The American baseball catcher, Yogi Berra, once said, “It’s tough to make predictions, especially about the future.” This is why good investors do not depend upon predictions but build a portfolio capable of surviving the unpredictable.
Diversification is among the most effective tools to future-proof your investments. This article summarizes how it works and why it is important.
What is diversification?
A diversified portfolio consists of a range of “uncorrelated” assets that do not all behave the same way.
We purchase securities because we are reasonably confident that the underlying company or government is stable or likely to grow. But specific circumstances or events may cause the value of a given security to decline. With a diversified portfolio, other assets that are unaffected by the same circumstances offset their effect, or at least diminishes it.
For example, during the pandemic, airline and hospitality stocks suffered while the technology and pharmaceutical sectors were resilient and certain sub-sectors grew strongly (e.g. remote working tools, medical devices, etc.).
How does diversification work?
Without dwelling on mathematical concepts, the principles of diversification are based on two premises:
- The greater the number of assets there are, the more diversified the portfolio.
- The less correlated a group of assets are, the greater the effect of diversification.
The rule of risk and return still applies: the greater the expected return for a given security, the greater the risk. But a diversified portfolio of assets protects returns and reduces risk.
Diversification is not about sacrificing potential gains to limit potential losses, it is about increasing risk-adjusted returns.
How to diversify a portfolio?
A common example of diversification is a portfolio of stocks and bonds. The two asset classes have fundamentally different profiles. Stocks flourish in a strong economy with stable inflation, whereas highly-rated bonds (e.g. prime corporate and government bonds) perform relatively well during recessions or deflationary environments.
Similarly, high inflation benefits certain assets and diminishes others. For example, floating rate asset-backed loans benefit as interest income rises while their risk is reduced by the growing value of the underlying collateral assets. Technology companies, on the other hand, may suffer lower revenues as inflation-strapped consumers and advertisers reduce non-essential spending. Regardless of the situation, investors must be ready to take advantage of attractively-priced securities (e.g. during a stock market crash or a credit squeeze).
Diversification can also be made by industry (e.g. Financial vs Technology), geography (e.g. emerging markets vs developed markets), company size (large cap vs small cap) and company stage (value vs growth).
Diversification is a complex process that must be customized to each investor’s situation. Investors whose wealth is heavily concentrated in their home country or a specific asset class (like real estate) should seek diversification internationally or in other asset classes whose performance is less correlated.
Limits of diversification
Diversification does not eliminate all risk. “Systematic” risk, for example, cannot be diversified away. These risks are inherent to the entire market and arise from a mix of factors including economic, socio-political and market-related events, such as war, recession, and natural disasters.
The aim of diversification is to lessen the impact of non-systematic risks related to specific businesses or sectors. These may include the departure of a CEO, changing regulations, disruptive competition, etc.
What you can do
There is no single rule book on how to diversify. Diversification is partly art and partly science. Over-diversification, for example, may lead to excessive transaction costs. But the most important aspect is judging the true level of correlation between assets and build a portfolio accordingly.
The financial plan you develop with a financial advisor should include the construction of a diversified portfolio that delivers the required return at an optimal level of risk. Your advisor will also help to update the asset allocation as your situation changes and market events emerge.
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