5 Important Facts About Portfolio Diversification You Might Be Missing
Diversification is a technique that aims to reduce risk by allocating investments across a variety of asset classes, sectors, and markets. By refraining from “putting all your eggs in one basket” and instead of holding a balanced portfolio of assets whose returns are less than perfectly positively correlated, investors can minimize portfolio variance (or risk) without sacrificing return. A stock market downturn may produce large losses for a portfolio consisting entirely of equities, while a portfolio containing a mixture of bonds, real estate, and other assets in addition to stocks would likely fare better owing to the fact that some of these assets tend to rise when stocks fall.
Most investors grasp the intuition behind diversification however many struggles to implement it properly or misunderstand some of its fine points which carry important implications for investment strategy. The purpose of this article is to highlight a few of these points so that investors are better equipped to make their own decisions when it comes to investing and risk management.
- Diversification does more than just offer protection during downturns: it provides the greatest benefit over a long-term investment horizon.
When investors consider the value of diversification they primarily think in terms of the loss-reduction benefit it offers during downturns. While diversification can certainly be a useful tool for protecting against declines, the benefits of diversification are not limited to instances where markets tank. Diversification offers benefits throughout the duration of the investment cycle by continuously stabilizing volatility and by broadening the investment universe to include alternative asset classes with superior risk-reward trade-offs, potentially resulting in higher returns. History has shown repeatedly that diversified portfolios outperform over the long run, but capturing these benefits requires that portfolios be given time so that the key fundamentals can take effect. In summary, diversification is more than just a defensive tactic used in anticipation of a downturn: it is a foundational strategy for prudent long-term investing.
- Diversification does not require extensive resources, sophisticated software, and complicated trading strategies.
Diversification is not restricted to Wall Street firms and traders with access to high-powered computing technologies and trading algorithms. On the contrary, diversification suits investors working towards defined, long-term investment objectives, as it is a strategy for achieving investment targets with a minimum degree of uncertainty rather than a method for maximizing profits in the short-term. While the language and mathematics of portfolio optimization theory may intimidate some investors, one does not need an advanced knowledge of statistics or a Ph.D. in finance to execute a successful diversification strategy. Anyone who understands the concept of spreading risk across different investments and who is willing to conduct research into non-traditional asset classes can profit from diversification.
- Diversification helps minimize risk for a given level of expected return, but it does not guarantee against a loss.
Diversification reduces risk by investing in assets across different financial instruments, industries, and other categories, however, it does not ensure full protection or prevent losses. Investors face two primary types of risk when investing. The first in unsystematic risk – the risk that is specific to a particular company, industry, market, or security, and which can be reduced or eliminated by holding various assets that respond differently to market events. The second type of risk is systematic or market risk – risk that is carried by an entire asset class, market, or economy and which cannot be reduced through diversification. Common sources of systematic risk include credit cycles, interest and exchange rates, and inflation. All investors accept a degree of systematic risk regardless of how they invest, however investors can partially cushion the impact of systematic events by expanding beyond traditional asset classes.
- Portfolios with exposure to all major asset classes are most likely to provide the maximum diversification benefit.
Proper diversification calls for exposure to all major asset classes, including real estate, commodities, and cash in addition to equities and bonds. Portfolios consisting entirely of stock and bond investments are not fully diversified, as bond and stock prices are generally correlated and factors like inflation and interest rates often impact their values in a similar way. Alternative assets exhibit lower correlations with stocks and bonds, and real estate, which historically shows almost zero correlation to stocks and bonds, is an essential component of diversified portfolios, providing the potential for stable income, capital appreciation, and inflation protection. US private real estate improved the risk-adjusted performance of traditional stock and bond portfolios over a 20-year time period (1999-2008) reflecting its low correlation and reduced volatility.
- Diversification can enhance portfolio returns by expanding the range of investment opportunities and providing the foundation for more aggressive investments.
Diversification opens the doors to alternative asset classes and unique investment opportunities. Investing alongside specialized private equity managers, for instance, allows investors to potentially capture market inefficiencies that are less common in traditional asset classes, namely publicly-traded stocks and bonds. In addition, a balanced and diversified portfolio creates the foundation to support more aggressive and riskier investments that offer higher returns. Research suggests that, on average, investors with more than 15% of their capital allocated to private investments consistently outperform over the long term. The Yale Endowment Fund, which allocates a minimum of 20% of its capital to real estate and other private investments, is just one example, outperforming the broad market by 7% per year over the past two decades.
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