Five things you need to know about diversification

Diversification and asset allocation are simply about not putting all your eggs in one basket.

Although asset allocation is widely associated with Professor Harry Markowitz’s work on modern portfolio theory published in 1952, the idea is “as old as the hills”, as the saying goes.

The ancient book of Jewish laws and knowledge, the Talmud, said: “Let every man divide his money into three parts, and invest a third in land, a third in business and a third let him keep in reserve.” Translated into modern investment assets, that becomes a portfolio of stocks, property, and bonds.

These days, we have many more asset classes to achieve that diversification, such as stocks, bonds, commodities, gold, hedge funds, private equity, etc. So, here are the 5 things you need to know about diversification.

Spreading your risks

The idea boils down to the old wisdom of spreading your money over a range of assets and securities. For example, high quality government bonds have historically been regarded as a safe haven for investors in times of fear.

Thus, when risk assets like stocks are sold down during times of market distress, investors tend to buy quality government bonds, which in turn drive up the bond prices. In this instance, declines in stocks are offset by gains in government bonds.

Citing another scenario, sometimes when inflation becomes a concern, stock prices might fall due to worries that the former may move up interest rates. Nonetheless, the same dynamics might also raise commodity prices, which can help a diversified portfolio offset some of the losses in stock prices.

Types of diversification

Broadly, there are a few major types of diversification. Among which, asset class, geographical, sectoral and securities or stocks diversification are the most typical.

Asset class diversification is where you have a portfolio that combines different categories of assets. The asset classes used in typical portfolios are stocks, bonds, commodities, hedge funds and cash. Beyond that, you may diversify further within each asset class, spreading risks over different geographies.

Take for instance, you can spread your risks within stocks through countries and regions, e.g. the United States, Europe, Japan, Asia ex-Japan, and Emerging Markets being typical geographic allocations.

Bonds may also be further diversified by sectors such as government, investment grade corporate bonds, and high yield corporate bonds. Stock or securities diversification is where you spread your risks over a large number of stocks or bonds, so that a failure in any one would not be catastrophic for your portfolio.

Using correlation in spreading risk

A correlation describes the relationship in the movement of prices of different asset classes. A correlation coefficient of +1 suggests a strong positive correlation, implying that both the asset classes move in the same direction and by a fixed proportion. A coefficient of -1 indicates a strong negative correlation, that is, the two asset classes move in opposite directions by a fixed proportion. A coefficient of zero suggests no correlation at all.

To use correlations in spreading risk, look at the assets’ long-term correlations. There have been criticisms of asset allocation strategies in recent years because the various asset classes have been more closely correlated than had been the case historically.

Arguably, part of that could be due to quantitative easing, where central banks create huge amounts of new money to buy assets, particularly bonds, since the global financial crisis of 2007-2008. This is why a longer-term view of asset correlation is necessary. To achieve a diversified portfolio, you need to have asset classes with either negative or low correlations with one another.

Securities diversification

Professional fund managers commonly have large numbers of stocks in their portfolios, such that any single stock would typically account for between only 1% and 2% of the overall portfolio. But, a portfolio of even 50 stocks is beyond the average investor.

For bonds, diversification becomes even more difficult, considering that non-retail bonds sold over-the-counter are traded at minimum values of S$250,000. Therefore, the average investor may only achieve significant single securities diversification in stocks and bonds via unit trusts or exchange traded funds.

From risk management to performance enhancement

Studies have also shown that apart from helping to spread risk, diversification generally achieves superior returns for any level of risk. Summarising a study into the impact of asset class diversification, well known investment author Roger Gibson wrote in his book “Asset Allocation”, “as we move toward broader diversification, rates of return increase, volatility levels decrease, and Sharpe Ratios improve.” (note: Sharpe Ratios measure risk-adjusted returns)

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