What is a Diversified Portfolio?
Diversification has been an extremely popular term in finance and investing for many years. Almost any article, video or a book about personal finance or investing mentions diversification at some point. Why the idea of allocating your capital in various assets is that popular? Are there cases when diversification isn’t the best way to go about investing?
Table of Contents
What is Diversification?
Diversification in finance means a strategy of allocating capital in different assets.
A diversified portfolio is a portfolio that has more that one asset.
The purpose of diversification is to reduce risks associated with having all your capital in just one asset. Diversification helps to reduce unsystematic risks (inherent in a specific company or industry), but systematic risks (inherent to the entire market or market segment) are much harder to avoid.
A common way to explain diversification is with “all eggs in one basket” analogy. It’s dangerous to put all the eggs in one basket because if the basket falls everything will be destroyed. Alternatively, you could carry two (or more) baskets with 50% of the eggs in each, then, if you lose one, you would at least save another. This simple example illustrates the idea of diversification.
Types Of Diversification
There are a number of ways to diversify a portfolio:
- By Assets Type: cash, stocks, bonds, ETFs, etc.
- By Industry: retail, manufacturing, banking, real estate, etc.
- By Geography: local, national, foreign, etc.
- By Size of the Company: small, medium, or large corporations.
Technically speaking, any variable related to a company can be the basis of diversification.
Example of a Diversified Portfolio
We aren’t going to be original here and pick a common real-life example of a portfolio, the one that Warren Buffett has. You can find the list of assets owned by his company on the Berkshire Hathaway website, or here.
As the textbook example of a successful portfolio, here is how Berkshire Hathaway diversifies:
- Berkshire Hathaway has more than 70 operating subsidiaries, companies where they hold a significant share of ownership, often 90 - 100%.
- The fund has more than 50 minority holdings with the ownership from 0.01% to 26.70%.
- They own companies in many sectors: business services, clothing, electronic component distribution, food and beverage, furniture related, household products, insurance and finance, logistics, luxury items, materials and construction, media, pipeline, real estate, etc.
- However, there are three sectors with a stronger focus: financial (46%), information technology (26%) and consumer staples (15%).
- Warren Buffett is generally reluctant to invest in stocks of companies based outside the United States, but he owns a few international companies, for instance, Restaurant Brands International Inc. and Suncor Energy based in Canada.
- Most of the companies Berkshire Hathaway owns are blue-chips, large and stable corporations with a long history.
Perhaps, even the famous Warren Buffett isn’t a perfect example of someone who embraces diversification fully. It could be because of his personal biases (like home bias) that we mentioned in the article about behavioral economics, yet overall he is a very successful investor with a diversified portfolio.
What is the Optimal Number of Assets in a Portfolio?
There are many opinions and studies regarding the optimal number of assets in a portfolio.
Edwin J. Elton and Martin J. Gruber in their “Modern Portfolio Theory and Investment Analysis” book concluded that as you increase the number of stocks in your portfolio you significantly reduce the stock specific risks (unsystematic risks) with each added stock.
With about 20 stocks in the portfolio, you’ll come close to achieving an optimal diversity which will eliminate unsystematic risks almost entirely. According to them, a portfolio with a single stock has a risk of 49.2 percent, but a portfolio with 20 stocks reduces risk to about 20 percent. It’s interesting that adding more stocks to the portfolio (from 21 to 1000) wouldn’t reduce risk by much.
Meir Statman in his work says that a well-diversified portfolio of randomly chosen stocks must include at least 30 stocks for a borrowing investor and 40 stocks for an investor.
“Some Studies of Variability of Returns on Investments In Common Stocks” by Lawrence Fisher and James H. Lorie, released in 1970 in The Journal Of Business, stated that a randomly created portfolio of 32 stocks could reduce the distribution by 95%.
This lead to the conclusion:
“95% of the benefit of diversification is captured with a 30 stock portfolio.”
So, with 20 - 30 stocks you should be well-protected against most of the unsystematic risks and it’s not necessary to increase the number of assets after that as it’s won’t reduce risk by a lot.
However, with all the respect to these great scholars, who and why would pick 20 or 30 random stocks?
Modern Portfolio Theory and Correlations
Modern Portfolio Theory (MPT) was developed by an American economist Harry Max Markowitz, he won the Nobel Prize for that. In the 1950s, he provided empirical evidence that a diversified investment portfolio is superior to any individual investment in terms of its risk-return ratio. MPT is a quite complicated concept that can cause a headache, so we won’t cover it and the Efficient frontier fully in this article. In simple words, to diversify a portfolio one should find assets with no perfect correlation in prices (from -1 to 1, but not 0) which are still expected to be profitable. By adding such assets to the portfolio you can reduce the overall variance and volatility, i.e. reduce risk. The hedging concept is somewhat similar to that, yet they aren’t the same.
Here is a simple example to show how it works.
Imagine that you have 50% of the portfolio in one asset and you buy another asset that is shown 0.5 correlation to the first one. If one goes up by 10%, another goes up by 5%, so together they increase by 7.5% considering their weights in the portfolio. Having two assets instead of one reduces individual asset risk, so that might be a good idea to add the second asset if you are willing to reduce the potential returns. The efficient frontier, a part of the modern portfolio theory, and the efficient portfolio concepts are about finding the set of portfolios with a higher expected return but with the same standard deviation of return.
You can find a practical example of how to find the efficient frontier in this article.
What are examples of assets that don’t correlate with each other? Seeking Alpha has a few examples of investments that have negative correlation with the S&P, which means that those investments can be used to diversify a portfolio that already has a significant portion of S&P stocks. In other words, it’s like betting against the U.S. (and partially world’s) economy to protect yourself for a recession. Gold is a common example of an asset that almost never correlates with the market.
How Diversification Can Help an Investor?
Benefits of diversification are obvious. It’s always better to split the money into two equally risky and profitable securities than to have all the money allocated in just one place. For instance, let’s say that an investor wants to buy some American IT stocks. There are risks associated with the U.S. economy in general, there are also risks associated with the IT sector, but there can be even more risks associated with a particular company and its management.
It’s much wiser to buy Google, Facebook, and Microsoft stock in some proportions, than to buy just Facebook. Who knows what Mark Zuckerberg will have in mind tomorrow? Maybe he’ll push his Libra idea further and face some kind of sanctions? Maybe someone at Google decides “to filter” some search results and get a lawsuit kickback? Not to mention that there can be hundreds less visible, but still harmful financial decisions within each company. Those unsystematic risks can be avoided with diversification.
The word “portfolio” itself implies that there is more than one item in it. It implies diversification. A portfolio is a collection of assets, otherwise, you can just say that you bought a stock, a bond, or another asset.
Even more colorful example of why you should diversify as an investor is to recall typical Elon Musk’s behavior. Sure, he is a great guy, but we all know that he may do something that will have a big effect on the Tesla stock price. So, if you, as an investor, interested in the emerging industry of electric cars, even if you support Tesla and Elon, it would be smart to add stocks of other electric car producers to your portfolio to avoid risks associated with this particular company and its owner.
ETFs, Index, and Mutual Funds
In today’s world, the question of diversification is kind of already solved by the invention of ETFs, index funds and passive mutual funds that diversify by default. The famous S&P index is already a well-diversified collection of assets according to the efficient portfolio theory and it’s readjusted regularly. Instead of picking 20 or 30 assets for your portfolio to achieve diversification, you can just buy a fund that is much better diversified across the sector/industry. Even better, you can buy 3 - 5 diversified funds in different industries (or just buy the S&P) which will protect you not only from company-specific risks but also from risks in the industry. In addition to that, it’d be a smart idea to purchase a foreign fund as well. That is why many modern investors came to the passive long-term investing approach where a simple diversified index fund replaces many old complicated and active strategies.
When Diversification is a Bad Idea?
There are some rare cases when diversification strategy might not be the best choice. Some people argue that it doesn’t make much sense if you invest with a small amount of money of $500 - $1000. It might be technically impossible as some stocks cost $300+ each, it might require you to buy more stocks on margin, and you might face some unpleasant fees from your broker.
A more common argument against broad diversification is that you risk to lose focus. It’s not easy to constantly track all news, annual reports and indicators regarding one stock, but it’s much harder to track and analyze 5 or 10 stocks, especially if they are in different industries. So, for a beginner, or for someone who doesn’t have enough time on investing analysis (which is needed even for a slow, long-term and conservative investing approach), it might be a good idea to avoid wide diversification. Buying 20 - 30 stocks in a few sectors might be enough diversification effort to protect you from most of the unsystematic risks.
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