What is Diversification?
Everyone is familiar with the idiom, “Don’t put all your eggs in one basket,” but what meaning does it hold for investors? This piece of advice suggests that one should not devote all of their efforts and resources to a single endeavor, as they risk losing everything. This brings us to diversification!
Diversification is the allocation of a portfolio’s resources or capital to a variety of investments. Diversification’s ultimate objective is to reduce portfolio volatility by offsetting losses in one asset class with gains in another asset class. Similar to the idiom, investors should not invest their entire portfolio in a single asset class, but rather in a variety of assets.
Why is diversification important though? Diversification’s primary purpose is to help eliminate unsystematic risk. Unsystematic risk is a risk that is unique to a single company or a small group of companies and does not affect the market as a whole. As a result, when a portfolio is well-diversified, the positive results from investments that have strong performance compensate for the negative results from investments that have poor performance.
What are Ways to Diversify?
So then how does an investor make sure they allocate their portfolio so that it is well-diversified? One way is knowing how one asset differs from others, which includes the style, size, location, sector, and class of asset in the portfolio. This is where the table below comes in handy since it explains the various ways in which assets might vary.
Types of Diversifying | Explanation |
|---|---|
Asset Style | Investing in the stocks or bonds of companies at different phases of their corporate lifecycle can provide diversification. Newer, rapidly expanding businesses have distinct risk and return characteristics compared to older, more established businesses. |
Asset Size | The past shows that market capitalization, which measures the size of a company, is a source of diversification. In general, small-cap stocks have higher risks and returns than those of larger, more stable companies. |
Asset Location | The location of a business can also be a diversification factor. In general, locations have been divided into three categories: companies based in the United States, developed countries, and emerging markets. |
Asset Sector | Diversification by industry is an additional essential method for mitigating investment risk. Investing in the stocks or bonds of companies in a variety of industries provides substantial diversification. |
Asset Class | Lastly, one of the most important decisions made by investors is how much capital to allocate to stocks vs bonds. The decision to allocate a greater proportion of a portfolio to stocks as opposed to bonds increases growth, but at the expense of greater volatility. |
What does the Data Show?
Diversification may sound too good to be true in theory, but how does it hold up in practice? The following plots show various portfolio combinations to illustrate the multiple ways to diversify.
The plots compare returns for multiple equities (Walmart, Apple, Facebook, Carparts.Com, Verizon, Abbott, Google, and 20-Year Treasury) and various portfolios (Style, Size, Location, Sector, and Class) containing two of each equity. Let’s analyze what the five plots demonstrate.
It is evident that diversification plays its role by reducing some of the volatility in the returns of the two equities while outperforming at least one equity at all times. This lines up perfectly with what was mentioned above stating “Diversification’s ultimate objective is to reduce portfolio volatility by offsetting losses in one asset class with gains in another asset class.”
This is precisely what occurs in the five plots and demonstrates why diversification is essential when making financial decisions. However, diversity is not only about selecting assets of various styles or sizes. It also boils down to correlation (click here to learn more!). Correlation helps analyze the relationship between the movements of two assets. In our case, each asset correlation is between -0.17 to 0.60. Negative to low correlations demonstrate the capabilities of diversification, by reducing the overall portfolio volatility.
Diversification plays a critical part in investment decision-making, and understanding the many ways in which it affects how each asset differs can be crucial in uncertain times.