Diversification

What is Diversification in Investing?

Diversification is an investment strategy that involves allocating capital across a variety of asset and sub-asset classes. The goal of diversification is to maximize returns while minimizing portfolio risk.

How Does Diversification Work?

Diversification works by spreading investments across different types of assets that tend to perform differently under the same market conditions. When some assets in a portfolio decline, others may increase or hold steady, helping to offset some of the losses and smooth out volatility over time.

Diversification capitalizes on the low or negative correlation between asset classes. Correlation is a statistical concept that refers to the degree of similarity between the behavior of one variable compared to another.

For example, when stock prices fall, bond prices tend to rise and vice versa. By combining assets with low correlation in a given portfolio, losses in one area can be compensated to some degree by the gains that other areas of the portfolio produce during the same period.

Optimal volatility is a concept that can hardly be achieved as the degree to which a portfolio should be diversified depends on investors’ individual and often unique characteristics, including their financial goals, risk tolerance, employment situation, and income.

However, some models, like Modern Portfolio Theory (MPT), have emerged to allow investors to determine the ‘optimal’ allocation for a group of assets. This is the specific weight assigned to each that produces the highest return for a given level of risk.

How is Diversification Calculated?

While diversification itself does not have a specific calculation, portfolio risk metrics like standard deviation can quantify the impact of diversification on a portfolio’s performance.

Standard deviation measures historical volatility.

A low standard deviation indicates lower volatility. Comparing the standard deviations of an undiversified portfolio to its diversified counterpart illustrates diversification’s risk-reduction impact.

Other helpful metrics include the Sharpe ratio, which measures returns adjusted for risk, and R-squared, which gauges the percentage of one investment’s performance explained by another. Effective diversifiers will have low R-squared values relative to other portfolio assets.

How Does Diversification Protect Investors?

Diversification protects investors from experiencing large losses, the impact of industry-specific events, and stock-picking risks.

• Mitigates Single Security Risk

By spreading capital across many assets, investors avoid overexposure to the risks associated with investing in a single security. For example, investors with a portion of assets in Enron stock during its collapse would have faced less damage if they had invested in other stocks as well.

• Smooths Volatility

Offsetting the gains and losses produced by non-correlated assets dampens portfolio volatility across market cycles. This helps investors rely less on market timing by staying invested through various boom and bust phases.

• Preserves Capital

Big drawdowns can drag a portfolio’s performance and an investor’s account balance to extremely low levels. During bear markets, individual stocks and sectors are often disproportionately damaged. By diversifying accordingly, investors can reduce drawdowns through their exposure to areas of the market that typically thrive during recessionary cycles.

• Matches Risk Tolerance

Investors who are uncomfortable with assuming certain levels of risk can define the optimal allocation and diversification strategy that delivers the kind of results they expect in terms of both returns and volatility.

• Enhances Risk-Adjusted Returns

Blending non-correlated return streams with standalone risk profiles improves return potential per unit of risk taken. Losses become less painful when accompanied by offsetting asset gains.

Diversification Strategies

The most popular diversification strategies involve the use of various asset and sub-asset classes to mitigate risks while generating decent returns at the same time.

Here’s a summary of the most popular techniques used by investors to diversify their portfolios.

Using Multiple Asset Classes

• How Does it Work? Allocating capital across various asset classes like stocks, bonds, cash, commodities, and real estate based on their unique risk and return profiles.
• Benefits: The performance of multiple asset classes can be either uncorrelated or display low correlations when compared to each other. This helps investors take advantage of the gains produced by certain classes during specific periods to offset the losses caused by underperforming assets.
• Considerations: The right mix of asset classes must be determined based on each investor’s time horizon, goals, and risk tolerance. Period rebalancing is required to ensure that the portfolio’s target allocations stay the same over time.

Diversification Within Stocks

• How Does it Work? Stocks come in various sizes and shapes. Companies with different market caps, sectors, and geographical locations are categorized accordingly. Investors can incorporate the stock of different types of companies to ensure that their funds are spread across a healthy range of businesses that may perform differently under the same circumstances.
• Benefits: Large-cap stocks are typically more resilient to recessionary cycles than small-caps. Meanwhile, international stocks may deliver better returns than US stocks during expansionary cycles. This negative correlation tends to be beneficial for portfolios from the perspective of diversification.
• Considerations: Some of the typical categories that investors focus on to achieve stock-level diversification include size (large, mid, and small caps), geographies (domestic, international, and emerging markets), type (value, growth, dividend), and other less traditional classifications like ESG-based and disruptive vs. legacy.

Fixed Income Diversification

• How Does it Work? To diversify the fixed-income portion of a portfolio, investors can focus on picking securities floated by various issuers like governments, municipalities, and corporations or instruments with different credit ratings, embedded terms (convertible issues), or different types of assets like certificates of deposit (CDs), bonds, money market funds, and preferred shares.
• Benefits: For income-oriented investors and individuals who are nearing retirement, fixed-income securities offer a combination of low-risk and tangible benefits that can be used to supplement their living expenditures while preserving their hard-earned capital.
• Considerations: Short-term instruments experience less price fluctuations when interest rates move but offer lower yields. High-yield bonds provide higher income, but investors must assume a higher risk associated with the possibility that the issuer could default on its payments.

Alternative Assets

• How Does it Work? Allocating to alternative assets like private equity, hedge funds, venture capital, and distressed debt can boost a portfolio’s return by adding non-correlated and non-traditional assets to the mix.
• Benefits: Alternative assets can deliver meaningful positive returns over time if they are picked wisely and held for a sufficiently long period.
• Considerations: Investing in alternative assets is often reserved for accredited investors and involves paying higher fees. In addition, the valuation of these assets is often less transparent, and the same goes for the vehicles used to invest in them. There are also liquidity concerns as alternative assets are traded privately. During recessionary cycles, it may be hard to get rid of certain types of assets if investors adopt a risk-averse position or if financing conditions deteriorate.

Examples of Diversified Portfolios

A simple diversified portfolio could contain the following asset classes and respective weights:

• U.S. stocks – 40%
• International stocks – 20%
• Investment-grade longer-term bonds – 30%
• Cash or cash equivalents – 10%

Meanwhile, a more sophisticated and complex example of a diversified investment portfolio may be:

• Large-cap value domestic stocks – 20%
• Mid-cap growth domestic stocks – 15%
• Developed international market stocks – 15%
• Emerging market stocks – 10%
• High-yield corporate bonds – 20%
• Commodities – 20%

Pros and Cons of Diversifications

Diversification is great in most cases but there are also a few disadvantages of this financial practice that investors must take into account.

Advantages:

Disadvantages:

The Bottom Line

Diversification is a strategy that any investor can tap into to manage portfolio risks. By spreading assets across multiple classes and sub-classes with low or negative correlations, volatility can be smoothed without necessarily sacrificing returns.

Diversification allows riding out storms that disproportionately impact individual asset classes. For long-term investors, diversification provides an accessible path toward improved risk-adjusted performance.

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