you were looking for that’s fine, but if that’s not the case, you don’t get the real benefit of diversification with an S&P 500 index fund since you are invested in one single asset class (stocks).
A diversified portfolio is built by mixing different kinds of investments in order to achieve the desired risk-reward profile by carefully balancing:
- Different Asset Classes
- Various Types of Securities
- Geographical Exposure
- Currency Exposure
- Protections and Hedges
There is no such thing as the perfect portfolio (perfect for whom?)
One of the keys to successful investing is getting clear on your goals and then learn to balance how you feel against risk and time horizon. How well you sleep at night is a really important indicator because it’s the one that will allow you to control your emotions.
When adverse market conditions occur (and they will occur since they are just part of how financial markets work), remembering why you started is a really good idea.
If you are young and you are investing for retirement in 30+ years, you should consider having a more aggressive risk profile in order to seek the growth of your capital. Conversely, if your time horizon is shorter and you plan to use the money you invested for life purposes, it’s better to avoid being exposed to high volatility.
As common sense would suggest, in order to avoid investing mistakes that will hurt you, you’ve got to know what you are doing.
Today everything is much easier thanks to the internet and new investment opportunities. If you set up an investment strategy that matches your goals and attitude (and then you follow it!) you can do better than most professional fund managers. Seriously.
You don’t need to become an expert, you just have to be willing to get the right knowledge and you can find it online, and that’s what you just did if you’ve read this article until now.
Also, index funds and ETFs are highly efficient securities that provide an easy way to get exposure to different asset classes in order to diversify your portfolio.
The Bottom Line On Portfolio Diversification
We all agree on the fact that investing involves some degree of risk. Investment risk can be managed and portfolio diversification is an effective way to reduce the risk of your portfolio.
The main takeaways from this article are:
- Portfolio diversification is the practice of allocating capital across a variety of securities and asset classes reducing the exposure to any one of them in order to reduce the risk
- A diversified portfolio can yield higher returns with lower risk compared to any individual investment within the portfolio
- Diversification works because not all the asset classes, securities, industries, or financial instruments move together. In order for portfolio diversification to work, the portfolio must be a mix of different asset classes that have a low correlation with each other
- The right mix of asset classes depends on your investment goals, time horizon, and risk tolerance
If you are an investor, you should take advantage of portfolio diversification in order to balance risk and reward of different investment opportunities with the goal of creating a portfolio that supports your investment goals and risk tolerance.
At the end of the day, a good portfolio diversification gives you a huge long-term advantage. If you are able to stay in the market and allow compound interest to do its job, you can expect great rewards from your investments.