What is Portfolio Diversification?
Portfolio Diversification refers to choosing different classes of assets with the objective of maximizing the returns and minimize the risk profile.
- Each investor has his own risk profile, but there is a possibility that he does not have the relevant investment security that matches his own risk profile.
- This is when an investor chooses a bunch of assets to equalize his risk & payoffs to the portfolios’ – the set of securities investor has chosen 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 wants.
Why Diversity the Portfolio?
Consider a person (Mr. A) who has just a basic idea about what finance is, and he plans to invest his retirement savings. Since the investment is for his retirement, he plans to invest at very low risk, and he just 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 you look at any one of the above scenarios, each one has its own risk profile – Mr. A has a very low tolerance for risk, and Mr. B has a very high tolerance for risk. One should be aware of the fact that risk tolerance is not the same as risk aversion. Risk aversion is the character of a person to take more or less risk to the returns he is getting. If he tries to take less risk than the returns he wanted, he is supposed to be risk-averse. Since that is not in the scope of this article, let us just park that apart and see what and how investment can be diversified.
Asset Classes for Portfolio Diversification
To know where to put your money, one should have an idea about what different type of assets is. Because of the growth in technology and the availability of different finance products, there is an infinite number of ways I can diversify my portfolio. To keep the difficulty of the concepts low, let us just consider a few classes of assets
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#1 – Stocks
As we know, stocks represent the ownership of a part of the company – which comes with some obligations and some benefits. This goes to say 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 risks the company poses. Without proper information, it is impossible to gauge the risk of the company. This makes stocks a risky asset. If a person is to invest them, they ought to be aware of the risks they are taking and should be willing to take that risks.
#2 – Bonds: Treasury and Non-Treasury
Bonds are one way to raise money by the company, where they guarantee cash flows. Unlike stocks, bonds have a guarantee on them. A pre-specified amount will be paid to the owner of the bond for each duration. In short, a bond is like a fixed-deposit except that it is tradeable. Therefore, the price of bonds go down and go up. Treasury bonds are bonds backed by the US Government, which makes them pretty much risk-free. Hence, for all practical purposes, this article will consider Treasury Bonds as the risk-free rate.
Apart from the assets that are available for portfolio diversification, one has to have an idea 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 had diversified enough, he would have market returns and market risks. This makes systematic risk an unavoidable risk.
- Unsystematic risk is the opposite of this. This risk can be reduced with enough diversification. If a person buys the entire market, this risk is zero. So this risk can be used as a measure of how risky a person’s portfolio is.
Elements of Portfolio Diversification
To diversify a portfolio, one must have measures of rates of return, how the prices change, and other statistical variables.
Let us look at the above graph, which provides an idea about what the entire topic of portfolio diversification is about. The safest bet is to invest in the 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 flow. 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 of this.
- High Risk – Companies that have a high probability of growing, but also, on the other hand, they are close to bankruptcy than the rest. Companies like Tesla are in this place.
There are thousands of companies that are traded daily, but buying any one of these does not complete the investor’s risk profile.
Assume an investor who wants to have the returns of the market (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).
How to Diversify your Investment Portfolio?
- Spread the wealth. Do not invest in one place. 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. Look for a portfolio where the risk matches the returns.
- 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 funds and bond funds will do the portfolio diversification for you. You need not go and study the entire history of finance to see how to diversify stocks and buy them. Look at 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, there are funds that 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 your country, market. Investing in a variety of places will help in diversification.
- Buying and holding have a different cost 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 assets that are available. There are almost enough types of investments to suit every risk profile. The point of diversification is too old. Having knowledge 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.
Advantages of Diversification
- You will receive the highest return for the lowest risk with portfolio diversification.
- This is one of the best defenses against bubbles and financial crises.
- Investment Diversification can help in protecting your capital, especially for investors that are saving up for something important – like retirements or marriages.
- By diversifying, dependency one asset class reduces.
- The portfolio will be a hedge against risks.
Disadvantages of Diversification
- Only unsystematic risks can be diversified. Systematic risks cannot be diversified.
- Over diversification is very expensive because of the number of assets that are available in a portfolio. The higher the number of assets, the higher the cost to manage the portfolio.
- The more you diversified, 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 is difficult to track a portfolio when it is diversified. Only the net change is monitored; each of the stocks cannot be tracked individually.
- There is a chance of below-average diversifications because of high fees.
Limitations of Portfolio Diversification
- Market risk cannot be diversified. Crashes like 2009, 2001 can always happen, and diversification will not protect the investor against them.
- Government policies play a large role in market movement, and it cannot be diversified.
- Diversification is generally for long-term investors. Diversification will not help in trading.
Conclusion
In words, diversification is a pretty simple concept. One looks out for his wants and tries to match them. Since the 1970’s when Vanguard started the first index funds, indexing is one of the prime gauges of diversification. When one compares the rates of return with the market, it might be difficult to put out where the market is. As there is no market that ensures all the assets are included. But diversification is so common these days that the number of people investing in single assets is almost nill.
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