What is Diversification?
Diversification is a risk management strategy that involves splitting up your investment portfolio into different types of assets that behave differently, in case one asset or group declines.
🤔 Understanding diversification
Diversification in finance is a method of trying to protect an investment portfolio by reducing exposure to the risks associated with any single asset or group of assets. A diversified portfolio includes different types of investments that typically respond differently to the market. The positive performance of some assets should offset the negative performance of others. A diversified portfolio may contain stocks in companies across a variety of industries and geographies. It may also hold an array of asset classes, such as stocks, bonds, cash, and real estate. How you choose to diversify your assets depends on the level of risk you feel comfortable with, your financial goals, and your investing timeline.
A balanced, diversified portfolio may have 35% in US stocks, 40% in bonds, 10% in short-term investments, and 15% in foreign stocks. The stocks may include both large-cap stocks (companies whose outstanding shares exceed $10B in value) and small-cap stocks (companies whose outstanding shares are valued between $300M - $2B). The portfolio may also be spread across different market sectors, such as energy, technology, and healthcare.
Diversification is like putting your eggs in different baskets…
Diversification involves owning assets that are not closely connected or affected by the market in the same way. By splitting up your investments, you limit your exposure to risk. So if one basket falls, breaking all the eggs inside, the eggs in the other baskets will hopefully remain unharmed.
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- What is diversification in finance vs. economics vs. business?
- What are the advantages of portfolio diversification?
- What are the disadvantages of portfolio diversification?
- What are the types of portfolio diversification strategies?
- How do you tell if you’re diversified?
- How to calculate variance and standard deviation
- What is Modern Portfolio Theory?
What is diversification in finance vs. economics vs. business?
In finance, diversification is about protecting your investment portfolio. It involves holding different types of investments across various sectors, geographies, and asset classes to lower your overall risk. The rationale is that, even if one investment fails, your other assets won’t, giving you a higher expected return than if all your investments simultaneously collapsed.
Diversification in economics suggests that a nation’s economy should not depend on a small number of products or a single industry. For example, a country should not rely exclusively on oil production. Instead, it should diversify into other sectors, such as agriculture and manufacturing.
The goal of economic diversification is to lower risk and volatility in the economy. For example, when an earthquake hit Turkey in 1999, employment in its agriculture and construction sectors fell, while service employment rose. By having these diverse sectors, the economy suffered less than it would have if it solely relied on construction.
In business, diversification is when a company builds new products and branches out into new markets. The hope is that if one enterprise takes a hit in the market — because of an economic downturn or change in consumer preferences, for example — the other products or services should offset the losses. For instance, Disney started as an animation company but diversified into theme parks, cruise lines, resorts, and on-demand video streaming. If tourism drops, it will likely reduce theme park revenues, but demand for the streaming service may increase.
What are the advantages of portfolio diversification?
Every investment comes with some level of risk. For example, a new competitor may affect the earnings and market share of a company you’ve invested in. Or a regulatory change, such as a new federal law, could shift sales across an entire industry.
Even though risks are unavoidable in investing, you may be able to reduce your exposure through diversification. When your funds are concentrated in just a few companies, sectors, or places, you’re more vulnerable to your investments experiencing losses at the same time. If you spread out your holdings, when a single company or industry experiences an event that affects an investment’s growth or profit, the rest of your portfolio is more likely to remain unharmed.
Another benefit of diversification is more opportunities to profit. It’s possible to invest in stocks or assets that tend to move in opposite directions. So while one stock may drop in value, another may increase, potentially more than offsetting your loss.
What are the disadvantages of portfolio diversification?
Diversification can also limit your potential for profit. If one company or industry performs exceptionally well, you would earn a higher rate of return by choosing it as your only investment than by having a diversified portfolio. Lower risk means lower potential reward — Of course, this is the trade-off for lower potential losses.
Having a diversified portfolio usually requires spending time and effort to maintain and rebalance your assets. This also may mean higher transaction costs and a more complicated portfolio.
What are the types of portfolio diversification strategies?
There are six main ways to diversify your portfolio. You don’t need to apply all the strategies at once. Keep in mind that true diversification means you will have a balance of winning and losing investments at any given time. So you may end up hating some of your investments, but you won’t hate your portfolio.
Individual company diversification
Many investors dream about investing in one company that later explodes. Unfortunately, that can result in huge losses if that company fails. Instead, it’s a better idea for most people to invest in several different companies.
One way to invest in many companies at once is through an exchange-traded fund (ETF). ETFs let you own a basket of stocks, instead of shares in a single company. For example, the SPDR S&P 500 ETF tries to track the performance of the S&P 500 Index, which includes 500 large-cap US stocks across 67 industries.
On top of investing in different stocks, consider diversifying across sectors and industries. Many investors tend to lean towards one sector, depending on where they live. For example, people in the western part of the US tend to invest heavily in technology, whereas people in the Northeast generally prefer financial companies.
Industry allocation (also known as sector allocation) protects your portfolio if one industry fails. So if energy companies suffer, the profit from your financial stocks can help you avoid a total loss.
The Global Industry Classification Standard (GICS) — a standardized system for classifying equities — includes 11 sectors: energy, materials, industrials, consumer discretionary (goods and services that people want but don’t need), consumer staples (goods and services that consumers need), health care, financials, information technology, communication services, utilities, and real estate. Diversification would involve holding assets across more than one of these sectors.
Asset class diversification
Asset classes are categories of financial products, such as stocks, real estate, and bonds. Each asset class generally performs differently in an economic cycle. For example, stocks may offer long-term gains in a booming economy, while bonds typically do better in a recession.
Some investment vehicles come with a measure of diversification. For instance, a mutual fund is a professionally managed portfolio that typically consists of stocks, bonds, and other securities.
There are five main asset classes:
- Stocks or equities. These are shares of publicly traded companies.
- Bonds or fixed-income investments. These are debt securities with a fixed rate of return.
- Cash or cash equivalents. These include money market funds, certificates of deposit (CDs), and US Treasury bills.
- Real estate or physical assets. You can invest in tangible assets, such as property or artwork.
- Futures or financial derivatives. You can purchase investments based on an underlying asset, such as buying and selling cheese using a futures contract.
Some assets may fall into several classes. For example, gold is a tangible, physical asset. But it’s also a commodity often traded using futures contracts or options.
Other alternative asset classes include cryptocurrencies and venture capital. A sample portfolio for a conservative investor might have an asset allocation of 50% bonds, 30% short-term investments (such as CDs or Treasury bills), 6% foreign stocks, and 14% US stocks. On the other hand, an investor looking to grow (and also take on more risk) might allocate 49% to US stocks, 21% to foreign stocks, 5% to short-term investments, and 25% to bonds.
Your asset class allocation will vary depending on your financial goals, how soon you want to reach your targets, and your risk tolerance.
Within an asset class, you can diversify your portfolio even more. For example, you might vary your investments based on exposure to risk, your own financial needs, or your comfort with volatility.
Bonds have different credit ratings that represent the creditworthiness of the bond issuer. For example, a government bond is often less risky and has a higher credit rating than a corporate bond.
Similarly, stocks also have different characteristics, such as company size and market capitalization (the dollar value of a company’s outstanding shares) that can affect risk level.
Most investors prefer trading stocks on domestic stock exchanges, such as the New York Stock Exchange for US investors. Geographic diversification encourages investors to break away from this “home country bias” by entering global markets and buying foreign securities.
By diversifying your investments across different international markets, if the economy of one country fails, your portfolio will have a buffer. One way to invest internationally is to trade in foreign exchange, or global currencies. Historically, the performance of forex markets doesn’t correlate with that of traditional asset markets. You can also invest in exchange-traded funds with an international focus or buy stock in US-based companies that do most of their business overseas.
This diversification strategy involves investing gradually over a long period of time, rather than investing a lot at once or for a short time. The idea is that holding an investment for a longer period can reduce its volatility, enabling the investor to weather short-term ups and downs. The stock market, for example, has historically trended upward over the decades, despite periods of decline. The effectiveness of this investment strategy is still much debated. At the very least, time diversification can help avoid the problem of lousy timing when investing a lump sum.
How do you tell if you’re diversified?
The basic principle of diversification is that your investments are unlikely to simultaneously move in the same direction. If you look at your portfolio and see that some of your investments are going up while others are going down, you may have some diversification.
Financial advisors and portfolio fund managers often use a statistical measurement known as “portfolio variance” to measure diversification. This number looks at how much your investments move together. A diversified portfolio has assets with low, inverse, or no correlation to each other. So when one goes up, others are unaffected or may even go down.
You can also measure your portfolio’s risk level by calculating the standard deviation (how spread out numbers are from the average). The standard deviation of a portfolio is calculated by taking the square root of the variance. The higher the standard variation, the more volatile and the portfolio is. Periodically checking your portfolio variance and standard deviation can help track the level of risk in your portfolio.
How to calculate variance and standard deviation
The variance of your portfolio is a weighted combination of each individual asset’s variance, adjusted by their covariances (how closely two variables move or change together).
For a two-asset portfolio, you’ll need five variables:
w1 = the first asset’s portfolio weight (the percentage that one asset takes up out of the entire portfolio’s value) w2 = the second asset’s portfolio weight σ1= the first asset’s standard deviation σ2 = the second asset’s standard deviation Cov(1,2) = the covariance of the two assets
The formula for variance in a portfolio with two assets is:
Portfolio Variance = w12σ12 + w2σ22 + 2w1w2Cov(1,2)
The correlation coefficient (a number that shows the strength of a relationship between two assets), p(1,2), can be expressed as Cov(1,2) / σ1σ2. So, we can rewrite the covariance of two assets, Cov(1,2), as p(1,2)σ1σ2.
We can rewrite the portfolio variance formula as:
Portfolio Variance = w12σ12 + w2σ22 + 2w1w2p(1,2)σ1σ2
For example, let’s say a fictitious portfolio has two stocks. Stock A is worth $10,000 and has a standard deviation of 20% with a portfolio weight of 40%. Stock B is worth $30,000 and has a standard deviation of 10% with a portfolio weight of 60%. The correlation coefficient between Stock A and B is 0.70.
So for our formula, we have: w1 = 40% w2 = 60% σ1= 20% σ2 = 10% Cov(1,2) = p(1,2)σ1σ2 = 0.70 x 20% x 10%
Variance = (40%2 x 20%2) + (60%2 x 10%2) + (2 x 40% x 60% x 0.70 x 20% x 10%) = 0.01672 = 1.672%
The more assets a portfolio has, the more terms you’ll need to calculate to find your portfolio’s variance.
The standard deviation is the square root of the variance. The square root of 1.672% is approximately 1.29%. This tells us how much returns in this fictitious portfolio fluctuate from the average. Our hypothetical investor may now choose to modify his portfolio to better fit his or her risk tolerance and goals.
What is Modern Portfolio Theory?
Harry Markowitz, a Nobel Prize-winning economist, pioneered Modern Portfolio Theory (MPT). This theory states that, for every risk level, there is an optimal portfolio that gives you the best balance of risk and return. This portfolio won’t lead to either the highest returns or the lowest risk of losses; instead, it will provide the best possible balance between the two. In other words, it will give investors the highest possible return for a certain level of risk (measured as standard deviation).
This meeting place of risk and reward, where optimal portfolios can be found, is called the “efficient frontier.” You can plot the efficient frontier on a graph. Risk-averse investors like to use MPT to see how efficient their portfolio is based on where it falls on the risk-return spectrum. Diversifying your assets is one way to get to this optimal balance of risk and return.
Additional disclosure: Diversification strategies do not ensure a profit and cannot protect against losses in a declining market.
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