By elmads

Investing is absolutely risky, as our invested capital can fluctuate at time to time, not to mention the potential economic recession which could make our portfolio returns be at the negative territory for a couple of years. That is just the risk of volatility and the economy. There are other factors that contribute to risks in investing like the interest rate, liquidity, credit, political, country risk, and company risk. I have discussed these in details in my blog titled “Investment Risks”.

Due to these various risks, investors spread their investments into different asset classes, regions, country and investment vehicle in order to reduce the risk of a complete destruction of their portfolio returns. This is called diversification of our portfolio investments

This strategy has been popular and widely practiced in the investment world. It gives comfort and confidence to investors, because the nature of it is to balance out any changes in the markets. Even if a certain asset goes down, the other asset either goes up or stays at the same price level. This in turn could dampen the blow of a tremendous downside total portfolio return.

But is diversification really for everyone? will all investors need this? is it that really important? Can we not just hold one asset forever? how does diversification work anyway? and is the saying “Don’t put all of your eggs in one basket” True?

The answer to those questions will always depend on you, but before you could answer that, you first need to understand Diversification.

Diversification strategies

1.) Industry Diversification

Company risk is the major threat into investing in a singular stock. The possibility for the management to make consistent bad decisions which can cause their company to decline overtime, a government regulation which can hinder further profitability and growth of the company, bankruptcy and fraudulent practices. These are just one of the few probabilities that make stock investing risky. Nonetheless, investing into different companies in various industries could mitigate that risk as well, such as technology, healthcare, oil & gas, and others more.

For instance, with the recent pandemic induced global recession. If you are invested in a singular airline company, then for sure your returns are still widely in the negative territory. But, if you have been holding other companies in different industries that has not been affected by the lockdown such as the technological companies, then your returns could significantly not be in the negative side when compared to, if you only have a concentrated holdings in the airline industry.

2.) Country diversification

Every country has their own risks, and this varies from minimal to high. Countries that have a conflict which involve the use of armed weapons and forces between two or more organized groups, government or non-government units are considered high risks, such as Yemen, Somalie and Syria. The more unstable a country is the more the riskier it gets in terms of investing in them. An unstable country, hinders growth of their people, government and the economy.

Furthermore, politics also plays a part in a country risk. Like imposing tariffs and increasing taxes on both companies and their residents.

The US has the largest capital markets in the world, as the number 1 economic power worldwide, they have been seen as the safest country to invest into. Yet, this does not mean that the US will not have any problems in the future that is why some investors diversify their holdings by investing into different countries that they deem will mitigate the risk of a possible shake-out or dilemma in the USA

3.) Small, Medium & Large Company Diversification

It is known that large capitalized companies are considered safer because of their scale and advantage in terms of their It is known that large capitalized companies are considered safer because of their scale and advantage in terms of their business operations. They posses great economies of scale, the pricing power, the branding and others more. These are what makes them the titans that they are today. Their competitive advantage serves as a deterrent for the small to medium capitalized companies to scale up and have the ability to compete with them.

Nevertheless, companies at this scale usually have limited growth potential, unlike their small to medium capitalized company counterpart. That is why some investors invest into these small and medium company stocks that still have a larger room for improvements, and can scale up faster than any other matured companies.

Only a few will be able to reach their full potential to become the future titan of their industry, this is where this kind of diversification can be of substantial help. By doing so, investors will be able to attain the potential upside growth of the smaller and medium sized companies, but also capture the downside risk it possess.

4.) Asset Class diversification

This is said to be the most effective strategy compared to the other types of diversification. This is due to the fact that the previous 3 categories are mostly stocks related, even including the country diversification, all because of globalization. Most countries are intertwined with each other via the international trades, foreign capital investments, and debt financing which also caused for capital markets to be somehow connected to one another. For instance, during the global financial crisis of 2008, which started due to the greed and mismanagement by most American banks. The problem trickled down to other countries because these American banks do not only operate in the US soil but also offer their services worldwide. The eurozone countries, the UK, Canada, Japan, China, South Korea, India, Australia and other more were hit hard by this catastrophic financial event. During that time, most stocks were significantly down regardless of the country you lived in.

How intertwined are the equity index of countries? Almost the same, like if an equity index of intertwined countries goes up, so does other country’s index stocks as well. That’s what globalization have done to the correlation of the equity asset index across the board.

This is why asset class diversification is better than others. Bonds and some commodities are inversely correlated to stocks. When the other one goes up, the other one goes down. Or, if both asset class goes down, one will be substantially declining while the other could be at a minimal percentage decline only. I have discussed asset classes further in my blog titled “The 5 Basic Asset Classes”.

This type of diversification is best for investors who have a low risk investment profile and for investors who will be needing their invested capital soon, like the soon to be retirees.

5.) Alternative Assets diversification

Other than diversifying in the 5 basic asset classes of cash, bonds, stocks, real estate and commodity we could also expand our portfolio outside these traditional assets.

The “other assets” are controversial assets for some people, because others consider it as a speculative asset rather than an investment asset, for example; cryptocurrencies. There are also the collectible assets such as paintings, sculptures, toys, wine, a pair of shoes, bags and loads more. These other assets are based on supply and demand, rarity, its value based on the community surrounding it and its relevance or relationship to history.

Most people diversify in other assets due to their passion, love and understanding of it. This makes their diversification effective because of their knowledge in this field. Other assets are more about pricing, this means that there is no cash that flows in and out form it, in short, it doesn’t give us any interest income and dividend income. This what makes it, for other investors a hard asset to understand and comprehend. Henceforth, a highly speculative investment for them.

The greatness of the other asset classes are its uncorrelated price movement from the 5 basic asset classes. See for example during the Covid19 pandemic induced recession, prices of Pokemon tradeable cards and even Retired Star Wars Lego Sets did not lose value at all, unlike stocks, and bonds.

What makes diversification a safe play?

Correlation

The key in diversification is the uncorrelation of assets. The more uncorrelated the assets are to each other, the more effective diversification will be. That is why Diversification by asset classes and the alternative asset classes are better than the industry, country and region diversification strategies.

Why is that you say? well because when uncorrelated assets move in different ways. When one market goes up the other market goes down, then the movements and changes in your overall portfolio returns will be not that large.

Smooths out the volatility

Diversification has less volatility compared to concentrated types of portfolio (money invested in a few assets or stocks, also called as concentrated portfolios). What is the benefit of this? it helps other investors not to panic when seeing significant price drops. Let’s face it, some investors will not be able to handle large price declines, like more than 20%.

Emotions are always the cause for investors into pull out their holdings when it goes low. Instead of doing the “buy low sell high”, they do the opposite, which is they “buy high and sell low”. Hence, losing their hard-earned capital, the initial money they placed into their investment accounts.

Capital weighting

The movement of our investment portfolio will depend on the amount of money we have invested in a certain asset. The larger we have placed into an asset compared to other assets, the more that it will have a significant impact in our overall portfolio return. To give you context, see examples below

Let’s say you have invested a total of 100,000 worth of your money in sample 1. In which, 90,000 of it is in stocks, while 10,000 invested in bonds.

After a couple of months the stock market had a decline of 20%, whereas bonds which is usually negatively correlated to stocks, increased by 5% during the same time. This will then give you an overall portfolio change of -17.50%, this is due to the fact that your investment allocation is heavily invested in stocks. If the reverse happens, the impact will also be the same, a strong incline in the stock market price will also pull your overall portfolio gains.

As shown above, we have samples 2 & 3 who both have the same factor as sample 1, such as the total amount invested, the percentage decline in stocks and incline in bonds. The only difference is the allocation amount of the 100,000 worth of capital.

The higher the weighting we have on an asset class, the more our portfolio returns will follow its performance.

Knowing the fundamental knowledge in each asset class is important, because it can give us insights which one usually does better in certain market and economic condition. This will also aid us to have a better and sound investment capital allocation, depending on our risk appetite and investment goals.

Main downside of diversification

It smoothens the ride but it does not give large investment rate of return most especially when we are holding a lot of different asset class. This is where portfolio concentration outperforms diversification, only if done right.

There are stocks that have been having stellar performance through out the years or even decades. A diversified portfolio can capture such gains when they hold that specific stock. Yet, it might not still equal the specific gains of that outperforming stock because their other holdings will pull down those returns most especially the assets that are negatively correlated to that stock. (negative correlation means that the two assets have direct inverse performance, one goes up and the other one goes down)

On the other hand, concentrated portfolios usually have a few stocks, but these stocks are held by investors who have high conviction on it. This means that they really believe that the company have great management, reinvestments, and investments which will further grow and expand in the long run. That in turn will also influence the stock market price, and have greater returns overtime. One of the best examples for this is Amazon.com, see chart below.

As depicted above, Amazon’s stock price performance (Orange Line) since 2011 have massively outperformed the SPY S&P 500’s returns (Purple line), with a difference of 1,685%! That is a complete major outperformance by Amazon. The S&P 500, is an index fund consisting of the top 500 companies in the United States of America, which Amazon is also included in that index. Nonetheless, the S&P 500 index only weights Amazon at a less than 10% of their overall holdings. To know more about Mutual Funds/Index Funds, see my blog titled “What are Mutual Funds?”

As you can see if an investor is solely invested in Amazon during those time periods, that investor would have crushed the returns of a diversified portfolio. Then again, not everyone will have the passion and love for investing, because these concentrated portfolios require a process, discipline, research, study and love for the game. This is the reason why diversification is pushed as a strategy for most people in the world. It is not because individuals do not have the capacity to do this, it’s just that only a few people will be willing to do the required work and have the passions for it.

To sum it up

Diversification is important not only for novice investors but also for the professional investors. It mitigates the risk of volatility in their portfolio returns. Others might not agree with this idea such as the concentrated portfolio value investors, but as long as an investor will be comfortable with the returns they have and what price fluctuations they can handle, then that is the most viable investment option for themselves.

Invest in a strategy that you understand and will always be comfortable with.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.