Portfolio Diversification

What Is Portfolio Diversification?

Portfolio Diversification refers to choosing different classes of assets to maximize the returns and minimize the risk profile. Each investor has his risk profile, but there is a possibility that he does not have the relevant investment security that matches his risk profile.

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This is when an investor chooses a bunch of assets to equalize his risk & payoffs to the portfolios – the set of securities the investor has decided to invest in. From a nonprofessional’s standpoint, it is not possible to buy one security to match the wants of an investor. Portfolio Diversification is the formation of a portfolio that matches the desires.

Portfolio Diversification Explained

Investment portfolio diversification is a risk management technique in which the risk is spread across various asset classes like bonds, stock, mutual funds and takes into account the sector, industry and economic performance. The main aim of this concept is to reduce dependence on one particular asset class so that if that asset does not perform well, then the entire fund is not negatively affected.

In words, diversification is a pretty simple concept. One looks out for his wants and tries to match them. Since the 1970s, when Vanguard started the first index fundsIndex FundsIndex Funds are passive funds that pool investments into selected securities.read more, indexing is one of the prime gauges of diversification. When one compares the rates of return with the market, it might be difficult to determine where the market is. As no market ensures all the assets are included. But diversification is so common these days that the number of people investing in single assets is almost nil.

Market risk cannot be diversified. Crashes like 2009 and 2001 can always happen, and portfolio diversification theory will not protect investors against them.

Government policies play a large role in market movement and cannot be diversified. The influence of these external factors are actually out of the control of individual investors and investment professionals. They can only take steps to mitigate and control such risks.

Diversification is generally for long-term investors. Diversification will not help in trading. Traders who usually look for profits on a short term basis, has the ability to take high amount of risk in the hope of making high profits. They directly invest their money in one or two types of short term investment options without diversifying them. Thus, this clarifies the fact that high diversifying the portfolio may also reduce return along with mitigating the risk.

Types

To know where to put the money, one should have an idea about what different type of assetsDifferent Type Of AssetsAssets are the resources owned by individuals, companies, or governments expected to generate future cash flows over a long period. There are broadly three types of asset distribution: 1. Based on convertibility (current and non-current assets), 2. Physical existence (tangible and intangible assets), 3. Usage (operating and non-operating assets)read more are. Because of the growth in technology and the availability of different finance products, there are an infinite number of ways I can diversify my portfolio. To keep the difficulty of the concepts low, let us consider a few classes of assets.

#1 – Stocks

As we know, stocks represent the ownership of a part of the company – which comes with some obligations and benefits. This says that the investor (owner of stocks) is not eligible for anything except for ownership in the company. If the company goes down, the value of the investment goes down, and vice versa.

Therefore, the owner will not be safe from the company’s risks. Without proper information, it is impossible to gauge the company’s risk. This makes stocks a risky asset. If a person invests in them, they ought to be aware of the risks they are taking and should be willing to take those risks.

#2 – Bonds: Treasury and Non-Treasury

BondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more are one way to raise money for the company, where they guarantee cash flows. Unlike stocks, bonds have a guarantee on them. A pre-specified amount will be paid to the bond owner for each duration. In short, a bond is like a fixed deposit except that it is tradeable. Therefore, the price of bonds goes down and goes up. Treasury bondsTreasury BondsA Treasury Bond (or T-bond) is a government debt security with a fixed rate of return and relatively low risk, as issued by the US government. You can buy treasury bonds directly from the US Treasury or through a bank, broker, or mutual fund company.read more are bonds backed by the US Government, which makes them pretty much risk-free. Hence, this article will consider Treasury Bonds as the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more for all practical purposes.

Apart from the assets available for investment portfolio diversification, one has to know about systematic and unsystematic risk.

• Systematic risk is the risk that is existent in the market. One cannot hedge himself against the market with high returns. If he diversified enough, he would have market returns and risks. This makes systematic riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more an unavoidable risk.
• Unsystematic risk is the opposite of this. If a person buys the entire market, this risk is zero. So this risk can be used to measure how risky a person’s portfolio is. This risk can be reduced with enough diversification.

Examples

Consider a person (Mr. A) who has just a basic idea about finance and plans to invest his retirement savings. Since the investment is for his retirement, he plans to invest at very low risk, and he wants his portfolio to grow along with inflation. This person is considered to have a very low-risk profile.

On the other hand, consider an investor (Mr. B) who plans to invest 10% of his money in extremely risky assets. Alternatively, he might want to invest such that he gets the returns the same as the markets.

If we look at any of the above scenarios, each one has its risk profile – Mr. A has a very low tolerance for riskTolerance For RiskRisk tolerance is the investors' potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor's age, income, investment objective, responsibilities and financial condition.read more, and Mr. B has a very high tolerance for risk. One should know that risk tolerance is not the same as risk aversionRisk AversionThe term "risk-averse" refers to a person's unwillingness to take risks. Investors who prefer a low-return investment with known risks to a higher-return investment with unknown risks, for example, are risk-averse.read more. Risk aversion is the character of a person to take more or less risk for the returns he is getting. If he tries to take less risk than the returns he wants, he is supposed to be risk-averse. Since that is not in the scope of this article, let us park that apart and see what and how investment can be diversifiedInvestment Can Be DiversifiedA diversified portfolio of investments is a low-risk investment plan that works as the best defence mechanism against financial crises. It allows an investor to earn the highest possible returns by making investments in a mixture of assets like stocks, commodities, fixed income.read more.

Strategies

To diversify a portfolio, one must have measures of rates of return, how the prices change, and other statistical variables.

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Let us look at the above graph, which provides an idea about the entire topic of good portfolio diversification. The safest bet is to invest in an area filled with green. The bad investment is the investment in yellow.

• Risk-free – US or Germany government bonds.
• Low Risk – Stocks of companies that are well settled and have a steady cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more. For Example, companies in Energy, Steel, and Utility industries.
• Medium Risk – Companies that are well settled, but there are risks that the company is facing. The company might be big or small – Apple or Amazon will be a good example.
• High Risk – Companies that have a high probability of growing but also, on the other hand, are closer to bankruptcy than the rest. Companies like Tesla are in this place.

Thousands of companies are traded daily, but buying any of these does not complete the investor’s risk profile.

Assume an investor who wants to have the market returns (he wants to reduce his nonsystematic risk to zero). He can try to replicate the returns and risk profile, either by a set of stocks and bonds or by a set of stocks (buying all the stocks as the market).

Methods

Here are some of the methods of a good portfolio diversification.

• Spread the wealth. Do not invest in one place. Look for a portfolio where the risk matches the returns. There are a lot of details regarding what are the different sectors, how they are correlated, and how each one of them affects the portfolio.
• Do not invest where risk and returns do not match. There is no free lunch out there.
• Consider investing in index or bond funds. Mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more and bond fundsBond FundsThe bond fund, also known as a debt fund, is a mutual fund that invests in bonds and other debt securities, pays dividends periodically and does not possess any maturity date. It generates a stream of income by investing in fixed income securities like government securities, bonds, debentures.read more will do the portfolio diversification. We need not study the history of finance to see how to diversify stocks and buy them. Look at the details of an index fund and trust in the index. Indexes like the S&P 500 and DJIA, in most cases, reflect the entire market. In addition, some funds follow and try to match the returns of these indexes for a very small (and sometimes zero) fee. Choose such a fund and invest in it.
• Go away from the country and market. Investing in a variety of places will help in diversification.
• Buying and holdingBuying And HoldingThe term "buy and hold" refers to an investor's investment strategy in which they hold securities for a long period of time, ignoring the ups and downs in market price during a short period of time.read more have different costs from active investing. Try to see which makes more sense. Invest in the one that has the least opportunity and real cost.
• Know the different types of financial assetsTypes Of Financial AssetsFinancial assets are investment assets that derive their value from a contractual claim of what they represent. Cash and cash equivalents, accounts receivable, fixed deposits, equity shares, debentures/bonds, preference shares, mutual funds, interests in subsidiaries, associates, and joint ventures, insurance contracts, rights and obligations under leases, Share-Based Payments, Derivatives, and Employee Benefit Plans are all examples of financial assets.read more that are available. There are almost enough types of investments to suit every risk profile. The point of diversification is too old. Knowing about this will help, but one need not go out and do the diversification themselves. Find out diversified funds and choose.
• Beware of asset bubbles – by following government and other regulations.

Objectives

Some important objectives of portfolio diversification theory are as follows:

• Stable returns – This method provides a stable and low risk return to its investors because the risk is spread over a longer period of time. Since different assets perform differently the risk and retuen balances out.
• Maximise return – It helps in earning the maximum return possible for a given level of risk. It optimises the trade-off between the two and captures the best possible gain by mitigating losses.
• Exposure to different assets – The process gives access to  different kinds of asset classes across sectorsand investors can identify them as per their financial goals.
• Aligns the financial aim – The diversification is the best way to achieve the financial goal within the set time horizon because it considers the investor profile and then frames the portfolio.
• Capital preservation – It helps to preserve the capital and protect the money from any substantial fall in its value because there is a balance between the risk and return.

Benefits

Like all financial concepts have their own benefits and limitations, so does this concept. Let us try to understand the benefits first.

• The investor will receive the highest return for the lowest risk with portfolio diversification.
• This is one of the best defences against bubbles and financial crisesFinancial CrisesThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more.
• The importance of portfolio diversification lies in the fact that can help protect the capital, especially for investors saving up for something important – like retirements or marriages.
• By diversifying, dependency on one asset class reduces.
• The portfolio will be a hedgeHedgeHedge refers to an investment strategy that protects traders against potential losses due to unforeseen price fluctuations in an assetread more against risks.

Limitations

Apart from importance of portfolio diversification, some limitations of the concept are as given below:

• Only unsystematic risksUnsystematic RisksUnsystematic risk refers to risk that is generated in a specific company or industry and may not be applicable to other industries or the economy as a whole.  There are two types of unsystematic risk: business risk and financial risk.read more can be diversified. Systematic risks cannot be diversified.
• Over diversification is very expensive because of the number of assets available in a portfolio. The higher the number of assets, the higher the cost to manage the portfolio.
• The more the investor diversifies, the less it is invested in the best companies that provide great returns (but also with great risk).
• The process of diversification is too complex, and many people find it difficult to gauge the effort it takes to diversify. The best way is to pay someone a small amount to do it.
• Customized diversification methods might be very expensive.
• It isn’t easy to track a portfolio when it is diversified. Only the net change is monitored; each stock cannot be tracked individually.
• There is a chance of below-average diversification because of high fees.

Frequently Asked Questions (FAQs)

Recommended Articles

This has been a guide to what is Portfolio Diversification. We explain its benefits with examples, strategies, types, methods, objectives & limitations. You can learn more about investment from the following articles –

• Formula of Portfolio Variance
• Career in Portfolio Management
• Portfolio Optimization
• What is Modern Portfolio Theory?