Diversification is a method of reducing the risk of our portfolio by investing in different assets. Its main objective is to improve the profitability we obtain about the risk we assume. By investing in assets that react differently to possible future scenarios, we can avoid extreme situations in our portfolio.
While diversification does not guarantee loss of money, it is one of the most essential tools we can use to boost our long-term investments’ return/risk ratio.
Different types of risk
We can distinguish between two main types of risk: diversifiable and non-diversifiable.
Non-diversifiable risk, also called systemic risk, is associated with the market. It is risk that does not affect any specific company or asset, but affects all assets in a market when it occurs. Examples of this type of risk would be increases in interest rates, inflation, wars, government changes, etc. Ultimately, we are talking about a type of risk that the investor must assume as inherent in investing activity. This risk cannot be eliminated by diversifying.
Diversifiable risk, also known as non-systemic risk, is the risk specific to each company or asset we can invest in. Common sources of this type of risk include business risk and financial risk of bankruptcy of a specific asset. As prudent investors, we can use diversification to minimize the impact these types of events can have on our overall investments.
Why should we diversify?
Wealth managers, including the likes of Ty J. Young, believe that investors should seek to diversify their investment portfolios. Young introduces the following analysis:
We have a portfolio made up exclusively of shares of companies in the tourism sector. If it is publicly announced that there will be a labor strike that affects the sector, our portfolio’s prices can fall unexpectedly.
If, on the other hand, we have added to our portfolio some shares of companies from another un-related sector (for example, technology companies, or pharmaceutical companies, etc.), the announcement of the strike will only have an impact on the part of our linked portfolio with tourism.
Statisticians speak of correlation. When the price of two assets moves in the same direction and the same proportion, we say they are correlated. Good diversification seeks to build a portfolio with assets that are not positively correlated with each other so that the volatility of the portfolio is low. As a rule, the less correlated the assets that make up our portfolio, the better. This is the same as saying that it is vital to have a diversified portfolio.
We can look for this lower correlation, or diversification, in many ways. Diversifying between different asset classes, such as fixed income and equities, can be an excellent way to reduce our portfolio’s volatility. A good mix of assets will reduce the sensitivity of our portfolio to market fluctuations.
Historically, the traditional way of diversifying our assets to avoid the volatility inherent in equities has been to keep part of our assets in fixed income instruments or guaranteed insurance contracts. The percentage of fixed income and equities that should be in our portfolio depends a lot on each case and each risk profile. The keys to making such a decision are to understand that equities have been more profitable in the long term but more volatile. In contrast, fixed income has historically been more stable but has offered worse returns. Guaranteed insurance contracts are a mix between the other two. They guarantee someone against losses, but you can still participate in more gains than a traditional CD.
How many companies should you have in your portfolio? What number gives me enough diversification?
From everything we have seen, it is easy to understand that if we are looking for a good risk/return ratio, it is better to have five companies in the portfolio than one. However, there may come a point where more companies do not necessarily bring enough benefit from diversification to justify the cost of spending time and attention on them. A portfolio with thousands of stocks can be time consuming and expensive to maintain. Fortunately, today we can use multiple assets, such as mutual funds or ETFs, to obtain extensive diversification at a meager cost.
One of the crucial decisions we make as an investor is to design a portfolio structure that suits our needs and characteristics. The degree of diversification we choose is one of the most important parts to consider. Diversification is one of the most effective tools at our disposal to control risks inherent in some financial assets and obtain a portfolio appropriate to our risk profile.