Why portfolio diversification is a must, what are the various avenues for portfolio diversification?

Why portfolio diversification is a must, what are the various avenues for portfolio diversification?

Avoiding risk entirely, is an impossible feat to achieve, no matter how or where you choose to invest. However, one should not take more risk than required when choosing one’s financial goals. Let us go back to our childhood when we used to play, hide, and seek. Everyone hid in different places. So, when the seeker comes looking, he has a hard time finding everyone. And we made sure we made it hard for them. Even if one or two people were caught, there is always a good chance others had a chance to win. When it comes to diversification, it is not that different. We put our eggs in different distinct baskets so that if one basket goes wrong, we’d still have the rest. Portfolio Diversification is a strategy to invest money in different asset classes and securities to reduce the overall portfolio risk. An investor selects a mix of assets that helps them minimise uncertainty in the returns from the portfolio. If your investment mix constitutes stocks of only technology companies, then on the occasion of a significant event that shakes up that industry, you will be facing a significant loss. For example, When the General Data Protection Regulation (GDPR) was enforced in May 2018, many technology companies saw a decline in their stock prices.

Wait. There’s a caveat?

Diversification is, no doubt, an essential aspect of managing portfolios. But all investments are risky, albeit high or low. An investor needs to do their due diligence before investing in any asset class. One needs to make sure they are investing in high-quality assets; otherwise, variety cannot get you out of losses. So, do your due diligence, be proactive, and any diversification you choose will only add to your gains.

(Source: CFI)

Diversification entails investing in securities whose returns do not move side by side. Technically, their investment returns should have a low correlation. The correlation coefficient is used to measure how the performances of the two securities are related to each other. For example, if two stocks have returns that move in lockstep, then they have a correlation coefficient of +1. Conversely, if two stocks move in the opposite direction, then they have a correlation coefficient of -1. Of course, these are ideal situations. But, to make an adequate diversification, an investor needs to aim at investments having low or negative correlation.

The ultimate goal of diversification is to improve performance while reducing risks. First, we have to understand the risks associated with investments, namely unsystematic and systematic risk.

Figure i: Shows the relation between risk versus the number of stocks in a portfolio.

The unsystematic risk or diversifiable risk is associated with a particular company. This can include declining sales to more extreme events such as strikes, natural disasters, and so on. Diversification can help reduce this risk. It is highly unlikely that such events could happen to two firms at the same time. So by diversifying, one can reduce the risk.

The systematic risk or un-diversifiable occur due to events that affect all the firms at the same time. Events such as a pandemic, war, inflation affect an entire country or the whole world. Diversification cannot eliminate these types of risks. Even the well-diversified portfolios are vulnerable to systematic risks. But a well-diversified portfolio will provide better returns in the times of systematic risks so that the investor can survive it through.

Here are six significant ways to diversify a portfolio. Let us look at some of the ideas.

1. Individual Company Diversification

It is one of the oldest types of diversification technique which has its origin from the 1950s when investment and diversification were in the nascent stage. This technique means you invest in an array of distinct individual company stock. It is the most accessible form of diversification where an investor buys shares of different companies which reduces overall risk to the portfolio. This type of diversification is mostly associated with the stock market only.

1. Industry Diversification

Much alike to individual company diversification, this technique sticks to the stock market. Here, we focus on different industries rather than sticking to one industry. For example, an investor can invest in the technology, industrial, and power/energy sector. This will reduce the overall risk as any adverse event would not affect all the industries at once. People tend to be partial towards one sector to which they are associated. Imagine if things turn sour, not only one will lose your salary, but the investments will take a hit too.

1. Asset Class Diversification or Across Asset class

Different classes such as stocks, bonds, cash, real estate, commodities perform differently in various economic conditions at a particular time. For example, when an economy is recovering, stocks will perform well. While in a recession, bonds will do better and provide better protection against the downturn. An investor cannot be an expert in all asset classes, so, this kind of diversification is necessary to mitigate the overall risk if one asset class is underperforming.

Figure ii: Example Asset allocation of a portfolio

(Source: Stockcharts)

1. Strategy Diversification or Within Asset classes

In this method, an investor invests in one asset class but of different companies. The diversification is across various instruments of the same types. For example, an investor decides to invest in equity. He has a capital of 10 lakhs, and he buys the stock of 5 different companies and invests two lakhs each instead of buying ten lakhs worth of stock in one company. The asset is the same here, i.e. equity but diversification is there because there are five different companies. The following figure is an example of diversification within stock allocation which spreads across Large-cap, Mid-cap, Small-cap, international markets, and emerging markets.

Figure iii: Diversification within the stock allocation

(Source: Stockcharts)

1. Geographic Diversification

Investors sometimes have a home country bias, i.e. preferring stocks or any other instruments of their home country. One economy will never perform well all the time, so if we invest in many economies, we reduce overall risk and improve returns. The investor can compensate for the volatility of one country through their investment in another non-volatile country. For example, you can buy stocks in India, the US, Japan, and many other countries. Here, expert investors can also take advantage of currency fluctuations.

1. Time Diversification

The investments can be diversified across time like long, medium, or short term investments. For example, if an investor wants to put their money in fixed deposits then instead of putting all the money in a 5-year deposit, it can be split into 6 months, 2 years, and 5 years investments separately. Investing in one 5 years fixed deposit will affect the liquidity of the portfolio. Extra charges have to be incurred if the fixed deposit is withdrawn before it matures. Investors can also choose between systematic investment plans (SIPs) and lump sum investments. SIPs invest a fixed amount of money set by the investor at a fixed interval of time, whereas lump sum entails investing a large amount of money at a time in an asset. Often SIPs bring consistency to a person’s investing, therefore, give better investment results.

Over diversification: An impending doom?

If you overdo your biceps at the gym, then you will be sore for the next week. If you keep doing this, then there are chances of serious injuries. The difference here is that your returns will suffer. Over diversification occurs when the number of investments in a portfolio exceeds the point where the marginal loss of expected return is greater than the marginal benefit of reduced risk. In other words, each investment that you add to your portfolio will lower the risk, but each time the risk reduced will grow smaller and smaller. Also, with each additional investment, expected returns would also be affected. For example, if you buy 1000 stocks individually, then it will surely remove or reduce the specific risk, but at the same time, your portfolio will not contain the best or high-quality stocks. If you rank those 1000 stocks, you will have the best and worst opportunities. There is only so much you can do to reduce the risk. After a certain point, there is no benefit to be gained from diversification.

Proper Diversification

Proper diversification is the key to getting optimal returns on your investments. Here, the most crucial aspect is that quality trumps quantity. More preference should be given to the quality of assets that you are investing in. It is a common belief among experts that having 15-30 different assets is optimal to mitigate any unsystematic risk. The number of assets will vary from person to person according to their risk appetite and time that they can devote to manage all the investments. Proper diversification would also be required to spread the assets in different industries and sectors. If you are thinking of buying 1000 stocks, instead it is better to own only 30 best of the shares and discard the other 970 that reduce the performance of your portfolio. Many institutional vehicles such as mutual funds, pension funds, equity index funds, and so on are over diversified thus, lacking quality over quantity. An optimal diversification would be to own individual investments large enough to eliminate significant risks while also not compromising in the quality of the finances.

Few Examples

Figure IV Figure V

A well-diversified portfolio always tries to get maximum returns possible at an acceptable level of risk by the investor. For example, a businessman decides to diversify his business by manufacturing and selling raincoats and sweaters. These two businesses are inversely related to the weather. In the monsoon, he can sell raincoats, but there will be relatively fewer or no sales of sweaters. In the winter, the raincoat sales will suffer or get halted altogether. So, he needs to prepare for both the seasons. Similarly, we cannot predict the market, so a diversified portfolio is our chance at safeguarding our gains against market risks.

In figure IV, we can see the diversified portfolio shows less volatility, and this would ultimately help reduce the volatility of returns. Similarly, in figure V, we see the comparative losses between the two portfolios during extreme events in the world. The chart shows that the diversified portfolio performed better and suffered lesser than the stock-only portfolio. Minimizing volatility for a certain level for return is important while investing in the long run. Volatility decreases when the markets are on the rise and vice versa. When it increases, the compounded returns decrease.

Let us look at a hypothetical portfolio.

(Source: Fidelity.com)

The most aggressive portfolio has a 12-month return ranging from 136% (best) to 61%(worst). There is a difference of 75% in returns which is highly volatile for many investors. If we look at the growth portfolio, sacrificing just about 11% in the domestic stock allocation, and allocating capital in bonds and short term investments would also generate returns nearly the same as the aggressive growth portfolio. But here, the difference in returns between the best and the worst reduces from 75% to just 56.63%. That is a big difference. Similarly, if we look at the conservative and balanced portfolio, we sacrifice long term returns in favor of reduced volatility. It is a trade-off, and many investors would prefer them as they grow older and become more risk-averse.

Figure VI Figure VII

Reducing risks does not necessarily mean better returns. But historical data shows that it might be possible. The above figures show a hypothetical portfolio. Here in figure VI, the stock only portfolio outperformed the diversified portfolio in 8 out of 15 years while underperforming 7 out of 15 years. However, in the above figures, a significant dip can be noticed during 2008 due to the global financial crisis. The extent of loss in portfolio value was significantly higher in the stock-only portfolio as compared to the diversified portfolio. Figure VII shows that the diversified portfolio outperforms the stock only portfolio by 60 percent. Cumulatively, on a compounded return basis, the diversified portfolio was up by 147% from January 2000 to December 2014 whereas the stock- only portfolio was up only 86%.

One of the possible side effects of reducing risk is that it diminishes the portfolio’s ability to maximize gains. In a favorable market, this effect intensifies. This is an opportunity cost for safeguard against the unknown future of the market. However, asset allocation captures a certain amount of gains with overall low volatility. In the long term, it helps the investors to outperform undiversified or less diversified and volatile portfolios.

Lastly, let us take a look at some real-life investments.

Swenson’s Model Portfolio

David Swenson manages Yale University’s endowment. An endowment is a donation of money or property to a nonprofit organization that uses the resulting investment income for a specific purpose. In most cases of endowment, the principal amount remains untouched while the investment income is used for charitable efforts.

Swenson took over the management of Yale’s endowment in 1985. The Yale endowment was $1.4 billion at the time. Today the endowment manages over 29 billion dollars and is the second-lar gest college endowment in the world. The first is Harvard University.

The asset allocation of Swenson:

Asset ClassAllocation Percentage

Domestic Equity - 30%

International Equity - 15%

Emerging Markets - 10%

Treasury Inflation-Protected Security(TIPS) - 15%

U.S. Treasuries - 15%

Real Estate Investment Trust (REIT) - 15%

Now, let us see the returns. We have limited data on returns.

Year & Returns

2006 - 17.3%

2007 - 8.0%

2008 - 26.6%

2009 - 26.3%

2010 - 14.5%

2011 - 1.3%

2012 - 13.6%

2013 - 11.3%

2014 - 8.7%

2015 -1.2%

2016 - 7.4%

2006-16 - 6.4%

From $1.85 billion to over 29 billion dollars, it means that Swenson almost doubled Yale’s money every four to four and a half years or so. There is no right asset allocation. The key to asset allocation is that you are comfortable with it and stick with it in the long haul.

Final words

Diversification is like candies. While it might feel great to have a ton of sweets, it will ultimately cause you harm. So, it is best taken in moderation. Thus, diversify but in moderation. Prefer the quality of the asset over the quantity. And do your due diligence before investing.

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Author - Abinash Baral

Content Writer at Escribo.