Listen to the article here below, narrated by Yunus Skeete:
Coined by Cervantes in Don Quixote, academically formalised by Markowitz in Portfolio Selection and recently popularised by the show Love Island – the idea, “Don’t Put All Your Eggs in One Basket,” has endured the test of time – and for good reason.
Technically understood by professional and retail investors alike as ‘portfolio diversification,’ the theory acts as a way to reduce risk without sacrificing the potential for higher returns through limiting exposure to any single security or market.
“Most investment professionals agree that diversification is the most important component of reaching long-range financial goals while minimising risk”. – Investopedia [1]
What is Portfolio Diversification?
Practically, Portfolio diversification is the process of investing your money in different asset classes and securities in order to minimize the overall risk of your portfolio.
Source: WallStreetMojo.com
Any investor can work to reduce their portfolio’s exposure to risk [2] by also investing across different sectors, industries, or countries.
Diversification cannot guarantee against all losses and it doesn’t necessarily boost performance; however, it is a hedge against volatility. After all, it is always possible to lose out when you invest.
How does it work? Diversification and Risk
Portfolio diversification is fundamentally used as a strategy to minimize the risk on your investments; specifically, unsystematic risk.
Unsystematic risk is inherent in a specific company or sector. Also known as specific risk, it is diversifiable and a function of more firm-specific factors such as changes in management and company financial statements.
As explained in detail by Tom Wookey in his recent FinFoc article “An introduction to Risk” [3] it is possible to completely eliminate unsystematic risk in your portfolio through a process of effective diversification.
Unsystematic risk can only be eliminated if the securities in your portfolio are not perfectly correlated – that is, they respond differently to changes in market conditions, often moving in opposite directions. When one investment may perform poorly in the market, another may simultaneously outperform (or at least not decline as much), ensuring you are not in a ‘lose-lose’ situation.
True diversification serves to smooth-out unsystematic risk shocks to your portfolio. The more diversified your portfolio, the lower the likelihood that you should experience large unsystematic losses, leading to a more consistent overall portfolio performance.
But, doesn’t lower risk guarantee lower returns? Enter Markowitz.
Rule 1 in the finance notebook: higher returns require higher levels of risk, vice versa. The ideal ‘high-return, low-risk’ investment is at worst impossible to find, at best illustrious. That being said, countless methods and strategies have been developed over time in search of this investing nirvana.
By far the most popular economic theory Modern Portfolio Theory (MPT) was developed by Harry Markowitz and published under the title “Portfolio Selection” in the Journal of Finance in 1952. [4] MPT advocates for diversification and argues that it’s possible to construct a portfolio that will provide you maximum returns by taking on a certain level of risk.
Markowitz demonstrated quantitively that the risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any one of the individual stocks. Investment professionals consistently use this technique to craft investments that can be characterised by simultaneously exhibiting high returns and (importantly) low levels of risk
What’s the best way to diversify my holdings?
Clearly, it’s beneficial for investors to diversify their investments. What is less clear-cut, however, is the ‘ideal’ level of diversification to aim for. In reality, asset allocation and the level of diversification within your portfolio should align with your investment time frame, financial needs, and comfort with volatility.
Most experts recommend 15-20 holdings spread across different asset classes, sectors, and geographies in order to achieve adequate levels of portfolio diversification.
Fidelity Investments, the world’s 5th largest asset management company, recommends a mix of stocks, bonds, and other short-term investments, tailored to an individual’s risk appetite.
Once you have achieved a satisfactory target mix, it is recommended that you need to keep it on track through periodic check-ups and rebalancing. If you don’t rebalance, changes in the volatility of certain assets, markets, or sectors could leave your portfolio with a risk level that is inconsistent with your goal and strategy.
What role can investment funds play?
Investment management vehicles such as Mutual funds and Exchange-Traded Funds (ETFs) can provide instant, low-cost diversification benefits. Funds can track a huge variety of asset classes, making any combination of security types you can imagine accessible without actually buying the securities yourself. The value of your shares in mutual funds moves up and down with the value of the fund’s investments.
One example, the Fidelity ZERO Large Cap Index Fund [6] seeks to provide copycat investment results that correspond to the total return of stocks of large-capitalization US companies. Your investment at around $11 per share (with 0 management fees) in this fund will mimic the diversified risk profile and performance of owning each individual stock for a fraction of the price.
Can you ever over-diversify?
Well… yes. It’s well documented that the benefits of diversification are marginal past a certain point, and can actually turn negative. This phenomenon, whereby the costs of pursuing portfolio diversification outweigh the benefits has been coined ‘di-worsification.’
“Diversification is protection against ignorance, it makes little sense for those who know what they’re doing.” – Warren Buffet [7]
Diworsification, the inverse to diversification, occurs from investing in too many assets with similar correlations that add unnecessary risk to a portfolio without the benefit of higher returns. [8]
More practically, the more holdings a portfolio has, the more time-consuming it can be to manage. The confusion brought on by owning too many separate investments can be overwhelming and unmanageable for an unsophisticated investor. A misguided investor, thoughtlessly prioritizing diversification benefits may actually forgo potential returns elsewhere due to lost opportunities.
Lastly, over-diversification can be extremely costly. Buying and selling many different holdings incurs more transaction fees and brokerage commissions than not. More frustratingly, risk-averse financial advisors, fearful of losing accounts over unsystematic shocks may over-diversify your account to the point of mediocrity.
Conclusion
When constructing your own portfolio, I would recommend considering the mantra, “Don’t put all your eggs in one basket.”
It’s clear that portfolio diversification is here to stay. It’s the ability (when applied effectively) to reduce portfolio risk and hedge against market volatility, all whilst simultaneously offering higher returns over a long-term horizon will continue to serve as a blueprint for investors and managers for years to come.
That said, diversification is not the be-all and end-all when constructing a portfolio. Investors should avoid ‘de-worsification’ by avoiding complex and costly investment strategies that actually forgo performance in place of obsessive diversity.
Reference Links:
[1] https://www.investopedia.com/investing/importance-diversification/
[2] https://www.investopedia.com/terms/r/risk.asp
[3] https://finfoc.com/2020/07/an-introduction-to-risk-types-and-diversification
[4] https://www.jstor.org/stable/2975974?seq=15#metadata_info_tab_contents
[5] https://www.fidelity.com/viewpoints/investing-ideas/guide-to-diversification
[6] https://www.marketwatch.com/investing/fund/fnilx
[8] https://www.investopedia.com/terms/d/diworsification.asp
Final Year Undergraduate Student at the University of St Andrews, Studying Finance
