The age-old idea of not having all your eggs in one basket is considered timeless wisdom, but does it always work wonders for you?
The age-old idea of not having all your eggs in one basket is considered timeless wisdom, but does it always work wonders for you? Diversification is a risk management strategy that mixes a variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles & is an attempt at limiting exposures to any single asset or risk. The thinking behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.
It strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments neutralizes the effect of the negative performance of others. It includes multiple investments in a portfolio in an attempt to reduce overall portfolio risk while generating maximum possible returns.
The key to diversification lies in simultaneously holding a variety of assets. These are assets like stocks, bonds, real estate, gold, etc. that generally do not generate positive returns for an investor in the same time frame. For example, gold generates extraordinary returns at a time when there is a lot of fear prevailing in the market. By including such assets in a portfolio, a buffering effect can be achieved whereby when one asset declines in value, another tends to appreciate so that overall risk is diversified.
To understand the diversification better one has to understand the correlations. Correlation coefficients range from +1 to -1, with +1 representing perfect positive correlation, 0 representing no correlation, and -1 representing perfect negative correlation.
However, diversification can act both as a friend and a foe. Let’s look at it in detail.
Diversification as a friend. The role of diversification is to reduce ‘specific risk’ from a portfolio. However, studies on both equity and real estate markets suggest that this objective can be largely achieved in concentrated portfolios with relatively few holdings. The analysis also indicates that diversification can bring diminishing returns and rising costs as the number of securities held in a portfolio become large. Although the idea that diversification should reduce risk is intuitive, it is nonetheless worth looking at the theory to determine what diversification can and cannot achieve. By diversification, we mean the inclusion of additional assets in a portfolio in order to reduce risk, with risk typically measured by the volatility of returns. Primarily, two sources of risk are identified and considered – a specific risk or systematic risk. Specific risk is unique to an individual asset and independent from one asset to another. It can thus be diversified by combining assets, each with its own idiosyncratic risks, and effectively eliminated through portfolio management. Hence it does not justify a premium return. On the other hand, systematic risk refers to the tendency of individual assets to move together in response to systemic factors that affect all asset classes to a greater or lesser degree. Exposure to systematic risk is a part and parcel of investing and is inescapable. This type of risk justifies a premium return. The key factor is that specific risk can be eliminated through the creation of diversified portfolios whereas systematic risk will remain even in well-diversified portfolios.
Diversification is a foe. Investment advisors, portfolio strategists, and Nobel laureates in economics have spent an enormous amount of time figuring out the best strategies to reduce investment risk. There is a general consensus that the best way to do this is by diversifying holdings into different asset classes like stocks, bonds, gold, etc. but it may not always work well. Diversification can only reduce the volatility and smoothen out the investment returns, but that’s a psychological decision. As a result, asset allocation diversification may not always help investment performance but many times also hurts it. For both professional investors and novices, the single biggest fear is being caught in a significant stock market decline, which is why portfolio managers and advisers diversify into bonds and other assets to reduce the volatility of the portfolio. However, such diversification strategies may hurt the investment performance in the long run. If you had an absolutely perfectly diversified portfolio, it would never change value. Every time one of the investments would appreciate in value, another would go down, leaving your portfolio balance unchanged. Sure, you’d essentially have a risk-free portfolio, but how beneficial would that be from a return point of view?
In nutshell, one can conclude that diversification can act as a two-edged sword. It may work in favor of investors reducing volatility but may also work against their objective of maximizing returns in the long run. So choose wisely. Diversification in broader terms can act like a friend when planned and can act as an enemy when unclear.
Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing. – Warren Buffett