Diversification is often talked about in financial circles, but what exactly is it and how will it benefit you? In this post, we look at the basics of diversification and how it can positively affect your investment portfolio.

What Is Diversification?

According to Investopedia, diversification “is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk”. Diversification is essentially a risk management tool.

Diversification is not a new-fangled theory. It has been practised by humans for years. Although we don’t use the term in everyday speech, how many times have you heard the saying “don’t put all of your eggs in one basket”? Diversification is the act of putting your eggs in multiple baskets, with each basket having distinct features and uses.

What Risks Can Diversification Protect You Against?

In our post on Risk, we defined the two main types of risk; systematic and unsystematic. Diversification is primarily concerned with unsystematic risk. Unsystematic risks affect companies and industries, whereas systematic risks affect the entire market. As you can imagine, it is much easier to reduce a specific risk than it is to reduce market risk.

Having said that, I believe diversification can also be effective against systematic risk, although not to the same extent. The key point when trying to reduce systematic risk is to diversify across multiple markets or asset classes. A portfolio containing safe-haven assets like gold should perform better than a portfolio containing only stocks (even if there is a good level of diversification within the stock portfolio) in a market downturn. The goal of diversification is to smooth out the bumps in the road. Losing positions should be offset by winning positions and the entire portfolio growth curve should be smoother than an undiversified one.

Stock Market Diversification and Correlation

Most of the material you read online concerns diversification within stock portfolios. A portfolio of two or three stocks is a lot more vulnerable to shocks than one that contains 30 stocks providing the 30 stocks are not closely correlated. Correlation measures the degree to which two assets move in relation to each other. An investor who holds 30 stocks all in one industry does not have a diversified portfolio, he is open to industry-specific shocks.

As we mentioned above, the goal of diversification is to offset poorly performing stocks with those that are performing well. Let’s take a simplified example. Investor A is holding a single stock in his investment portfolio, take Ryanair as an example. Using what we know about risk and diversification we can see that he is exposed to both systematic and unsystematic risk. Poor market performance, poor company performance or poor industry performance could lose him a lot of money. In order to remedy this, he decides to invest in a second company. As he is already familiar with the airline industry and holds Ryanair stock, he invests in Aer Lingus. Has he achieved diversification?

To a small degree, he has. However, he is still exposed to market risk and industry risk. All his new investment has done is to lessen the company risk. A shock to the airline industry (Covid-19 anyone?) would still have an adverse effect on his investments. Assuming he isn’t overly concerned with market risk and wants to stick with stocks, he would have been much better off if he had chosen a company that was not strongly correlated with Ryanair and in a different industry.

The Difficulty With Diversifying

Diversification should be a cornerstone of your investment portfolio, but it isn’t always easy to achieve. For the average person, it can be difficult to keep track of one company’s performance, how on Earth could you manage 30? (A 1970 study called “Some Studies of Variability of Returns on Investments In Common Stocks” showed that a portfolio of 32 stocks could capture 95% of the benefits of owning the entire market. There is some debate to the validity of this number, in my opinion, the more high-quality stocks you own the better).

Added to the complexity of monitoring 30 or more companies, there are also additional costs involved when diversifying. The commission on purchasing a single stock will be less than purchasing 30 individual stocks. With all of the low-cost brokers operating this shouldn’t be much of a concern but is something to be aware of.

These two reasons combined are why funds are so popular with retail investors. Funds offer diversification through a single security. Index funds take this even further by replicating the entire market, resulting in maximum diversification. In the short term, diversification may reduce your returns, but over the long term, a diversified portfolio should outperform an undiversified one.

Imagine you invested €10,000 in 5 stocks, assigning €2,000 to each. Now imagine that one of those stocks doubles to €4,000 and the rest stay where they were. Your initial investment is now worth €12,000, not bad right? While a 20% return is nothing to be sniffed at, had you invested all of your money in the company that doubled, you would now have €20,000 or a 100% return. As you can see, by diversifying your upside has been limited, but more importantly, your downside has been too. You don’t need me to explain what would happen to your €10,000 if the one company you invested in went bust.

Beware The Appearance of Diversification

Before you rush in and decide to diversify your portfolio, take the following into account. This is a summation of the risk posed by subprime mortgage bonds that led to the financial crash in 2008, courtesy of “The Big Short” by Michael Lewis which I am currently reading (well worth a read, plenty of interesting characters). It also highlights the risks of perceived diversification.

During the lead up to the economic crash in 2008, banks (particularly in America) were lending mortgages to people who had very little chance of repaying the debt. In some cases, they were lending to people who did not even have to submit proof of earnings. As a result, banks had a vast amount of mortgages they were set to lose money on, so in order to reduce their exposure, they would bundle a group of mortgages into a bond and sell it to the Wall St. investment banks. These became known as subprime mortgage bonds. The bonds themselves were rated by Moody’s and S&P based on the underlying mortgages and the likelihood of them defaulting. The lowest of the bonds were rated triple-B. The rating assigned by them was supposed to reflect the risk involved in owning the bonds.

Triple-B bonds were the most likely to fail, and so attracted the highest interest rate but were difficult to sell. In order to overcome the problem of having triple-B bonds on their balance sheets, Wall St. banks combined many of these triple-B rated bonds into another instrument, called a CDO. The banks brought this new CDO to the rating agencies and put forward an argument that as these CDOs represented multiple bonds which represented multiple mortgages, they were less likely to fail due to the inherent diversification.

While this argument makes sense on the surface, it was fundamentally flawed. Although the mortgages were owned by a vast array of different people working in different industries and across different parts of America, they were all exposed to the same risks. Even though they all had different circumstances, an interest rate increase or a drop in the housing market would spell disaster. The CDO’s were comprised of the worst-rated subprime mortgage bonds, but many ended up getting a triple-A rating, signifying a low-risk asset.

This may not be the most comprehensive example of subprime mortgage bonds, or the financial crisis but it does highlight a key point. When diversifying a portfolio, you need to look at the underlying risks and not just the companies (or mortgages) in isolation. An aviation company and a hotel company might have different business models and operate in different areas of the country, but both will be impacted by a drop in tourism.

Should You Diversify?

In short, yes. Diversification, when done well, offers you protection from downside risks while maintaining the potential for upside risk. Just like the market as a whole, there is no magic formula or secret recipe you can follow to achieve perfect diversification. A well-diversified portfolio will take months or years to build, but that shouldn’t stop you.

As always, it is important to do your research before deciding on an investment, particularly when you are looking to diversify. Don’t just look at the companies on the surface, dig a little deeper to try to understand the risks the business is exposed to and how that relates to companies you already own.

The Stoic Trader

Posted in Investing, The Basics and tagged , , , , .
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