Diversification

What is Portfolio Diversification?

Diversification is a key risk management technique that aims to provide a smoother investment journey for investors and reduce the overall level of volatility in a portfolio over time. Diversification involves holding a broad mix of investments spread across different asset classes, geographies, sectors, and currencies, where any losses in one instrument or product are offset by gains in another. However, not all risks can be diversified, and a portfolio cannot be totally immune from suffering losses.

Types of Portfolio Diversification

To discuss the different types of portfolio diversification, we will first explore the different types of risk that a portfolio is exposed to. Generally, there are two types of risk:

1.     Systematic Risk

Systematic risk cannot be diversified as it is not unique to any business or industry, but rather extends to the whole market (or in other words, the entire system). For example, the global COVID pandemic impacted all areas of the global economy and even more conservatively positioned portfolios (i.e. with lower risk) suffered losses. Other examples may include natural disasters and unusual weather patterns, global geopolitical unrest, recession, changes in interest rates and inflation. Typically, the most efficient approach to managing systematic risk is through hedging, however, using hedging to reduce risk can also result in a reduction of expected returns.

2.     Specific Risk, also known as Idiosyncratic or Unsystematic

This relates to risks concerning a specific business, as well as groups of businesses operating in the same industry or sector of the economy. Examples may include legal or management issues, the financial health of an entity or its product range. Since these issues are specific to individual companies, industries or sectors, the effect can be mitigated through building a well-diversified portfolio.

To decide on best approach to diversify a portfolio, investors would typically go through a detailed assessment of the portfolio constituents. Key points for consideration include:

Asset Classes

Different assets offer different risk-return profiles and therefore having exposure to a broad mix of investment types (i.e. equities, fixed income, real assets, commodities etc.) could be a good way to reduce risk.

Investment Style

There are different investment approaches, such as growth or value investing, which seek to invest in companies with specific features. In the case of growth investing, for example, the focus is on businesses with unique and highly advanced products with the prospect for significant growth in earnings over time (tech companies are good example here). On the other hand, value investors seek to buy shares of companies that are underappreciated or have experienced difficulties, meaning their share price is currently lower than its intrinsic (or fair) value. Having exposure to different investment styles could make for a more balanced portfolio that may not necessarily significantly underperform during a particular market (such as growth or value rallies).

Market Cap

Similarly, to investment styles, a well-diversified portfolio would have exposure to companies of different sizes, since different size companies react to risk factors in different ways. For example, small caps tend to do well in a lower interest rate environment, where access to funds is relatively unrestricted and allows for growth of businesses that are not necessarily profitable. On the other hand, large caps are mature companies that tend to grow at a lower rate and deliver smaller gains, but do offer the benefit of being less volatile.

Geography and Sectors

Having a concentrated exposure to a specific region or sector of the market could well increase volatility. Typically, investors seek to invest in a wider set of companies across developed and emerging markets, and across multiple sectors (which are typically categorized as either sensitive, cyclical or defensive).

Factor Exposure

Monitoring that a portfolio to ensure that it does not become overexposed to any single factor would ensure a good level of diversification. The major factors that investors typically pay attention to include  . Volatility, the potential for stocks with higher volatility to generate higher returns or losses. Liquidity, this factor refers to the impact of an asset’s liquidity on its returns (more liquid companies would have different return profile to their less liquid peers).

How Do You Calculate Portfolio Diversification?

Correlation

Correlation is a statistical measure that shows how the returns of different assets in a portfolio move in relation to each other and help investors assess the degree of diversification across their assets. It is a key concept in modern portfolio theory and risk management and has a value ranging between +1 and the -1.

Positive correlation between assets, which is anything above 0, means that the investments move, on average, in the same direction over a specific time frame. The higher the positive correlation , the lower the potential benefits from diversification.

Conversely, negative correlation (i.e. anything below 0) indicates that assets move, on average,  in the opposite direction, potentially offering more diversification benefits. Effective diversification seeks to include assets with low or negative correlations to create a balanced and stable portfolio that can better withstand different market conditions. However, during periods of market stress when many investors are looking for diversification to help insulate their portfolio from large declines in value, correlation across asset classes tends to increase. An example of how the Covid-19 pandemic has impacted correlation can be found in the following article by Morningstar. Some of the key takeaways include:

• The only negative correlation over 10 years is between US Aggregate bonds and Commodities. Finding negatively correlated asset classes is unusual
• Municipal Bonds and Commodities have the weakest positive correlation over 10 years. Even if correlations are not negative, low positive correlation can still deliver good diversification benefits to portfolios
• Over 5 years, both International and Small Cap (i.e. stocks with small market capitalization) equities tend to be highly correlated to the return of the S&P 500 index (both at 0.9). For equities, this indicates diversification across asset classes is much more important than diversification within the asset class. Over 10 years, both US Aggregate and Municipal bonds show relatively weak correlation to the S&P 500 stock index (0.31 and 0.32 respectively). This provides good evidence of low correlation between equities and bonds and the benefit of holding both asset classes in a well-diversified portfolio

Source: Morgan Stanley Investment Management

The Portfolio Manager online course provides a deep dive into the portfolio management process, covering the investment management industry, economic analysis and asset allocation, security selection, trading, and performance measurement, as well as fundamental accounting, valuation, and modeling skills.

Technical Example

This example gives us data on the share price performance of two companies Chevron Corp and Pfizer Inc from 2018 to 2023. It asks us to calculate the correlation between two of them, commenting on our findings. Download the diversification workout to access the full list of data.

Explanation in Steps

To determine the correlation between the two stocks we need to know:

1. What is the variance against the mean for each stock and the product of variances?
2. We need to also calculate the standard deviation for the two stocks.
3. Then we need to find what is the sum of the product variances, along with the number of observations (i.e. the number of data points for each stock).
4. Calculate the covariance by dividing the sum of product variances by the number of observations.
5. Finally, calculate the correlation by dividing the covariance by the product of both standard deviations.

Access the full workout file to follow along with these steps.

Concentration

Portfolio concentration, which is essentially the opposite of diversification, refers to the degree to which a portfolio is heavily invested in a limited number of assets. A concentrated portfolio would have relatively few constituents, which theoretically increases the risk. However, portfolio concentration should also be looked at from different angles, for example what’s the level of concentration in the top 5 or 10 positions, across different asset classes, sectors, regions etc. While highly concentrated portfolios may lead to higher returns if their underlying holdings perform well, they could also suffer significant losses should they face unfavourable market conditions.

What is Warren Buffett’s take?

Warren Buffett, the chairman and CEO of Berkshire Hathaway, is one of the most prominent investors on Wall Street. Contrary to many investors and academics, his view is that diversification reduces returns over the long term. In his view, having an in-depth knowledge of one or two industries should be used to gain greater returns, through better understanding of those companies, rather than spreading a portfolio across a broad range of companies and sectors which cannot all be followed as closely. Bill Gates explores this more closely in the Harvard Business Review.

Diversification General Rules

The goal of diversification is not to necessarily boost performance, but good diversification can lead to improved risk-adjusted returns, as similar returns might be achieved for lower levels of risk. To achieve this, investors should seek to hold a specific asset mix (dependent on risk tolerance) across equities, bonds, cash and other asset classes, or in other words, they should have a multi-asset portfolio. In addition, diversification should also be sought at an asset class level (as discussed above, this can be from a sector, geographical or market cap perspective).

What is the 5% Rule for Diversification? 

In relation to the weightings of individual stock holdings, investors should also beware of overconcentration in a single position. A high-level rule of thumb for avoid high levels of concentration is that a single stock should not make up no more than 5% of the overall portfolio. This is known as the 5% rule of diversification.

What is Portfolio Diversification with Example?

The exhibit shows the composition of four different portfolios, where Conservative is the lowest risk and Aggressive Growth is the highest. The asset mix of these models changes as risk increases and more stocks (equity) are added while exposure to bonds and short-term investments (such as cash or cash equivalents, i.e. money market funds) is reduced. This has generally proved to be an efficient portfolio construction strategy as the portfolio with the lowest equity allocation had the lowest historical volatility (Conservative had historical volatility of 4.54%) and did not suffer as much during its worst 12-month period (-17.67% compared to -40.64% for Balanced, which was the second best performing). On the other hand, adding more equity has proven to increase return potential. For example, the Aggressive Growth portfolio had the best average return (9.45%) and managed to capture the most upside during its best 12-month period.

Overall, there isn’t an optimal portfolio mix that fits all investors, but that should rather be determined to align with investors’ time horizon, objectives, needs, and comfort with volatility.

Source: Fidelity Investments and Morningstar

Benefits and Limitations of Diversification

While diversification can make the longer-term investment journey less stressful and potentially enhance returns depending on the preferred level of risk, it also has drawbacks that should be outlined.

Benefits:

• Reduces volatility over the long-term
• Could improve long-term investment returns

Limitations

• May limit gains
• It is time consuming and requires certain level of knowledge
• It is more expensive due to more transaction costs, and other fees

Conclusion

Overall, diversification is an essential mechanism to control risk. While spreading investments across various assets, sectors, and geographies can certainly reduce vulnerability to significant fluctuations of individual holdings, it is not that straightforward to build and maintain a well-diversified portfolio.  This is because correlations between different asset classes are dynamic and may also be influenced by unusual market events, investor sentiment (for example concerns around high valuations) and various other factors. Therefore, in some cases investors would rather prefer choosing a ready-made option run by professionals, such as a multi-asset fund.

Additional Resources

Correlation and Covariance

Modern Portfolio Theory

Rolling Return

Portfolio Management Course