Portfolio diversification is a fundamental investment strategy. That doesn't mean it comes built-in — the investor must still employ it. Properly implementing portfolio diversification can help protect an investment portfolio.
But how? This article will look at how portfolio diversification adds a layer of protection to any portfolio.
The Undiversified Portfolio
To understand how diversification protection works, let’s first see what happens to a portfolio with no diversification.
A portfolio that lacks any diversification is one made up of similar investments. The prices of these investments tend to move together. These investments don’t have to be within the same industry for their price movement to be related. There can be other complex factors that create similar price movements.
Correlation Of Investments
When we say similar price movements, the underlying reason for this is correlation. If two investments have positive price correlation (i.e., close to 1.0), their prices will move nearly in-sync. Uncorrelated investments have correlations near zero, and investments that move in opposite directions have negative correlations.
When the prices of correlated investments within a portfolio fall, we should expect the portfolio to lose value as it draws down. The portfolio has no way to protect against this drawdown since everything in it is losing value.
Weight of Investments
In another scenario, a portfolio has uncorrelated investments, which is a step towards portfolio diversification. However, the investor has placed 80% of his holdings in one investment. This means the portfolio is overweight in that one investment. Whatever happens to that investment will have an outsized impact on the portfolio. If this one large holding draws down in price, the overall portfolio will drawdown with it.
To counter this scenario, it’s important to properly weight investments within a portfolio so that no single investment has the potential to cause adverse effects on the portfolio.
Now that we can see two components of portfolio diversification are the correlation of investments and their weightings, let's put them together to understand how diversification can protect a portfolio.
Protection Through Diversification
Correlating investments and weighting them will help manage the impact of any single investment on the overall portfolio. That’s how diversification can help provide portfolio protection. When we say protection, we’re referring to a drawdown in the portfolio’s value.
Does diversification mean the portfolio is fully protected? No, but diversification has shown to be a useful investment strategy for many scenarios.
Deciding on the weight of investments within a portfolio can be tricky. One investor might decide that ten investments will each carry a 10% weight. Another investor with the same investments might decide that two carry 15% weight while the remaining eight carry 8.75% each.
Is either investor right or wrong? That’s a difficult question to answer and would take analyzing the portfolio in more depth to fully understand which weighting is appropriate.
In the above example, both investors haven’t grossly overexposed themselves to any single investment. That is the key interpretation with weighting. Weighting a portfolio involves using portfolio analysis software. Such software is available for equity-based (i.e., stock market) investments but not so much for real estate. Most financial advisors have access to portfolio diversification software.
Companies such as Realized are working on a more quantitative approach to real estate investment analysis, similar to what is already available for more traditional investments.
Without portfolio analysis software, real estate investors can still work with experienced real estate investment firms to get feedback on their portfolio diversification.
Those real estate investors who wish to eye-ball it may want to consider the following diversification factors:
- Potential growth of the area
- Gentrification trends
- Trends in local and state regulations
- Property class
- Property type
For example, investing in five single-family homes within the same neighborhood is not diversification. Investing in several different property types and classes that are in different locations is heading down the right path for diversification.
Real estate investors can’t really apply exact correlations to real estate properties. But they can consider similarities based on the above bullet points. From there, investors can weight their properties to ensure the portfolio is not overly allocated to a single property or properties.