Don’t put all your eggs in one basket
In the first part of our series on investment portfolios, we discussed the fundamentals of portfolio management and distinguished between focused and diversified portfolios. Having debated the pros and cons of the focused investment approach, today’s article will describe the diversified portfolio approach in detail.
Diversify to Spread the Risk
The Merriam Webster’s dictionary describes the term diversification as “an increase in the variety or diversity” of something – in the financial context, this concerns investments. Diversification is a fundamental economic philosophy based on the principle not to “put all your eggs in one basket”.
The idea behind diversification is to reduce one’s risk (or variance) by spreading investments over a number of assets, asset classes, countries and industries without reducing the expected return. By putting your eggs in multiple baskets, you will still have eggs over in case one of the baskets suddenly drops – as stock markets and asset prices sometimes do.
The Diversified Portfolio
A diversified portfolio contains a large number of investments that are strategically spread over a variety of assets, asset classes, countries and industries. A diversified portfolio may contain growth and value stocks, short-term bonds and physical investments like gold or silver; it could also consist of growth and value stocks in developed and emerging markets.
Typically, the more diversification the better – hence, a diversification in all the mentioned dimensions is advisable. Investments – regardless of their asset class – are always exposed to risk. The stock market could crash, commodity prices could tank, real estate prices in a certain region may fluctuate. Diversification brings stability to a portfolio and peace of mind to the investor.
Low Correlation is Key
There are infinite ways to configure a diversified portfolio, but as Modern Portfolio Theory (MPT) has shown: the most important factor is that the contained investments have a low correlation. Correlation is a statistical measurement describing how strong price changes in one asset go together with a price change in the other asset.
Correlation is measured on a scale of -1 to +1, 1 meaning a “perfect correlation” – a price increase of 10 % in asset A leads to a price increase of 10 % in asset B. A correlation of -1 is a perfect negative correlation – a price increase of 10 % in asset A leads to a price decrease of 10 % in asset B. A correlation of 0 would mean that the two assets have absolutely no price correlation.
Low correlation is important for the diversified investor because he wants his investments to be as independent as possible. A risk-averse investor sleeps better knowing that an unexpected price drop in one asset will not affect the other investments in his portfolio – at least not strongly.
It is important to note that practically all assets have some degree of correlation. The key is to have enough diversity in a portfolio that one can comfortably overcome shorter or medium-term price decreases in one part of the portfolio or even have price increases in other parts of the portfolio. Studies have shown that a diversified portfolio should contain at least around 40-50 investments (Alexeev & Tapon, 2014; Dbouk & Kryzanowski, 2009).
Science shows: efficient diversification yields the highest returns
Not only investors, but financial analysts and academic authors have dedicated a lot of attention to the topic of diversification. Numerous studies have shown that it is international diversification which yields higher returns through reducing the variance of investments without lowering the expected return (e.g. Lekovic, 2018). Proper diversification can reduce the risk for a given level of expected return (Markowitz, 1952).
Diversification decreases returns, but risk even more
Of course, diversification comes at a price: the investor gives up some returns achieved with one investment through the losses another investment has incurred. This is the point of critic that proponents of a focused investment approach always mention.
If asset A goes up by 10 % while asset B goes down 2 % and asset C 4 %, the investor would have been better off to only invest in asset A. This makes logical sense – but the reality is a little bit more complex. How could the investor have known upfront which one of the three assets would go up and which ones down?
No investor – focused or diversified – will include assets in his portfolio that he thinks (or “knows”) are going to decrease in value. The focused investor often just believes with a seductive perceived sense of certainty which assets are going to increase. Given his perceived certainty, he invests a larger percentage of his resources in one financial instrument and is convinced he doesn’t need other financial instruments to balance the risk.
Diversified investors are more conservative and realistic. They assume that they cannot time and predict the market – despite their best hunches. Therefore, they spread the risk over a larger number of investments with low correlation and know that diversification may decrease their returns, but it decreases their risk even more.
A diversified portfolio offers its owner further benefits: long-term investors do not have to watch and monitor such a portfolio as closely, because as diversification reduces variance, it makes significant price losses less likely. Conservative investors with higher risk-aversion should opt for a diversified portfolio that offers them a solid risk-reward-ratio.
Portfolio management is key to professional and profitable investing. While a focused portfolio invests in a concentrated number of assets – based on assumptions of promising investments/industries/markets – a diversified portfolio contains a broader number of investments spread across asset classes, industries and markets.
Ultimately, each investor is different. Depending on their personal and financial situation and goals as well as their real (not their expected) risk tolerance will lean more towards one or the other approach described. In any case, a certain degree of diversification and risk management is essential for any investor and their portfolio.