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What is portfolio diversification?

Explaining portfolio diversification in simple terms

Looking for a portfolio diversification definition? As the name suggests, the basic definition of portfolio diversification is that it involves spreading investments across a broad selection of assets in order that losses in one part of the portfolio are offset by gains elsewhere.

Where have you heard about portfolio diversification?

If you are an investor, it is a topic that it is impossible to avoid. Most financial advisers, writers of investment guides and financial journalists are fully convinced of the benefits of portfolio diversification. That the best portfolio is a diversified portfolio forms a central piece of conventional investment wisdom. ‘Concentration risk’ – the technical term for putting too many eggs in too few baskets – is frowned upon. Diversification is seen as the responsible approach to investment.

What you need to know about portfolio diversification…

A diversified portfolio, by definition, contains diversified investments.  But what are diversified investments? They are best thought of as being a collection of assets that have as little in common with each other as possible. That means that market movements affecting one asset will have little or no impact on the others. This builds an element of safety into the portfolio, rather like circuit breakers in electricity systems. How does one go about assembling such a portfolio? An obvious route would simply be to buy lots of different assets – some stocks, some bonds, perhaps a position in one or more commodities – and hope for the best.

But would these be truly diversified investments?

To answer that question, we would need to undertake what is called correlation analysis. This is the process whereby both obvious and hidden linkages between the various assets are examined to see just how diversified they really are.

Uncovering the ties that bind – correlation analysis in action

Correlation’ is a word that describes the extent to which one asset or security faces the same or similar risks as another. Sometimes, the correlations are obvious. A share in a food wholesaler and a share in a supermarket chain would both be affected by a downturn in consumer spending, and both would benefit from a rise in household grocery expenditure.

Sometimes the links are less immediately visible. An investor with stock in an advertising agency may well feel diversified by a holding in a car maker. After all, one is a service business, the other is a quintessentially manufacturing enterprise.

However, the motor industry has traditionally been a major customer for advertising agencies. Correlation analysis would seek to uncover the extent to which the agency in question was exposed to the ups and downs of the car industry.

Good correlation analysis is essential to ensuring that the portfolio contains genuinely diversified investments. Such diversification must go well beyond simply totting up the percentage exposure to this or that asset and look at correlation in the round.

For example, a portfolio in which Unilever or Shell or Daimler accounts for no more than three per cent of total holdings may seem well diversified away from too much exposure to the company in question, with little sign of concentration risk.

But correlation analysis may find that the other stocks in the portfolio are highly correlated to Unilever or Shell or Daimler, thus the portfolio is actually less well diversified than if ten per cent of it were accounted for by shares in one of these companies, but the rest of the stocks had a low correlation to them.

Correlation analysis can be expressed mathematically, using three ‘correlation values’: -1, 0 and +1. If two securities have a value of 0, that means they are entirely uncorrelated. A value of -1 states that they have a completely negative correlation and move at all times in opposite directions, either up or.

A value of +1 expresses a completely positive correlation and move at all times in the same direction, again either up or down. Two securities with a +1 value are definitely not suitable for inclusion in a diversified portfolio!

Different schools of thought on diversification

So far, so uncontroversial. But beyond this, the whole issue of portfolio diversification gives rise to sharp disagreements in the investment world as to how it ought to be pursued.

One key area of controversy is the question of whether passive investment strategies are a useful diversification tool. Proponents say that simply tracking market indices, buying securities in proportion to their weight in the index concerned, is, by definition, a form of diversification, because it is a neutral strategy that spreads investment across the market as a whole.

Many investors achieve this objective through buying exchange-traded funds, marketable securities that track an index but behave like any other stock.

Critics say that it is a fundamental mistake to confuse passive investing with neutral investing. In buying the stocks in an index, they say, an investor would be buying into all the speculations made by all the previous investors right up until that moment. There is, they claim, nothing neutral or diversified about an investment strategy that buys shares at the point where they are probably over-priced and selling them when they become cheaper.

Connected with this is the issue of so-called smart beta. To define smart beta, we need to look first at the meaning of beta. This is the extent to which a stock is related to the volatility of the entire market. If a stock has a beta of 1, it responds to volatility in the same way as the market. A beta of above 1 means it is more responsive to market volatility than is the market as a whole, while below 1 means it is less responsive.

Beta has been contrasted with alpha, the search by fund managers for above-average returns. Thus, beta investing is precisely the style we have just examined, the passive buying of a market index.

Ten or more years ago, some managers pioneered a style entitled smart beta, which proposed a more refined approach to beta investing. But there is no agreement on the definition of smart beta, with two very different approaches.

One involves so-called factor investing. An investment manager will target one aspect of shares, such as growth stocks or value stocks, and will take advantage of any mis-pricing of such stocks to buy or sell.

But ‘beta purists’ protest that this is not smart beta because it involves managers taking a view of stock prices and ought properly to be seen as a branch of alpha investing. True smart beta, they say, involves careful correlation analysis to construct the most diversified portfolio that is possible. It does not involve subjective manager insights.

Diversification and unsystematic risk

Diversification is an investment tool designed to guard against what is known as unsystematic risk, or specific risk. This is the risk attached to one stock or security, or a particular group of securities, such as those in the retail sector or the mining industry.

This is called unsystematic risk because it does not affect the whole market, only part of it. Thus, a diversified portfolio will contain stocks outside the affected sector or sectors, preserving at least some of the portfolio’s value.

Unsystematic risk is the only type of risk against which diversification offers protection. Systematic risk – which affects the whole of the market – cannot, by definition, be guarded against through diversification because there are no assets outside the market to include in a diversified portfolio.

Diversification and its critics

Diversification may be the conventional investment wisdom, but not everybody supports it. So-called ‘high conviction’ investors point out that diversification may prevent investors losing all their money but neither are they likely to make very much. Hedging bets, they say, is all very well, but ruling out big losses tends also to rule out big wins.

Find out more about diversification…

You will find many of the terms used in this article defined further in our glossary. These include stocks, bonds  and exchange-traded funds.

Fidelity Investments has published a guide to diversification. You can read it here.

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