Portfolio Diversification as Investment Strategy

Do not put all your eggs in one basket   

What is an investment portfolio? 

  An investment portfolio refers to a collection of assets, such as stocks, bonds, cash and cash equivalents, commodities, and real estate, held by an investor (individuals or financial institutions).   

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What is portfolio diversification?  

  Portfolio diversification refers to an investment strategy where an investor includes a mix of various asset classes in an investment portfolio to maximise investment returns and minimise his/her risk profile.     Expressed in terms of the well-known investment principle, ‘Do not put all your eggs in one basket,’ Investors should diversify their portfolios, instead of investing in a small number of asset classes, such as stocks or bonds.   

Objectives of portfolio diversification 

  Typically, portfolio diversification is used by long-term investors. Hence, it is not an investment strategy that will be executed by traders who aim for profits on a short-term basis, willing to take high investment risks. Short-term traders usually invest in one or two types of asset classes, without diversifying them.    The major object of portfolio diversification is to mitigate the dependence on one type of asset. This implies that if one or two asset classes do not perform well, then the entire investment portfolio is not negatively impacted. Put differently, by owning many investments in diverse types of assets, an investor’s investment risk is minimised. This strategy helps to decrease the volatility of the portfolio because the value of different classes of assets should be rising and decreasing at different times, stabilising the returns of a portfolio overall.    Benjamin Graham (1894 - 1976), a famous British-born American economist and investor, formulated one of his investment principles as follows: ‘There is a close logical connection between the concept of a safety margin and the principle of diversification.’ Not for nothing was Graham dubbed ‘the father of value investing.’    Other key objectives of portfolio diversification, amongst others, are: 

• Balancing risk and returns implies a stable and low-risk return to investors because the risk is spread over a longer period. This is because diverse types of assets behave differently to risk. Assets prone to higher risk usually provide larger returns. However, these assets carry increased risk. Contrarily, lower-risk assets bring stability but may provide more moderate returns. 
• Distributing investments across different asset classes, enabling investors to spread investments across diverse types of classes, inter alia, stocks, commodities, bonds, and currencies. Each asset class performs uniquely in response to market volatility and political and macroeconomic changes. By applying this strategy, an investor can mitigate the effect of poor performance in a single asset. 
• Mitigating over-concentration in one investment 

  If an investor concentrates a considerable portion of his/her portfolio on one type of investment or a few closely associated assets, they are exposed to higher investment risk. If that specific investment underperforms, the value of an entire portfolio could decline. Portfolio diversification helps an investor to avoid the risk of over-concentration and its potential negative financial impact.   

• Maintaining capital 

Diversification enables investors to preserve capital and to safeguard funds invested from any substantial decline in its value due to the balance between investment risk and return.   

Components of a diversified investment portfolio 

  Investors and fund managers typically diversify their investments across asset classes and decide what percentages of a portfolio to allocate to each asset class.    Each asset class has a distinctive set of risks and investment opportunities. Hence, it is important to assess the type of asset you are investing in and what level of risk is involved.     There are various asset classes, including:   

• Stocks 

The terms ‘stocks’ and ‘shares’ are often used interchangeably, but there are subtle differences. According to SoFi Learn, the differences are as follows:   Stocks 

• A stock is the actual asset in which you invest, describing what you are investing in. Put differently, a stock is a broad term for an investable asset. 
• Stocks can refer to the ownership of many different companies. 
• Stock is used as a more general term. 

Shares 

• A share is the unit of measurement for the asset invested in. In other words, a share indicates how much of the stock of a company an investor owns. 
• If the total market value of a company declines, the value of its shares falls. 
• Share is a more precise term. 
• An investor who owns shares is called a shareholder. 

 

• Bonds 

Contrary to a shareholder, a bondholder has no ownership rights.   A bond represents a loan from a buyer (individual or entity) to the issuer of a bond. Typically, a company, corporation, or government wants to raise money.  Issuers of bonds pay periodic interest payments (at a specific interest rate) to bondholders. In addition, a bond issuer is obliged to pay the bondholder back the face value of the loan on a specified date.   

• Commodities 

Commodities, also known as primary products or primary goods, are basic goods found in nature and sold and used for the production or consumption of other products. Examples of commodities are crude oil, copper, gold, iron ore, rough diamonds, and agricultural commodities such as wheat, tea, and cotton.   

• Commodity funds 

A commodity fund, also referred to as a commodity-focused fund, is inter alia: 

• linked to an index that focuses on commodities, 
• an investment in companies that operate in commodity-based industries, or 
• a fund directly holding commodities. 

 Investments in commodity funds are only for the most experienced investors.   

• Real estate 

Real estate includes land and any permanent structures (buildings and or improvements) attached to the land.  Real estate is a type of real property.   

• Real estate investments 

Real estate investments, such as real estate funds and real estate investment trusts (REITs), can also enable investors to diversify their portfolios, providing some protection against inflation risk.  

• A real estate fund operates like a mutual fund that invests in securities provided by public real estate companies. These funds offer value through the appreciation of real estate.  
• REITs are corporations that invest directly in real estate, generating income. REITs are traded like stocks. 

 

• Sector funds 

Sector funds mainly invest in stocks, focusing on a specific sector (segment) of the economy. Experienced investors typically diversify across multiple sectors because certain sectors will often outperform other sectors.  Sector funds focus, inter alia, on the following sectors: 

• Industrials 
• Health care 
• Energy 
• Financial services 
• Information technology 
• Telecommunications 
• Real estate 

 

• Exchange-traded funds (ETFs) 

An ETF is a marketable basket of investments (like stocks and bonds) that follows a specific index, sector, or commodity. ETFs allow investors to invest in diverse types of assets all at once.   

• Cash and short-term cash equivalents (CCE) 

Investors who include the CCE-component to diversify their portfolios use certificates of deposit (CDs), treasury bills, money market funds, and short-term debt instruments.     

Diversification versus concentration in investing 

  Contrary to diversification, concentration is an investment strategy where an investor invests a considerable portion of his/her capital in a small number of assets or industries, or sometimes in a single stock or sector.    Investors who apply this strategy believe that investing all the available capital in one or a few carefully selected assets can generate better returns than a diversified portfolio.    However, a concentrated portfolio is prone to higher investment risk levels. An investor’s entire portfolio may suffer considerable losses when something unforeseen causes a significant loss in the value of a single stock or industry.   

Advantages of portfolio diversification 

  Like other investment strategies, portfolio diversification has its advantages and disadvantages. Let us look at some of the benefits first: 

• Diversification reduces portfolio risk, enabling investors to generate the highest return for the lowest risk. 
• It reduces the short-term market volatility risk. 
• Diversification provides higher long-term returns with lower investment risk.  
• It helps to protect investors against financial crises, protecting their capital.  
• Portfolio diversification reduces the impact of extended bear markets.  
• It enhances the chances for investors to select an asset that generates above-average profits. 
• Diversification offers target growth in two ways: capital gains and income generation. 

 

Disadvantages of portfolio diversification 

  Besides the numerous pros of portfolio diversification, there are also various cons to take note of. For example: 

• Diversification across many types of asset classes can be time-consuming, complex, and difficult to track. For instance, only the net change of a portfolio is monitored, while each stock cannot be tracked individually, according to WallStreetMojo. 
• Managing a diverse portfolio might be quite expensive due to the number of assets included in the portfolio. The cost to manage a portfolio increases with the number of assets available in the portfolio. 
• Furthermore, high fees can induce below-average diversification, implying that some assets in the portfolio will be low-quality assets. 
• In addition, the more the investor diversifies, the less he/she is investing in the quality companies that offer great returns, although with higher risk. 
• Portfolio diversification may be overwhelming for novice or inexperienced investors. 
• WallStreetMoyo warns that ‘only unsystematic risks can be diversified. Systematic risks cannot be diversified.’   
• Systematic risk refers to the risk that exists in a financial market and which applies to a specific asset class. Systematic risks include interest rates, geopolitical events, and inflation, causing instability in financial markets. 
• Unsystematic risk (also called non-systematic risk) includes financial risk, business risk, and operational risk.  

 

Last thoughts on portfolio diversification 

  Portfolio diversification is an investment strategy to help investors generate more profitable and consistent returns over a given period. Diversification plays a key role in developing long-term investment and financial goals. In addition, it is a strategy that provides a distinct number of benefits that can significantly impact an investor’s investment journey.    Smallcase is clear about the importance of diversification in the complicated world of investments, saying: ‘… portfolio diversification stands as an unwavering principle that can make all the difference.’     Portfolio diversification is not just about choosing assets at will or ‘scattering’ investments. It is also not a once-off exercise, but a continuous process of attention and adaptation.    You must consider your financial and investment goals, your tolerance for risk, as well as your investment time horizon. Keep in mind that you will sometimes unexpectedly face situations that do not go according to plan, and eventually suffer losses. However, a well-diversified portfolio should provide the perfect balance between risk and reward, countering losses.    There is no one-size-fits-all rule for portfolio diversification - it depends on individual circumstances.     Lastly, remember the golden rule: ‘Do not put all your eggs in one basket.’    Note: This article does not constitute investment, financial or trading advice. Its purpose is informative. Please obtain the advice of a professional, reputable, and regulated broker before making trading and investment decisions.

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