Importance of Diversification in Portfolios

Portfolio diversification is the process of investing your money in different asset classes and securities to minimize the overall risk of the portfolio. When you diversify your portfolio, you incorporate a variety of different asset types into your portfolio. 

Diversification can help reduce your portfolio’s risk so that one asset’s performance doesn’t affect your entire portfolio. The fundamental purpose of portfolio diversification is to minimize the risk of your investments. Each asset class performs differently in various economic and financial environments, so when you have multiple asset classes, you have more opportunities for your portfolio to make money in almost any environment.

Different types of risk

Investors confront two main types of risks when they invest. The first is known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This risk category is not specific to any company or industry and cannot be eliminated or reduced through diversification. It is a form of risk that all investors must accept.

The second type of risk is diversifiable or unsystematic. This risk is specific to a company, industry, market, economy, or country. The most common sources of unsystematic risk are business risk and financial risk. Because it is diversifiable, investors can reduce their exposure through diversification. Thus, the aim is to invest in various assets, so they will not all be affected the same way by market events.

There are two ways to diversify your portfolio: across asset classes and within asset classes. When you diversify across asset classes, you spread your investments across multiple types of assets. For example, rather than investing in only stocks, you might also invest in bonds, real estate, and more. When you diversify within an asset class, you spread your investments across many investments within a specific type of asset. For example, rather than buying stock in a single company, you would buy stock from many companies of many different sizes and sectors.

Risk, therefore, comprises all the variables that could alter the trajectory of an investment's return, whether positively or negatively. Examples include:

• Market risk: How the movements of the overall stock market affect your returns. This is also known as systemic risk and is unavoidable if you're investing in assets other than cash.
• Interest rate risk: How changes in interest rates affect your returns and yields, especially for fixed-income assets (for example, how long-term treasuries suffer when rates rise).
• Geographical risk: How changes in political or social regimes affect a particular market's equities and fixed-income assets (for example, in the recent Russian stock market collapse).
• Idiosyncratic risk: How specific changes in a particular company's fundamentals can affect its stock returns (for example, if you were invested in Enron before it declared bankruptcy).

How diversification works

At the heart of diversification are two academic concepts: correlation and variance/standard deviation.

• Correlation measures the direction and magnitude of the relationship between two assets' returns. A correlation of 1.0 means both assets move perfectly in the same direction, while -1.0 means both assets move perfectly in opposite directions. A correlation of 0 means both assets move entirely independently of each other.
• Standard deviation and variance measure the historical range that an asset fluctuates, on average, around its expected return. For example, if a stock has returned a compound average growth rate, or CAGR, of 7% annually, but it has a high variance (and therefore a high standard deviation, which is the square root of variance), this means that its return varies widely and 7% might not be a reasonable expectation in any given year.

A rule of thumb is that a diversified portfolio of volatile (high standard deviation) and uncorrelated (between 0.20 and 0.50) assets with positive expected returns will produce a better risk-return profile than an undiversified portfolio consisting of a single asset.

How do you diversify your portfolio?

No magic formula can tell you exactly how diversified your portfolio should be. However, a basic rule of thumb is to include investments in your portfolio whose returns are negatively correlated. That way, if a market event affects a part of your portfolio, it either doesn’t affect the entire thing or has an opposite effect on another part of your portfolio.

Investing in equities is good, but that doesn’t mean you should put all your wealth in a single stock or a single sector. The same applies to your investments in other options like mutual funds and gold. However, if you want to invest in just the stock market, you should:

1. Invest in companies across different stock market sectors. 
2. Invest in companies of different sizes (large-cap, mid-cap, and small-cap). 
3. Invest in both domestic and international stocks.

On the other hand, you can use alternative investments include:

• Hedge funds pool the capital of many investors and invest it across various securities with the intention of managing risk to outperform the market’s rate of return.
• Private equity is the investment of capital in private companies and encompasses venture capital, growth equity, and buyouts.
• Real estate is the investment of capital in residential, commercial, or retail properties, either individually or through a real estate venture fund or investment trust.
• Debt investing is capital invested in the debt of a private company and can be distressed or private.
• Commodities is capital invested in natural resources, such as oil, agricultural products, or timber.
• Collectibles such as rare wines, cars, and baseball cards are purchased with the intention of selling them when their value appreciates.
• Structured products involve fixed-income markets and derivatives.

The sample asset mixes in Figure 1 combines various amounts of stock, bond, and short-term investments to illustrate different levels of risk and return potential.

Figure 1

Advantages of diversification

• Makes your portfolio more shock-proof: This is one of the significant benefits of diversification. A well-diversified portfolio can better absorb the shocks during a market downturn. The risk is well-spread out when you invest in different asset classes.
• Enhances risk-adjusted returns: This is another significant benefit of portfolio diversification. When two portfolios yield the same returns, a diversified one will take lesser risk than a concentrated one. The latter will be more volatile than the former.
• Provides Stability and Peace of Mind: Another significant advantage of the diversification strategy is that it gives your portfolio the much-needed stability and peace of mind. As you know, it can better combat a downturn. With a more predictable return, it cuts out the emotional quotient from investments, which is essential for achieving the desired goal.

Disadvantages of diversification

• Can go overboard: Sometimes in the name of portfolio diversification, investors tend to go overboard and end up investing in too many assets that they don’t even require.
• Tax complications: The tax structure differs across asset classes, and buying and selling them can lead to major complications.
• Risk of investing in an unknown asset: Sometimes, in the name of diversification, you can end up investing in an asset that’s unknown to you. You may get caught off guard if investing in that asset isn’t legal in the country. Also, investing in an unknown asset may result in losing capital in the long run, bringing down your overall portfolio returns.
• Can make investing complicated: When you diversify too much, it can complicate investments. Before proceeding, you need to understand the structure and working of the asset class, and this can be a task too much.
• Can also be expensive: Not all investment vehicles cost the same, so buying and selling will affect your bottom line—from transaction fees to brokerage charges. And since higher risk comes with higher rewards, you may end up limiting your returns.