Valerie MedlevaWhen it comes to investing, portfolio diversification is essential. Why? Without it, you run the risk of losing everything if one investment, sector or market fails. Here, we discuss diversification in detail, explaining its importance and ways of ensuring your personal portfolio is diversified.
It’s all about the asset classes
When speaking about diversification, it's important to first understand what the asset classes are. So let’s quickly recap the definition. An asset class can be explained as a grouping of investments that exhibit similar characteristics and behave alike in the marketplace.
Historically, the three principal asset classes have been equities, fixed income and money market instruments or cash equivalents. Today, the list has enlarged, and most investment professionals include many more assets than just stocks and bonds in their portfolios. These can be:
The big general asset classes can be broken down into subclasses by size, industry and location. Each asset class offers a different degree of risk and return investment characteristics and perform differently in a particular market environment. Investors interested in maximising returns often do so by reducing portfolio risk through asset class diversification.
What does diversification mean?
Ever heard the adage about not putting your all your eggs in one basket? The same concept applies to the management of your investment portfolio. And here is how.
Diversification is a technique of a risk management strategy that mixes a wide variety of investments within a portfolio. Used by both investors and traders to reduce risk, it allocates investments among various asset classes of different sizes, industries and countries. The idea behind this technique is that the good performance of some investments balances out the negative performance of others in your portfolio.
Its goal is to maximise returns by investing in different areas that would each react differently to the same economic event. Most investment professionals agree that, although it does not fully guarantee against loss, portfolio diversification is the most important component of reaching long-range financial goals while reducing risk.
So, why portfolio diversification is important?
By diversifying your portfolio, you're acknowledging that the market is extremely volatile: one year, some assets will flop, while the next year they'll do just great.
There are several benefits of portfolio diversification. The key advantages are:
Risk reduction. Truth be told, you can't eliminate risk completely, but you can manage the level of it. If one investment performs poorly, other investments may perform much better over the same period of time, minimising the potential loss of your investment portfolio.
Portfolio hedging. Diversification allows a portfolio to grow both when markets blossom and returns crumble in one sector. Investors who have had 100% equity portfolios over the past decade have likely seen very poor returns due to the overall unstable stock market performance. If included investments in bonds, commodities, and currencies, their portfolios would have experienced greater returns. By diversifying a portfolio, an investor gets the chance to achieve positive returns in one market while another market doesn't do well.
Capital preservation. Some investors strive for capital appreciation, while others use capital preservation as their investment objective. Capital preservation allows you to protect the money you already have, rather than focusing on the rate of return for your investments. Portfolio diversification makes it much easier for an investor to protect their savings, allocating money to different investments.
Returns generating. Diversification comes in handy when some investments don’t perform as expected, so you don’t have to depend entirely on one source of income. A good diversification strategy helps investors to avoid the worst of market ups and downs. With enough variety in your portfolio, you will usually own some investments that are in favour. The assets that perform better help cushion the blow of those that are falling.
How it works
So, portfolio diversification means not investing everything you have in one area. Let's see how it works in an example.
Imagine you own an investment portfolio that consists of only tech stocks – the FAANG constituents in particular. So, FB, AAPL, AMZN, NFLX, and GOOGL have been a big deal at the beginning of 2018. At that time, your portfolio was smooth sailing, bringing you large stable returns. However, in the second half of the same year, these companies have shown rather poor performance, losing a combined $728 billion in market value. Then, you would literally lose everything at once. Sounds tough, doesn’t it? If, however, you counterbalanced your tech stocks with a couple of others from different industries, only a small part of your portfolio would be affected and the downturn wouldn't hit you as hard.
You can invest in dozens of stocks, but if they’re all British iron ore companies, you aren’t truly diversified. In case if the entire sector goes down in value, so will your money. Therefore, it is important to diversify across not only different types of companies and their cap-sizes but also industries. Geographics also matter, as volatility in Australia most likely won’t affect securities in the US, so investing in that country may reduce and offset the risks of investing at home. The more uncorrelated your assets are, the better. True diversification protects you from loss because, even if one of your investments completely tanks, it won’t drag down the performance of your entire portfolio.
How to diversify like a pro
How many assets do you need to achieve diversification? The majority of active investors suggest that a well-diversified portfolio should include at least 30 stocks. This belief comes from research on ‘Some Studies of Variability of Returns on Investments in Common Stock’ conducted back in 1970 by James H. Lorie and Lawrence Fisher.
However, for many, especially novices, owning more than 10 investments can already be overwhelming. Don’t chase after quantity. Diversify by strategy, size, sector, industry and country. Here are some tips on how to diversify your portfolio.
A good portfolio should be diversified at two levels: between and within asset categories. So in addition to allocating your investments among bonds, stocks and other asset categories, you may also consider spreading out your investments within each of them. The key is to identify investments in segments of each asset category that may perform differently under the same market conditions.
Your portfolio should also include a mix of defensive and growth assets classes:
Defensive assets, such as cash or fixed interest, generally provide a lower return over the long term, but also a lower level of risk and volatility than growth assets.
Growth assets, such as shares or property, generally provide longer term capital gains, but typically have a higher level of risk.
Because achieving diversification can be quite challenging, some investors may find it easier to diversify within each asset category through the ownership of mutual funds, such as Exchange Traded Funds (ETFs), rather than through individual investment holdings. These make it easy to own a small portion of several investments.
You may have to invest in more than one mutual fund to achieve the diversification you seek. Within asset categories, look for large company stock funds as well as some small company and international stock funds. Between asset categories, look for stock and bond funds. However, as you add more investments to your portfolio, don’t forget that you are likely to pay additional fees, which will, in turn, lower your investment returns. So you’ll need to consider these costs when choosing the best way to diversify your portfolio.
After you choose the assets, you have to decide how much of your portfolio you want each investment to be. It’s important to review and rebalance your investment portfolio regularly to make sure the asset allocation is still meeting your investment goals.
Careful diversification of your assets is a significant part of financial planning. If you want to reach your personal financial goals, remember that diversification is one of the keys. Although having a diversified portfolio won’t eliminate risk, a well thought out diversification strategy can reduce risk and help with gaining more consistent returns over the long run.
