Diversification

What is diversification?

Looking for a diversification definition? Diversification is a strategised form of risk management. It's a technique that incorporates an assortment of investments that are part of a portfolio. The aim is to minimise risk or volatility by investing in a wide variety of instruments, asset classes, industries, markets. The idea is that a portfolio made up of various diverse investments will, on average, produce greater returns and will present a lessened risk than any one lone investment within that particular portfolio. Diversification and hedging are the two widespread techniques for lowering investment risk.

Where have you heard of diversification?

The basic concept of diversification is something we all learn at relatively young age.  The proverb “don't put your eggs in one basket” is a very familiar one to most. If all your eggs are in one basket and you drop or lose your basket, then you have lost or damaged all your eggs. Dividing your eggs into different baskets is more diversified. You stand a greater risk of losing one egg, but a far smaller risk of losing all of them. 

In financial terms we encounter diversification when we start to look at systematic and unsystematic risk. For example, if you had a portfolio which held only one stock, then this would be a high-risk asset, as an individual stock can often go down by as much as 50% in one year alone. It is, however, less prevalent for multiple stocks to decrease by such a large amount, especially if there is a high volume of them and they are selected randomly. When it comes to portfolio management and asset allocation, you must look at what is going to be best for your portfolio in the long term. An ideal portfolio would bring income, growth and a certain amount of steadiness and a diversified portfolio holds a greater chance of achieving this.

What you need to know about diversification...

Diversification was formalised, named and analysed in the 1950s by the economist Harry Markowitz, and the modern understanding of the term would not exist if it wasn't for his work. However, the concept is mentioned in the Bible, the Talmud and even by Shakespeare. Financial diversification aims to appease incidents of unsystematic risk in a portfolio, so that the positive achievements of those investments neutralise the weak performance of the others. However, do not forget about the systematic risk that can not be reduced through diversification and just should be accepted by investors. A more diversified portfolio means a costlier portfolio and mutual funds have proved popular in recent years, as they can afford investors with a cheaper source of diversification. However, research has shown that a well-diversified portfolio of 25 to 30 stocks is the most cost-conscious form of portfolio management. 

Here are some brief introductions to a few diversification techniques:

Correlation

This is a statistical method that can highlight whether a pair of variables are linked and how actively so. For example, a commodities price and the demand for it are inextricably linked and would be considered related variables. If demand increases, price will inevitably increase too, and if prices rise, so does demand. When there is a change in a variable which leads to a change in both variables, then these variables are thought to be correlated. This highlights the variables and their relationship to one another, whether their relationship is positive or negative. 

In the case of Correlation trading, the investor is disclosed the average correlation of the index. The main tool in correlation trading is being able to anticipate when the future stock correlation on a certain index will be less or more than the implied correlation level, determined by the derivatives on that particular index and its single stocks. In terms of correlation trading, if the correlation between the individual securities is lower, then the volatility of the portfolio in total will be lower. This is because of the ways that variances behave when determining the correlation between random variables.

Foreign investment

An investor may maximise their diversification benefits by investing in foreign securities, as they tend to be more loosely related to the domestic economic climate. For example, an economic decline in the US may not affect the Swiss economy in a direct way. By having investments in Switzerland an investor is slightly protected as these securities live in a different economic climate. When it comes to asset allocation, many experts think that it’s best to spread your investments across geographies to minimise unsystematic risk.

Exchange Traded Funds (ETFs)

While the diversification of different asset classes provided by mutual funds are gathered, Exchange Traded Funds provide access to investors of narrow markets that would generally be difficult to access. These markets include international plays and commodities, and this can be done by constructing a portfolio of carefully composed securities that target incredibly specific asset classes.

Smart beta

The Smart beta approach allows diversification by monitoring underlying indices, but they don't always measure stock according to market capital. Exchange Traded Fund managers (ETA managers) complete an in-depth screening of equity issues and re-adjust portfolios in line with the analysis and not just the company’s capacity. The main aim of Smart beta is the outperformance of the index itself.

Maximum diversification is recommended by experts – this is referred to as “buying the market portfolio”. However, pinpointing that portfolio isn't always easy. The earliest definition of maximum diversification comes from the Capital Pricing Model, which states that it can be achieved by acquiring a pro rata share of every available asset. As long as there are more assets available to attain, diversification has no real maximum. Each uncorrelated, even weighted, asset that's added to a portfolio can enhance that portfolio's calculable diversification. 

Basel ll have formed a set of techniques to measure credit risk and it’s referred to as standardised approach. With this method, it is compulsory for banks to use ratings from the External Credit Ratings Agencies to measure the amount of capital needed for credit risk. Once assessed, assets are given a grade or a weighting that highlights the level of risk attached to them. These grades, and the level of risk associated to them, vary between different types of assets. For example, if a bank has an AAA to AA- rating, thing means it carries a risk weight of 20%. In contrast, all retail products carry a risk weight of 75%.

Another theory related to diversification is 'Risk Parity”, which weights assets in contrary proportion to their risk. This means that all asset classes in the portfolio have an equal amount of risk. This idea is justifiable with the argument that future market price is much harder to predict than future risk. An expansion on risk parity is “correlation parity” and trusts that each individual asset in a portfolio has an equal interaction with the portfolio, which makes it “the most diversified portfolio”.

One way to quantify financial risk is variance on the return of the portfolio. The variance of a portfolio's return can be reduced by diversification to what it would be if the whole portfolio were invested in an asset with the lowest variance of return, even if the asset in questions returns are uncorrelated.

Professors Edwin Elton and Martin Gruber devised an empirical example of the gains of diversification as far back as 1977. Their strategy took into consideration 3,290 possible securities which were available for incorporation in a portfolio. They examined the average risk over all other randomly chosen n-asset portfolios that had an equal measure in every included asset, for various values of n. Their summary of results is in the table below:

Portfolio models of a corporate nature address diversification as being either horizontal or vertical. Vertical diversification is in line with consolidating the supply chain or compounding distribution channels, whereas horizontal diversification is perceived as the growth of a product line or the gain of similar companies. Non-incremental diversification is a method practiced by conglomerates, where the unique business lines don't have much to do with one another, yet the company is achieving diversification from external risk factors which give active opportunity for the management of diverse assets.

With various methods and formulas to consider, it is clear that there is not one definitive model of diversification or asset allocation that will suit every investor. Your own resilience with regards to systematic risk, personal investment goals, time frame, level of experience and financial capital will all build the foundations for your choices regarding your portfolio. A good place to begin is by looking at the types of bonds, stocks and cash required to suit you. Then figure out specifically which investments to use, alternating some traditional assets for alternative ones where you see fit. If you feel as though you may need some assistance, there are many financial services available to help you along your way.  

Find out more about diversification...

Our glossary has a lot more information on the workings of the stock market and, for example, what the Capital Pricing Model is and how it works or types of financial risk. You can find out more about diversification and portfolio management by looking at Samuel Edwards's article on Entrepreneur.com – The Importance of Portfolio Diversification for Your Investments.