What is Portfolio Diversification and Why is It Important?

What is Portfolio Diversification and Why is It Important?

Posted by on Mar 4, 2021

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Imagine buying several similar property types in the same area of town. These properties make up your entire portfolio. At this point, your portfolio is highly dependent on the outcome of properties in this one area of town. That’s another way of saying there’s increased portfolio risk due to the concentration of properties in one area. 

If, for some reason, properties in the area begin losing value and people start moving out, your portfolio is likely to suffer. This is the proverbial putting all of your eggs in one basket.

Instead of creating a portfolio with the same types of investments vulnerable to changes in one specific area, diversifying across properties can help manage risks. To see why we’ll take a closer look at portfolio diversification and understand what makes it tick.

Defining Portfolio Diversification

Portfolio diversification is well defined by Harry Markowitz in his Modern Portfolio Theory framework. Diversifying a portfolio means choosing asset classes that are uncorrelated to each other. By being uncorrelated, the prices of these assets move in different directions or intensities within the same direction. In theory, uncorrelated assets shouldn’t all go down simultaneously.

Let’s look at an example of diversification by comparing two portfolios. To do this, we’ll factor in beta, which is the correlation of a stock’s price movement to a specific market, such as the S&P 500. 

If a stock has a beta of 1.0, it moves with the market. A beta greater than 1.0 means the stock is more volatile than the market, and its moves are amplified compared to the S&P 500. A beta of less than 1.0 means the stock is less volatile than the market.

Portfolio 1 has three high beta stocks. As the market loses 3% over a week, we’d expect these stocks to lose more and vice versa. Portfolio 1 is not diversified because all three stocks have similar correlations. This is considered a high-risk portfolio, which means expected returns are likely to be higher.

Portfolio 2 also has three stocks but with different betas — high, low, and 1.0. This portfolio is designed to be more (price) stable than Portfolio 1 since a price movement in one stock will be offset or less affected by price movements in another stock. This is a lower-risk portfolio and is likely to have lower expected returns.

From the above examples, we can see some of the potential trade-offs when managing correlations. A portfolio that isn’t diversified has higher risk with higher expected returns. A more diversified portfolio has reduced risk but also reduced expected returns. 

It’s important to point out that diversification only reduces idiosyncratic risk. That’s the risk associated with a single stock or property. Diversification can’t reduce systemic risk, which is overall market risk.

Why is Diversification Important?

Diversification is a risk management method. If two stocks are uncorrelated, the risk of holding those two stocks can be managed. The reason is stability in price movements. As one stock goes down, the other moves less down, moves up, or basically doesn’t move. It all depends on correlations. 

Holding uncorrelated stocks doesn’t mean the portfolio can’t experience a drawdown. It certainly can. But through diversification, the hope is that the drawdown should be less than a portfolio that isn’t diversified.

How to Diversify a Portfolio?

As mentioned above, choosing uncorrelated assets is a component in diversifying a portfolio. Another is to weight each asset so that no one asset is so overweight that its price movements greatly impact the portfolio.

Portfolio diversification can get complicated as more assets are added to a portfolio. This can make it difficult for an inexperienced investor to properly diversify their portfolio. Even if they have uncorrelated asset types, they may not have proper asset weights, defeating the purpose of diversification. 

It’s best to work with your financial advisor when diversifying a portfolio. In addition to diversification, your advisor will consider your financial goals and risk tolerance, which are all essential to good investment decision making.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.

Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.

 


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