What is “Diversification”?
Diversification is one of the most essential risk management techniques in portfolio management. Its basic philosophy is to invest in a wide range of investment products and combine them in a portfolio with the aim of limiting exposure to any particular single investment, asset class, region or style. (also referred to as “specific risk”). By doing this, an investor with a longer-term investment horizon could, on average, expect higher returns, but those with shorter-term perspective and more aggressive approach (also referred to as day traders) may not find diversifying risk as effective.
Key Learning Points
- Diversification is risk management technique used to reduce potential volatility in investors’ portfolios
- Correlation is key statistical metric that quantifies the extent to which the underlying securities move in the same, or opposite, direction. The lower the correlation, the more diversified the portfolio is.
- Portfolio concentration is another criterion that can influence diversification. Generally, the large the number of stocks in a portfolio, the lower the risk.
- There are a number of risks that can be diversified, such as country, currency or single security risk.
- The main advantage of diversification is reduced risk exposure, but for investors with more aggressive approach this may not be optimal, as it limits the probability of higher returns within a short time period
The main purpose of diversification is to “smooth” the investor’s journey and limit the downside from specific events, such as the release of company results or adverse currency movements, that can negatively impact the overall performance of a portfolio. However, the idea of blending assets with as many different features as possible is only beneficial to the degree of correlation between those assets. The lower the correlation between assets in a portfolio, the more risk reduction there will be. Diversification also relates to the number of securities held in a portfolio, also referred to as concentration. Increasing the number of investments within a portfolio will the lower the overall level of portfolio risk, through providing additional diversification.
Correlation and Concentration
The correlation coefficient is the most common statistical measure that is used to quantify diversification. It measures the degree to which two different securities move in relation to each other over a specific period of time. The correlation coefficient has a value between -1.0 and +1.0. A correlation coefficient of -1 indicates that the two securities move in completely opposite ways to each other, in an entirely predictable manner. This is also referred to as perfect negative correlation.) If the correlation coefficient between two securities is +1, then then two securities always move in the same directions as in each in an entirely predictable way. This is called perfect positive correlation.
Portfolio concentration is usually regarded as the opposite of diversification, as the smaller the number of securities, the higher the risk. There are many studies that have tried to establish the optimal number of holdings within a portfolio to derive the benefits of diversification.
Examples of Risks That Can Be Diversified:
- Company specific risk
- Single asset class risk
- Currency risk
- Geographical exposure risk
- Investment style bias
Advantages and Disadvantages
The key advantage of using diversification as a risk management technique is the ability to hedge against higher volatility on stocks within the market, as well as potentially earning better returns, adjusted for risk, over the long-term. Combining assets that do not necessarily respond to risk factors in the same way as each other, such as equities, bonds, property, commodities, along with holding a larger number of individual securities that demonstrate different factor exposures (for example growth, value or momentum) could result in holding a well-diversified portfolio and have the potential to navigate investors through all market conditions.
On the other hand, whilst well-diversified portfolios may limit the potential downside for investors, it may also limit the upside too. This means holding a diversified portfolio may not be suitable for investors with high growth expectations since risk and return are typically positively correlated.