Why it Pays to Diversify Your Portfolio

By Chika

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Last Updated: August 18, 2021

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Investing replicates many of the principles we hold dear in life. For example, the maxim, you reap what you sow is duly replicated in investing. Patience as a fulcrum for achieving your desired goals is also found in investing when people are told that spending time in the market is better than timing the market.

 

 Another value that has trickled down into the world of investing is diversification. We are all familiar with the saying: Do not put all your eggs in one basket. This aptly speaks of portfolio diversification as a way of protecting the value of your assets and preventing them from being too exposed to a particular sector which increases risk and potential losses. It is a way of balancing risk and reward in your portfolio. While diversification is not fool-proof against potential losses, it can reduce its severity.

 

While many are knowledgeable of the benefits that come with diversification, not many know how or when to diversify. This article explains how to diversify your portfolio in detail. Let's dive in.

 

What Is Diversification?

Diversification is a risk mitigation technique used by investors and asset managers. The aim is to spread the allocation of capital across different asset classes so that the risk/volatility/losses in one asset can be offset by the reward/stability/profits in other assets. As such, this brings a sort of balanced composition to your portfolio.

 

Diversification can be used to taper the effects of unsystematic risk. Unsystematic risk is the type of risk that affects only one company or a small group of companies. As such, when a portfolio is well-diversified, assets that have underperformed are compensated by the overperformance of other assets.

 

Diversification does not mean spreading your capital among different asset classes. You have to ascertain the level of correlation among the different investment vehicles. In the case of diversification, you have to go for investment vehicles or assets that are inversely correlated. This implies that a rise in one asset would lead to a decline in the other assets. Going for assets that are inversely correlated helps you to hedge against potential losses and reduces volatility in your portfolio.

 

Strategies of portfolio diversification

#1 Diversify across asset classes

One strategy of portfolio diversifying is by spreading your capital across different asset classes. This implies investing in assets such as Equities, fixed income investments, commodities, cryptocurrencies, or cash. This helps to preserve the value of wealth at any given time because the financial market panders to any of these assets at any given time depending on the macroeconomic condition. 

 

For example, in periods of low-interest rates, while equities would perform well, fixed income instruments tend to underperform, similarly in periods of rising inflation, while equities underperform, assets like real estate and commodities tend to outperform. By diversifying your portfolio across these asset classes you can appropriately hedge your investment.

 

#2. Diversity across sectors and industries

If you are invested in a particular asset like stocks or bonds, you can diversify across sectors or industries within the asset class. For example, if you are invested in equities you can diversify your portfolio by investing in growth or value stocks. You may choose to invest in energy, industrials, utilities, consumer staples, consumer discretionary, or tech stocks. If you are investing in bonds, you can choose to diversify by investing in bonds that have different maturities (2-year, 10-year, or 30-year) or issues (government, municipal or corporate). If your forte is indexes (Russell 2000, S&P 500, Nasdaq), then you can diversify using index funds.

 

#3. Diversify by location/market

You can also choose to diversify across locations or markets. You can choose to hold investments in developed markets and also in emerging markets. You can also choose to structure your portfolio by region for example by investing in European, Asian, or North American assets. Sound knowledge of geopolitics, including country-specific risk and drivers, is needed in this case.

 

Factors to consider when diversifying

There are certain factors to consider when diversifying. These are:

 

Risk appetite: Your risk appetite determines how you allocate capital across assets and sectors. Those with a high-risk appetite tend to allocate more capital to risky assets such as equities, or cryptocurrencies. Those who want the safety of their capital tend to tilt towards fixed income instruments which would guarantee the safety of their capital.

 

Time: Your investment horizon also determines how you diversify your portfolio. If you are younger, there is a higher probability that you would want to invest in more risky assets and those whose benefits are far out into the future such as real estate. However, if you are older or closer to retirement, you may seek the safety of bonds, treasury bills because there is less room for mistakes at this point.

 

Macroeconomic condition: the prevailing economic condition determines the weight you assign to assets in your portfolio. If inflation is rising, you would be focused on present benefits rather than future ones because the value of money tends to erode in the future. As such, you may want to invest in real estate, precious metals, or value companies. However, in periods of low interest rates, you would find growth stocks appealing. Similarly, in periods of scarcity of supply chain constraints, investing in commodities would be the most logical step.

 

Measuring portfolio diversification

 

Modern portfolio theory stipulates that for every holding in a portfolio, there should be an optimized combination to provide the greatest return for a given level of risk. This implies that weighing the holdings of your portfolio should be structured in such a way that when combined, they produce the greatest returns for your portfolio at a given time. 

 

But how do you measure your holdings in your portfolio? How do you determine the amount of capital that should be allocated to each asset in your portfolio? You can decide to weigh them equally by investing the same amount in each asset class or you may decide to weigh them by using parameters such as volatility, revenues, sector, market capitalization, trading volume, short interest, etc. This implies you assign capital to each asset based on these parameters.

 

 For example, the more volatile asset/sectors would have lower amounts invested in them in comparison to less volatile ones. However, this type of weighing needs serious knowledge of statistics and quant. If you are averse to calculations, you can use your discretion, but this may not optimize your portfolio to bring the expected returns.

 

Conclusion

The importance of diversifying your portfolio cannot be underscored. It protects your investments against volatility and preserves wealth in the long run. It also ensures that you have a plan b in case things go south in any asset. However, remember that diversification cannot prevent losses, it can only be used to reduce or manage them.

 

Photo by Joshua Mayo on Unsplash

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