Regardless of whether you ask a novice or a seasoned veteran, almost any investor will tell you that diversifying your portfolio is important.
Diversification refers to spreading one’s holdings across different investments and/or asset classes to avoid over-exposure to any particular one.
According to finance professionals, the outcome of doing so is reduced risk as measured by lower portfolio volatility.
Find negatively correlated assets
A properly diversified portfolio contains securities that have low correlation with one another.
Suppose there are two investments within a portfolio.
If they move in opposite directions, they are said to have a negative correlation and vice versa.
A common way to diversify is to invest across asset classes, examples of which include cash, stocks, bonds, real estate, and commodities.
Different asset classes such as stocks and bonds exhibit a low, possibly negative correlation between them.
Altering their compositions will produce different risk-return profiles that are tailored to meet the goals of individuals.
Theoretically, undertaking less risk will yield lower returns.
However, investing across asset classes may help investors to reap the best of both worlds by reducing risk while simultaneously improving returns.
Other ways to diversify
Spreading out your bets within each asset class is equally important.
There are multiple ways to achieve this.
The first is sector diversification because different phases of the business cycle favour different sectors.
Size is another consideration.
The third element is geography.
Different locations exhibit varying levels of development.
During the pandemic, it was shown that investors allocated their assets across continents based on the number of infections per country to hedge against uncertainties.
Finally, investors can also factor time into their strategy.
Risk appetites and the need for liquidity change depending on which stage of life an individual is currently in.
Time horizon will thus impact what investments are suitable to attain your financial goals.
To illustrate, traditional investments like stocks and bonds are more liquid than alternative investments in real estate.
Retirees may therefore prefer the flexibility that more liquid assets provide instead of locking their net worth in illiquid properties.
Pitfalls of diversification
Even though diversification is essential for any investor, there are times when having too many holdings may backfire.
The Oracle of Omaha Warren Buffett even denounced diversification as “protection against ignorance”.
As with many things, moderation is key.
Excessive diversification has its pitfalls.
The most salient disadvantage is that diversification caps the upside potential for investors.
This is most obvious when there is a mismatch between risk tolerance and portfolio composition.
Imagine the markets are on an upward trajectory and an aggressive investor seeks to maximise returns.
Buying into the wrong basket of stocks, bonds, and liquid securities during a bullish run can cost this individual to leave more than three times the potential returns on the table.
Evidently, investors should understand how various investments affect their portfolio and ensure that each attempt at diversifying brings them closer instead of further away from their financial goals.
Since the Great Financial Crisis of 2008, the number of regulated funds worldwide such as mutual funds has increased.
Mutual funds provide varying degrees of diversification and liquidity that cater to different investor needs.
However, such funds incur many layers of fees and expenses which erode returns.
Overlaps in fund holdings also counteract the advantages of diversification.
There may also be conflicts of interest between investment platforms and investors.
For example, some robo-advisors may synthetically increase the fees incurred by pouring capital into exchange traded funds (ETF) that have allocations to the same strategy.
Furthermore, blindly diversifying can bloat a portfolio with complex instruments – a possibly self-perpetuating problem.
This is because time needs to be devoted to keep oneself abreast of the forces that change the underlying value of securities.
When investors do not understand what they are invested in, it makes rebalancing their portfolio more difficult.
Longer reaction and selling times may leave investors holding onto suboptimal assets when market conditions change quickly.
Lastly, market trends play a decisive role when rebalancing asset mix.
The extent to which investors reap diversification benefits depends on timing as well.
For instance, the addition of alternative assets like real estate or commodities can hurt returns during a credit crisis.
Also, there are years such as 2022 when the options for hedging alternatives are few and far between.
This was demonstrated in one of the largest registered losses in a 60%/40% portfolio distribution between stocks and bonds which have historically performed well.
Get Smart: Play the long game
Diversification is a double-edged sword so one should approach it systematically to improve the odds.
Start by assessing your investment objectives which in turn govern your risk appetite, time horizon, and liquidity needs.
Avoid diversifying for the sake of it and do your due diligence when in doubt.
For some of us with time constraints or are at an inflection point in life, seeking professional advice may be useful.
Ultimately, it helps to perceive investing as a long-term endeavour so refrain from being too bothered by unavoidable short-term fluctuations.
Disclaimer: Tan Ke Xuan does not own shares in any of the companies mentioned.