Diversification

What Is Diversification?

Diversification is a risk management strategy that creates a mix of various investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt to limit exposure to any single asset or risk .

The short answer: The better you spread your investments across different assets, the less likely they are to all experience a loss. Or in other words, your aggregate losses will likely be less severe.

Understanding Diversification

Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. Investing in more securities generates further diversification benefits, but it does so at a substantially diminishing rate of effectiveness.

Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated —that is, they respond differently, often in opposing ways, to market influences.

However, diversification isn’t a cure-all, or a guaranteed safeguard. Similarly to how a balanced diet won’t protect you from ever getting sick (we all get ill from time-to-time), having a diversified portfolio doesn’t mean your investments will never drop, or even drop dramatically — Diversification is simply a strategy that can help you prevent losses from being as severe as they could be otherwise, and has the potential to help bring less volatility to your returns.

Diversification Strategies

As investors consider ways to diversify their holdings, there are dozens of strategies to implement. Many of the methods below can be combined to enhance the level of diversification within a single portfolio.

Asset Classes

Diversification strategies often start with asset class allocation. This involves investing in a mix of asset classes such as stocks, bonds, real estate, commodities, and cash. Each class reacts differently to market changes, providing balance in a portfolio.

• Stocks : Shares or equity in a publicly traded company
• Bonds : Government and corporate fixed-income debt instruments
• Real estate : Land, buildings, natural resources, agriculture, livestock, and water and mineral deposits
• Exchange-traded funds (ETFs) : A marketable basket of securities that follow an index, commodity, or sector
• Commodities : Basic goods necessary for the production of other products or services
• Cash and short-term cash-equivalents (CCE) : Treasury bills, certificate of deposit (CD), money market vehicles, and other short-term, low-risk investments

The theory holds that what may negatively impact one asset class may benefit another. For example, rising interest rates usually negatively impact bond prices as yield must increase to make fixed income securities more attractive. On the other hand, rising interest rates may result in increases in rent for real estate or increases in prices for commodities.

Industries/Sectors

Investing across different industries or sectors can protect against sector-specific risks. For example, technology and healthcare sectors may react differently to economic changes, offering a hedge against sector downturns.

Investors can diversify across industries by coupling investments that may counterbalance different businesses. For example, consider two major means of entertainment: travel and digital streaming. Investors hoping to hedge against the risk of future major pandemic impacts may invest in digital streaming platforms (positively impacted by more shutdowns). At the same time, they may consider simultaneously investing in airlines (positively impacted by fewer shutdowns). In theory, these two unrelated industries may minimize overall portfolio risk.

Corporate Lifecycle Stages (Growth vs. Value)

Diversification can also be achieved through investment in companies at different stages of their lifecycle. Growth companies are typically in an expansion phase with higher potential returns and risks, while value companies are more established, often offering stability and consistent dividends.

Growth stocks tend to be more risky as the expected growth of a company may not materialize. For example, if the Federal Reserve constricts monetary policy, less capital is usually available (or it is more expensive to borrow), creating a more difficult scenario for growth companies. However, growth companies may tap into seemingly limitless potential and exceed expectations, generating even greater returns than expected.

On the other hand, value stocks tend to be more established, stable companies. While these companies may have already experienced most of their potential, they usually carry less risk. By diversifying into both, an investor would capitalize on the future potential of some companies while also recognizing the existing benefits of others.

Market Capitalizations (Large vs. Small)

Market capitalization, referring to the total market value of a company’s outstanding shares, is another diversification strategy. Investing in a mix of large-cap (established, stable companies) and small-cap (smaller, potentially faster-growing companies) can balance risk and growth potential.

Each company will have a considerably different approach to raising capital, introducing new products to the market, brand recognition, and growth potential. Lower cap stocks have more room to grow, though higher cap stocks tend to be safer investments.

Risk Profiles

Investments can vary in their risk profiles. Some assets are high risk with potential for high returns (like certain stocks), while others offer lower risk and returns (like government bonds). There are considerable differences between several 10-year bonds based on the issuer, their credit rating, future operational outlook, and existing level of debt.

The same can be said for other types of investments. Real estate development projects with more risk may carry greater upside than established operating properties. Meanwhile, cryptocurrencies with longer histories and greater adoption, such as Bitcoin, carry less risk relative to smaller market cap coins or tokens.

Maturity Lengths

For fixed-income investments, diversifying by maturity lengths (short-term vs. long-term bonds) can help manage interest rate risk and liquidity needs. Short-term bonds tend to offer lower interest rates; however, they also tend to be less impacted by uncertainty in future yield curves. Investors more comfortable with risk may consider adding longer term bonds that tend to pay higher degrees of interest.

Maturity length is also prevalent in other asset classes. Consider the difference between short-term lease agreements for residential properties (i.e., up to one year) and long-term lease agreements for commercial properties (i.e., sometimes five years or greater). Though there is more security in collecting rent revenue by locking into a long-term agreement, investors sacrifice flexibility to increase prices or change tenants.

Physical Locations (Foreign vs. Domestic)

Diversification can also be geographical. Investing in both domestic and foreign markets can protect against country or region-specific economic risks.

Alternatively, there may be a greater potential upside (with associated higher degrees of risk) when diversifying across developed and emerging countries. Consider Pakistan’s current classification as a frontier market participant (recently downgraded from an emerging market participant). Investors willing to take on higher levels of risk may want to consider the higher growth potential of smaller yet-to-be-fully established markets such as Pakistan.

Tangibility

This involves diversifying between tangible assets (like real estate or commodities) and intangible assets (like stocks or bonds). Tangible assets often provide a hedge against inflation and a different risk-return profile.

There are also unique risks specific to tangible assets. Real property can be vandalized, physically stolen, damaged by natural conditions, or become obsolete. Real assets may also require storage, insurance, or security costs to carry. Though the revenue stream differs from financial instruments, the input costs to protect tangible assets are also different.

Diversification Across Platforms

Diversification across platforms refers to the strategic allocation of investments across different trading platforms or financial institutions. This approach can offer several advantages:

1. Risk Management: By spreading investments across multiple platforms, investors can reduce the risk associated with any single platform’s potential operational issues, security breaches, or financial instability.
2. Access to Diverse Opportunities: Different platforms may offer unique investment opportunities, tools, and products. By diversifying across platforms, investors can take advantage of a broader range of investment options and strategies.
3. Regulatory Considerations: Different platforms may operate under varied regulatory environments, offering distinct protections and obligations. Diversifying across platforms can mitigate the risks associated with regulatory changes impacting a single platform.
4. Performance Comparison: Investors can compare performance and fees across platforms, enabling more informed decisions and potential cost savings.
5. Liquidity Enhancement: Multiple platforms may offer differing levels of liquidity. Diversification can ensure more options for entry and exit, enhancing overall portfolio liquidity.
6. Customization and Control: Using multiple platforms can provide investors with more control over their portfolios, allowing them to tailor their investments according to specific goals and risk appetites.

However, diversification across platforms also requires careful consideration of the complexity and management overhead it introduces, as well as the need to stay informed about the nuances and changes in each platform used.

Diversification and Retail Investors

Time and budget constraints can make it difficult for noninstitutional investors—i.e., individuals—to create an adequately diversified portfolio. This challenge is a key to why mutual funds are so popular with retail investors. Buying shares in a mutual fund offers an inexpensive way to diversify investments.

While mutual funds provide diversification across various asset classes, exchange-traded funds (ETFs) afford investor access to narrow markets, such as commodities and international plays, that would ordinarily be difficult to access. An individual with a $100,000 portfolio can spread the investment among ETFs with no overlap.

There are several reasons why this is advantageous to investors. First, it may be too costly for retail investors to buy securities using different market orders. In addition, investors must then track their portfolio’s weight to ensure proper diversification. Though an investor sacrifices a say in all of the underlying companies being invested in, they simply choose an easier investment approach that prioritizes minimizing risk.

Pros and Cons of Diversification

Pros of Diversification:

1. Risk Reduction: The primary benefit of diversification is risk mitigation. By spreading investments across different assets, sectors, and geographies, investors can reduce the impact of any single investment’s poor performance.
2. Portfolio Stability: Diversification tends to stabilize a portfolio, smoothing out the highs and lows associated with individual investments, leading to more consistent overall performance.
3. Access to More Opportunities: A diversified portfolio allows investors to explore a wider range of investment opportunities, potentially capitalizing on different economic cycles and market conditions.
4. Protection Against Market Volatility: Diversification can provide a buffer against market volatility, as different assets often react differently to the same economic event.

Cons of Diversification:

1. Complexity: Managing a diversified portfolio is more complex and time-consuming, requiring constant monitoring and rebalancing.
2. Reduced Potential for High Returns: While diversification reduces risk, it can also dilute the high returns that might be possible from a single, highly successful investment.
3. Costs: Diversifying a portfolio can involve additional costs, such as transaction fees, management fees, and taxes, especially if frequently rebalancing.
4. Over-Diversification: There is a risk of over-diversification, where the sheer number of investments can lead to mediocre overall performance and diminish the benefits of diversification.

Diversifiable vs. Non-Diversifiable Risk

Diversifiable

1. Definition: Diversifiable risk, also known as unsystematic risk, refers to the risk associated with individual companies or industries. It can be mitigated through diversification of investments.
2. Characteristics: This risk is specific to a company, industry, or sector. Examples include a change in management, a product recall, or a regulatory change affecting a specific industry.
3. Management through Diversification: By investing in a variety of assets, sectors, or industries, investors can reduce the impact of these specific risks on their overall portfolio.

Non-Diversifiable Risk

1. Definition: Non-diversifiable risk, or systematic risk, is the inherent risk associated with market investments as a whole. It cannot be eliminated through diversification.
2. Characteristics: This risk is linked to factors that affect the entire market, such as economic recessions, political instability, changes in interest rates, and natural disasters.
3. Management Strategies: While it cannot be diversified away, non-diversifiable risk can be managed through other strategies like asset allocation, hedging, or by choosing investments with different levels of exposure to systematic risk.

Understanding the difference between these two types of risks is crucial for investors in crafting a well-balanced and effective investment strategy. While diversification is a powerful tool for managing diversifiable risk, it’s important to recognize and have strategies for dealing with non-diversifiable risk.

Measuring Diversification

It can become complex and cumbersome to measure how diversified a portfolio is. In reality, it is impossible to calculate the actual degree of diversification; there are simply too many variables to consider across too many assets to truly quantify a single measure of diversification. Still, analysts and portfolio managers use several measurements to get a rough idea of how diversified a portfolio is.

Correlation Coefficient

The correlation coefficient is a statistical measure that calculates the degree to which two securities move in relation to each other. Values range from -1 to +1.

• Closer to -1 : There is strong diversification between the two assets, as the investments move in opposite directions. There is a strong negative correlation between the two variables being analyzed.
• Closer to 0 : There is moderate diversification between the two assets, as the investments have no correlation. The assets sometimes move together, while other times, they don’t.
• Closer to 1 : There is a strong lack of diversification between the two assets, as the investments move in the same direction. There is a strong positive correlation between the two variables being analyzed.

In portfolio management, a correlation coefficient close to 0 or negative suggests that the securities behave independently or inversely, providing diversification benefits. Highly correlated assets (close to +1) offer less diversification advantage.

Standard Deviation

Standard deviation measures the amount of variation or dispersion of a set of values. In finance, it’s often used as a measure of an asset’s or portfolio’s risk.

A lower standard deviation in a diversified portfolio indicates less volatility and, by implication, lower risk. Diversification aims to lower a portfolio’s overall standard deviation by combining assets with varying levels of individual standard deviations.

For example, imagine two investments, each with an average annual return of 5%. One has a high standard deviation, which means the investment returns can vary greatly. The other investment has a low standard deviation, meaning its returns have been closer to 5%. The higher the standard deviation, the more risk there is—but there is a chance for higher returns.

A portfolio full of investments with high standard deviations may have higher earning potential. However, these assets may be more likely to experience similar risks across asset classes.

Smart Beta

Smart Beta is an investment strategy that combines the benefits of passive investing and the advantages of active investment strategies to improve returns, reduce risks, and increase diversification.

Smart Beta strategies often use alternative index construction rules based on factors such as volatility, quality, value, size, and momentum, which can lead to more diversified portfolio construction compared to traditional market-cap-weighted indices.

Count/Weighting

The simple count of different assets in a portfolio. More assets typically suggest more diversification, but it’s crucial to consider the type and correlation of these assets.

This refers to the proportion of each asset in the total portfolio. Effective diversification involves not just owning a variety of assets, but also balancing the weightings to ensure that no single asset or type of asset dominates the portfolio.

Example of Diversification

Imagine a day trader, comfortable with high-risk strategies, looking to diversify their trading portfolio. This trader decides to focus on a mix of technology stocks, European bonds, and oil futures. To achieve this, they could opt for shares in the Technology Select Sector SPDR Fund (XLK), the SPDR Bloomberg Barclays Euro Corporate Bond ETF (SYB6), and the United States Oil Fund LP (USO).

By selecting this blend of ETF shares, the trader achieves a diversified spread across different asset classes and market segments. The Technology Select Sector SPDR Fund provides exposure to a range of U.S. technology companies, known for their high growth potential but also significant volatility. In contrast, the SPDR Bloomberg Barclays Euro Corporate Bond ETF offers a more stable investment in European corporate bonds, which may react differently to economic changes than U.S. equities. Lastly, the United States Oil Fund LP gives the trader access to oil futures, a commodity that often moves independently of stock and bond markets and is sensitive to geopolitical events and changes in global supply and demand.

This strategic choice ensures that the trader’s portfolio is not overly reliant on the performance of a single market or asset class. The differing correlations and responses to market events among these securities provide a balance, allowing the trader to potentially capitalize on gains in one area while buffering losses in another. It’s a practical example of how diversification can be implemented in a trading context, balancing the desire for high returns with the necessity of risk management.

The Bottom Line

Diversification is a very important concept in financial planning and investment management. However you need to keep in mind that managing a diversified set of trades requires more time, research, and effort. It can also increase the complexity of tracking and executing trades. Spreading investments too thin over multiple assets may dilute a trader’s focus and reduce the potential gain from any single trade.

Successfully diversifying in day trading requires a higher skill level and a deep understanding of multiple markets and instruments.