Diversification: a common investment buzzword that is often overused and sometimes, unfortunately, misused.
Meet with any investment firm and chances are high that the word diversification will come up in some shape or form. Diversification says this: don't put all your eggs in one basket. However, sometimes this seemingly simple concept can become somewhat misconstrued. So while we may already have a general idea of what diversification refers to, it's worth unpacking a bit.
Let's take a look at this from a viewpoint that affects us all: nutrition. We're told that throughout the day we should be consuming a variety of food groups including fruits & veggies, grains, protein, and dairy products. Imagine for a moment if we were to consume only one of these food groups day in and day out; our diet.
In the same way, it is paramount for us to hold several differing asset types (such as equities, bonds, alternatives, etc.) such that we can be protected against the potential downsides of any particular asset type or what are known as asset classes.
Real diversification isn't necessarily about diversifying asset classes, it's about diversifying risks.
Now let's dig into this a little deeper still. Supposing we have a portfolio containing several different asset classes but when one goes up the others go up. Assets that react similarly regardless of whether they are from the same or differing asset classes are said to be correlated. When certain risk factors play out in the marketplace and all our assets begin to move in the same direction, the portfolio becomes exposed to undue risk. The key, therefore, lies in holding a combination of assets having low to no correlation to each other.
So if we hold innumerable assets in our portfolio surely we're covered? The truth is that while we need to be intentional in our approach we also need to be careful that we don't run into a case of "Diworsification,' a term coined by the famous investor Peter Lynch. When risk has already been reduced to its lowest level, the addition of surplus assets can actually impede potential returns. So it's not necessarily a case of more is always better, there is a tipping point where too many assets can become a detriment to our overall portfolio.
One final note worth addressing: sometimes in our attempts to diversify, we may think it wise to have different pots of money tied to several different investment managers. Unfortunately, what can sometimes happen, given a lack of communication, is that there may be a tendency towards overlapping strategies leading to potential over-concentration in certain areas and under-concentration in others. This too is not an effective form of diversification.
So with this newfound knowledge, how can we ensure our portfolio is properly diversified? Work with a Portfolio Manager who not only understands this multi-faceted concept but applies it to their investment philosophy and strategy. A portfolio that is correctly and adequately diversified is one that will be well positioned to achieve an optimal risk-adjusted return.