Since the dawn of the market, investors have taken note of the correlation between risk and return. The oldest financial rule states that the higher the return you are aiming for, the higher the risk you would have to bear. On the other hand, taking lower risks also means you’re making profits with lower returns. It wasn’t until 1950 when an academic called Harry Markowitz won a Nobel prize by proposing a modern portfolio theory that people begin to understand the objective and usefulness of diversification in a mathematical sense. In his theory, Markowitz introduced a tool to reduce risk while having the same expected return by using diversification of investment portfolio that behaves differently from one another with little to no correlation.
The returns of your portfolio are often determined by stocks with a strong performance in the market. And yet, we cannot predict which stocks will be the star-performer nor the direction of the market. As a result, a single portfolio will miss out on opportunities if you don’t possess the star-performing stocks. So the solution is to spread the fund across securities with little to no correlation with each other. This technique also suggests that a portfolio that includes different kinds of investment will achieve a higher return with lower risk as compared to a portfolio with a single investment. This is due to the positive performances of some stocks neutralizing the negative performance of others.
The rationale of this technique is to avoid the high, concentrated risk of having a risky, singular portfolio. As the saying goes, “Don’t put all your eggs into one basket”. We cannot control or predict the direction the market is heading to, so it is wiser to strategize and spread your risk across different securities to prepare for the market ahead. Thus, when it is bullish, investors would profit from the gains, and during the bearish market, you would also be able to avoid extreme losses.
Nowadays, people think that diversification means having as many investments in your portfolio, but quantity is never a true measurement of the risk you are exposed to. Thus, the benefits of diversification only hold true if your stocks investments are not correlated with each other and possess different performance and behaviour. The key to a good strategy is to stop relying on your feelings and biased judgment to improve your investment performance. However, this is a trait all human possesses and a flaw that hinders us from making the best decision when it comes to stock-picking. One example that you can do to gain more benefits from diversification is through foreign stock investment because they tend to be less correlated than domestic securities. If you invest in the Singapore market when there are trade wars between the two giants, China, and the US, you will be provided with an escape route should a crisis looms ahead on the US economy.
Another common perspective that investors have is that a diversified portfolio would have lower returns than the US market and always underperform against the best performing asset classes, which is the US stocks. Essentially, diversification is not a strategy to increase your return. It is a risk-management tool that helps to lower the risk on the portfolio while expecting the same return. Investors can diversify their portfolio by choosing stocks with low correlation or stocks with different market capitals.
And yet, diversification also comes with its own disadvantage, which is a lower return for a period of time. While it ensures that we won’t put all our investment into one risky security, it also means that we won’t be holding just the star-performing stock. This limits the possible outcomes and helps to increase the success likelihood to achieve our expected return. Therefore, when a popular benchmark beats the other asset classes, a diversified portfolio will slow down. Impatient investors will then rush to save themselves and abandon diversification, only to regret it when the benchmark starts lagging against other asset classes. This is why diversification is not a tool for everyone. Nonetheless, if you can get used to the discomfort, it would help to protect your portfolio against the unpredictable future.
Over-Diversification
As mentioned above, diversification is a risk-management tool that has withstood against the challenge of time. However, over-diversifying your portfolio can be a bad thing. This issue was first raised by Peter Lynch on “One Up on Wall Street” (1989). Diversification or over-diversification is the inefficiency of an entire investment portfolio. Over-diversification can be confusing and arduous, adding the extra cent to the cost, and increase the risk of your investment. Some financial advisors do this because of job security and personal gains, so in order to understand and identify with this, we’ve put down this list on the top signs of over-diversification (Allison, 2018):
- You own too many investments with high correlation,
- You’ve excessively used multimanager investment products,
- You own superfluous numbers of individual stock positions, and
- You own privately held non-traded investments that are not fundamentally different from the publicly traded ones.
When it comes to diversifying, too much can end up costing you the returns of your investment. What was supposed to reduce the risk could be catastrophic instead. Therefore, quality should be forsaken for the sake of gaining quantity in your portfolio. Over-diversification may create a sense of security and confidence, but in actuality, holding a large number of highly correlated investments actually increases the risk. Thus, investors should always be wary not to over-diversify their portfolio. It is a useful tool to control and reduce the risk against the unforeseen future of the market. Hence, investors should always remember to diversify with a purpose and caution.
