Oran Hall | Of what value is diversification?
Diversification is a risk-management technique by which a wide variety of investments is included in an investment portfolio. The best results from diversification are derived from a portfolio in which the assets do not lose value at the same time or at the same rate so the negative performance of some assets can be negated by the positive performance of others.
Imagine investing all of your money in one instrument. If it does well, you do well. But what if it does not? It could be a real disaster. To avoid such a scenario, you would invest in more than one instrument. As you do so, you reduce the risk of the portfolio, but you also reduce your maximum potential returns.
Some studies suggest that about 90 per cent of the maximum benefits of diversification can be achieved with a portfolio of 16 to 20 stocks. Beyond this point, the benefits of diversification decline. So, it is possible to over diversify. This happens when adding to the portfolio results in the marginal reduction of total portfolio returns being greater than the marginal reduction of the risk of the portfolio.
STOCKS AND BONDS
There are several ways to diversify an investment portfolio. One way is by type of security, such as stocks and bonds. Another is by currency. Another is by market or geography, meaning investing in more than one country. Another is by industry group. Beyond these more traditional asset classes are alternative investments such as precious metals and structured products.
But there is also room to diversify within the groups I mentioned above. Take stocks, for example. Diversification can be achieved by investing in stocks in different industries or sectors or by the size of company, such as large capitalisation, medium capitalisation or small capitalisation companies, or by categories such as growth, value or income stocks.
A bond portfolio can be diversified by the term to maturity of the bonds: long term, medium term or short term. It can also be diversified by issuer, such as government bonds or corporate bonds, locally issued or foreign-issued. The bond portfolio can also be diversified by the quality of the bonds, or by how interest is computed, such as at a fixed rate or at a variable rate.
Diversification has several advantages. It reduces the volatility of the portfolio: increases its risk-adjusted returns, and reduces reliance on one company, industry or country, while at the same time providing multiple streams of income. Diversification also makes it possible for the higher returns of some elements of the portfolio to compensate for the poor performance of other elements. It lessens the pressure to sell. Overall, it minimizes the risk of loss and thus preserves capital.
It also allows investors to invest in assets that they would normally avoid, so retirees and other conservative investors may invest a moderate portion of their funds in riskier instruments such as stocks to boost returns without increasing the risk of the portfolio.
But there are disadvantages. Diversification reduces the potential maximum return of the portfolio due to the reduced exposure to risk, and the negative performance of some instruments may negate the positive performance of others. Additionally, it may require an inordinate amount of the investor's time to manage the portfolio.
Diversification mitigates against specific risk, also called unsystematic risk, which relates to a particular company or industry. Risks cancel out each other in a portfolio that is diversified because the prices of the securities tend to rise and fall at different times and at different rates. Portfolio diversification does not, however, protect against systematic or market risk, which relates to the entire market. Thus, when the stock market declines, there is a widespread decline in the prices of stocks to different degrees regardless of the quality of the stocks.
Small investors do not have to miss the benefits to be derived from diversification. They can invest in diversified portfolios such as those offered by unit trusts and mutual funds. There are many different types. Bond funds are diversified, as are equity funds, and some funds are mixed, in that they invest in several different types of instruments.
Investors in unit trusts and mutual funds may also invest in funds offered by more than one unit trust or mutual fund to diversify by management and may invest in several different types of funds to derive better diversification benefits.
Diversification is not achieved by random decision-making and, by spreading the investment to more than one asset class, industry and country, helps to maintain performance, eliminate losses, and make returns more certain.
- Oran A. Hall, principal author of 'The Handbook of Personal Financial Planning', offers personal financial planning advice and counsel. Email firstname.lastname@example.org