Portfolio diversification: A brief how-to guide
Content
How many assets does a trader or investor need to achieve diversification? Is it about quantity? To diversify a portfolio, traders might consider multiple factors, including assets’ performance, market share, industry and geography.
What is diversification in trading?
Diversification in trading is the process of investing in a mixed set of asset classes, and a diverse set of assets within that class. The aim is to potentially smooth out volatility and leave investors less exposed to headwinds in an individual segment.
But what is portfolio diversification?
There are many ways to diversify. It can occur within one asset class such as equities and indexing, or by rationally building a collective portfolio comprised of assets from several industries, geographies and commodities, as well as some level of fixed income.
Why is it important? Pros and cons of diversification
There are several obvious advantages of portfolio diversification, as well as several potential drawbacks, the palatability of which depends on a trader’s individual knowledge and their appetite for risk.
Advantages: Could smooth out volatility and improve knowledge
The benefits of portfolio diversification mainly lean on the idea that it could smooth out volatility within a sector, across companies or even within a business.
For example, a supply chain crunch might add to costs of essential materials, which could impact retail or manufacturing stocks, hurting their fundamentals and, accordingly, their share price.
But an investor who also has funds in commodities like oil and metals could soften that blow by seeing these assets appreciate in value.
Likewise, investing in assets in different continents, like North America and Asia, opens an investor to divergent economic conditions, including different supply chains, employment and inflation levels, and monetary policy. For example, a country’s underperforming economy may take steps to strengthen its currency with contractionary monetary policy, allowing investors to potentially benefit if it has other assets based in the thriving economy.
From a practical point of view, it is likely there are also educational benefits to monitoring a diversified portfolio. While trading diversification could reduce exposure, all assets are interlinked in some way, and an investor can stand to benefit from observing different avenues of the economy through their portfolio.
Disadvantages: Could diminish returns and quantity doesn’t mean quality
Naturally, any tactic designed to smooth volatility also means it’s less likely to realise big gains. And it doesn’t always translate into quality. As research byTeji Mandi suggests, diversified investments doesn’t mean they’ll all be quality ones.
Indeed, in the climate of soaring inflation and interest rate rises in 2022, previously safe-haven assets like cash and bonds could grow more slowly than the market as a whole, doubling down on losses investors experience in their riskier holdings like stocks, foreign exchange and commodities.
How to diversify? Key principles of diversification in trading
There are several ways to diversify, including several tried and tested techniques within or amongst several asset classes. Diversification of a portfolio often starts with equities, but it’s encouraged across many areas.
60:40 split
The 60/40 split in diversified investing is popular for its simplicity. It typically refers to a portfolio balance made up of 60% equities and 40% fixed-income assets, particularly government bonds.
This helps investors enjoy the potential returns from stocks while smoothing out some risk with government bonds, which return a fixed rate of interest. Note that stock markets are volatile and can always move against your positions, triggering losses.
The 60/40 split is also not very demanding, with rebalancing suggested around once a year.
This strategy became popular in times of low inflation and interest rates. Now, with an inverted yield curve and investors fleeing fixed income as interest rates rise, bonds are not as safe a return as they once were, while a sustained bear market in stocks makes strong investment there similarly dangerous.
But, in general, investors are still encouraged to invest some of their holdings in fixed income, with JPMorgan research indicating a “reimagined 40” that weaves in some risk might be the way to proceed in today’s market, noting:
Market capitalisation
Another classic way of diversifying an investment portfolio within one asset class is by focusing on a company’s market capitalisation, distributing a proportion of your holdings to a company based on its value in a process called indexing.
Index funds are often used as a way of diversifying. For example, the S&P 500 (US500) and the Dow Jones (US30) were holding $13.5trn and $18.9trn in indexed or benchmarked assets, as of 31 December 2020.
Investors who index might put more money into the biggest companies like Apple (AAPL) and Alphabet (GOOGL), where growth has been sustainable over years, while putting a relatively small amount into smaller cap companies, often growth stocks. While growth stocks can potentially offer faster returns, they can also be more volatile and are not immune to a bear run, which could trigger losses. You should remember that past performance is not a reliable indicator of future results, neither for value nor for growth stocks.
For example, Vanguard Total Stock Market ETF (VTI), the exchange traded fund that tracks the performance of the CRSP US Total Market Index comprising large, mid and small-cap equity diversified across growth and value styles, has contracted more than 10% year-to-date as of 11 August 2022 as big cap and small cap stocks alike got burned by the stock market.
Industry
Industrial portfolio diversification can occur across a number of asset classes.
For example, someone might diversify across the agricultural sector by investing in every stage of the supply chain, from wheat futures that go into bread and feed livestock right through to McDonald’s (MCD) stock, with investments in cooking oil along the way for good measure.
Industrial investment diversification allows for specialist knowledge, removing some of the risk of picking poor quality assets in your portfolio. Investors might consider investing in negatively correlated industries, in other words those that are cyclical and countercyclical, helping investors rise out of wider economic volatility.
Geography
Among these variant asset classes and industries, investors could mind the location of the holdings. Failure to do so could upend an otherwise sound strategy.
The reasons for geographical portfolio diversification include differences in the sizes of economies and growth expectations, regulatory differences, supply chain, and sectoral dominance and advantages within a country. Analysis in March 2022 by Innes McFee of Oxford Economics illustrated the importance of geographical diversification in the current climate.
In terms of fixed income, investors may also consider to mix secure bonds like US Treasury notes with debt from emerging markets, which while riskier offer higher interest. This strategy echoes JPMorgan’s suggestion of the “reimagined 40”.
Final take on diversified investment
Research by Charles Schwab suggested a portfolio diversified across several asset classes delivered the smoothest returns over time.
That was backed up by Blackrock analysis, showing that a diversified portfolio outpaced the S&P 500 by 20 percentage points between 2000 and 2008.
That steady, wider ranging portfolio diversification, in addition to using risk management tools such as stop losses, and performing a thorough fundamental and technical analysis, can bring positive results. However, you should note that trading contains risk and can result in losses. Never invest money that you cannot afford to lose.
FAQs
What are the benefits of diversification?
Diversification could allow investors to smooth out volatility found in more focused investing, as assets classes and geographies are often negatively correlated.
What is the purpose of diversification in trading?
Diversification is meant to offset potential losses seen for example when the stock market contracts, by investing in other assets like commodities, bonds, and assets in other countries. Note that all the markets are inherently volatile and the price of any asset you trade may go against your position, triggering losses.
What are the risks of diversification?
Diversification means investors could get less gains from trading, given some money might go to less risky fixed income securities. But even these aren’t ideal in the current inflationary environment.
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