Diversification is the process of spreading your investments around to more than one type of assets. Essentially, it is to “place your eggs into different baskets”. This practice has one important role in your investment strategy: to reduce risk.
We all know it is a good thing to have, but how do we diversify our portfolio? Let’s look at the different ways of diversification.
Asset class diversification
Different assets (stocks, bonds, real estate, cash) behave differently when the market shifts. For example, a simple announcement by the Federal Reserve that interest rates will increase can easily cause stock prices to drop. On the other hand, real estate prices are not as volatile and would take a much longer time to adjust as they are much less liquid than stocks.
Typically, in a recession, bonds provide protection while in an economic boom stocks are likely to perform well. Within each asset class, there are also different strategies to gain exposure.
Mixing industries in your portfolio will make it more robust. This means that the overall portfolio returns will not suffer so much from an economic shock.
The reason is simple – different industries perform differently in various economic situations.
It is important to diversify away from the industries you are most familiar with. For example, you can create a mix of different companies that have businesses in different industries to invest in.
Specifically for real estate investments, sub-sector diversification means investing in different types of property. This includes residential, commercial, office, etc.
Studies have shown that during the Global financial crisis, residential and healthcare properties had the most favourable risk-adjusted returns, while office and industrial property stock prices suffered the most. Diversification across sub-sectors would have helped a portfolio containing the poorer performing stocks or property to suffer less during the crisis.
One way to do this is to invest in a Real Estate Investment Trust (REIT), which are companies that invest in property and usually diversify across property types and sub-sector.
Research shows that diversifying internationally is beneficial for your portfolio. Again, different economies react differently to situations and some outperform others.
You should not rely so heavily on a single country’s asset market to get returns. Diversifying globally may or may not increase your returns, but it definitely reduces risk.
We also need to avoid the “home country” bias, a famous cognitive bias that causes investors to prefer owning assets of their home country. Because of this, investors consistently own too high a percentage of investments based in their own country and fail to sufficiently diversify internationally.
So how does diversification reduce risk?
The main risk that diversification reduces is called “unsystematic risk” or “specific risk”. This risk is specific to a company or an industry.
For example, if you have stock in a healthcare company, and one day the employees decide to go on strike, you will bear the risk of this company’s stock price plummeting. It is almost close to impossible for the investor to predict how consumers and other stakeholders would be affected during this unexpected event.
Or for example, we all remember that when United airlines received bad publicity in 2017 where a passenger was forcibly removed from a plane, its stock dropped by USD $1.4 billion. This drop in stock prices might be detrimental to an investor’s portfolio if it was a large contributor to the portfolio returns.
The main goal of diversification is not only to maximise returns but to limit the risk of a portfolio. The important thing is to diversify with uncorrelated assets.
This means that the more different of ‘far away’ the assets are to the rest, the more diversified it is. This includes asset class, industry, geographical diversification as mentioned above.
So if the investor of United Airlines (United Continental Holdings) had diversified to companies from the oil industry or the technology industry, for example, he would spread out the aviation industry-specific risks.
Even with a well-diversified portfolio, we cannot possibly eliminate all risk. Another risk always remains and it is called “market risk”.
“Market risk” is the uncertainty that a market faces as a whole in reaction to macroeconomic events like an increase in interest rates, presidential elections, wars, etc. When such events occur, the portfolio will inevitably bear its consequences. Diversification does not remove this form of risk.
Other important things to consider when thinking about your asset allocation:
- The time which you want the money back
- Your risk tolerance.
Let’s say you are looking at a retirement investment, and you want to take out the money 30 years from now. You may be able to take on additional risk as you are aiming for long-term growth. Having long-term investment plans means that you have time to recover losses from short-term market changes.
The longer you plan to hold the investment, the higher your risk tolerance can be.
An important thing to note is that you should not take on investments that bear a risk higher than your risk tolerance.
With that being said, this is a general way of looking at allocation; there are many ways to calculate expected returns and risk and mathematical techniques to decide if you should take on a new investment when diversifying your portfolio.