Investors can protect their portfolios against risk in several ways. One significant way is by diversifying. Portfolio diversification is a great strategy for anyone looking to reduce risk on their investment for the long term. The added security can be measured by the increased profits a diversified portfolio brings in compared to an individual investment of the same size.
How does portfolio diversification work?
In portfolio diversification, an investor opts to include various types of securities and investments from different issuers and industries. The idea here is to invest in many areas so that even if one fails, the rest will ensure the portfolio as a whole remains secure.
The process of diversification also involves investing in assets that are not significantly correlated to one another. The idea here is to pick different asset classes and securities with different lifetimes and cycles to minimize the impact of any negative conditions on a portfolio. If the investments in a portfolio are highly correlated, no matter how diversified the types of assets are, they may be vulnerable to the same risk and, therefore, the portfolio will react in unison.
Correlation is the measurement of the degree or extent to which two separate assets move together, according to Investopedia. The maximum amount of correlation possible is 100%, which is expressed as 1.0. When two assets have a 1.0 correlation, when one moves, the other always moves. Although the amount of these assets’ movement may differ, a 1.0 correlation indicates that they always move in the same direction together.
When two assets move in opposite directions, their correlation is negative. If they always move 100% of the time in opposite directions, their correlation is considered -100% or -1.0. So, when examining assets’ correlation, the closer to -1.0, the greater is the impact of diversification.
What are the types of portfolio diversification?
There are two forms of diversification: naïve and optimal.
In naïve diversification, an investor simply chooses different securities at random, hoping it will lower portfolio risk due to the varied nature of the selected securities. Naïve diversification is not as sophisticated as diversification methods that use statistical modelling. Despite its random nature, when it is dictated by experience, careful examination of each security and common sense, it can be an effective strategy for reducing risk based on the law of large numbers.
Optimal diversification takes a different approach in creating a diversified portfolio. Its focus is on finding assets with a not-perfectly-positive correlation with one another. This helps minimize risk in fewer securities which, in turn, can also help maximize return. With this approach, computers run complex models and algorithms in an attempt to look for the ideal correlation between assets.
Although diversifying becomes less efficient under extreme conditions, typical market conditions will almost always mean that a well-diversified portfolio can significantly reduce the risk investors are facing. As such, it is important to continually strive to optimize a portfolio’s diversification to maximize the protection it offers an investor’s investments. It means performing due diligence to locate assets that do not move in correlation with one another, as opposed to naïve diversification.
The supposed benefits that complex mathematical diversification provides, however, are relatively unclear. How to apply and operate such complex models is even more unclear for average investors. Indeed, computerized models can appear convincing and impressive, but that does not mean they are more accurate. Ultimately, whether or not a model yields results is more important than if it is based on a highly complex algorithm.
Thus, both types of diversification can be effective, simply because diversification is the result of spreading investable funds across different assets.
What are the options for portfolio diversification?
Investors with limited means or who prefer uncomplicated investment scenarios can choose a single balanced mutual fund and invest all their assets in that fund. But investors with large sums of money often need strategies designed to address more complex needs like minimizing capital gains taxes or generating reliable income streams. While investing in a single mutual fund provides diversification among the basic asset classes (stocks, bonds and cash), diversification opportunities go beyond these categories.
With stocks, investors can choose a specific style, such as focusing on large, mid or small caps. Stocks are additionally categorized as growth or value in each of these areas, wherein the additional selection criteria include choosing between domestic and foreign stocks.
Aside from the variety of equity investment choices, bonds also offer diversification opportunities. Investors can choose long-term or short-term issues, high-yield or municipal bonds.
While stocks and bonds represent the traditional portfolio construction tools, alternative investments – such as real estate investment trusts, hedge funds, art, and precious metals – provide the opportunity to invest in vehicles that do not necessarily move in tandem with traditional financial markets.