The concept of diversification is exactly that, a strategy for reducing the overall risk in a portfolio by diversifying assets into different regions, investments, providers and so on.
When it comes to risk management, the idea of ‘not putting your eggs in one basket’ is directly applicable. At its core, diversification is about mitigating losses in any given part of the portfolio with gains in others.
Diversification can be achieved in a number of ways. It could be allocating funds to different bank accounts, investing with different providers, and even safeguarding assets in different countries.
Diversifying an investment portfolio
At a portfolio level, diversification can be done by mixing a wide variety of investments to reduce overall portfolio risk.
This is most commonly done by investing in different asset classes like stocks, bonds, commodities and real estate.
It’s important to note that diversification itself can be done with different levels of complexity. You can vary the portfolio by asset class, as described above, or you can buy investments in different geographies, different sizes of companies, varying industries and different term lengths for income-paying instruments like bonds.
Where ETFs come in is that they generally provide immediate access to a range of different assets. ETFs are baskets of securities that aim to track a particular index. For example, a FTSE 100 ETF would track the FTSE 100 index and is made up of the top 100 companies by market capitalization in the United Kingdom.
Using the FTSE 100 as an example, we can see that the index is exposed to several different industries. Within those industries, there will be many different companies.
|FTSE 100 – Top Industries Breakdown
|Oil & Gas
Source: Bloomberg 02/02/2023
This creates a level of basic diversification at a sector level. Despite the FTSE 100 being a UK focused index, most of the companies carry operations overseas. For example, Shell and BP (the oil giants) are part of the index and have significant revenues from abroad.
Another layer of complexity to this index is that overseas revenues in most cases have to be repatriated back to the home country. Any fluctuations in the price of the Pound will have some effects on the performance of the company.
From a diversification standpoint, by investing in a FTSE 100 ETF, an investor gains exposure to a number of different industries and to the US Dollar. For example, in the case of BP, around 30% of its revenues is generated in US Dollars. If the US Dollar strengthens against the Pound, this gives the performance of BP a boost.
Examples of diversification
Let’s say a conservative investor has a portfolio of UK bonds and is concerned about the UK’s economic landscape. To mitigate their exposure to the region, the investor can allocate some of the portfolio to US Treasuries, thus reducing the exposure to the UK.
On the other hand, if a more aggressive investor is heavily exposed to the US technology sector and is concerned with valuations in that particular space, the investor can reduce the allocation into the sector and allocate capital to lower-risk sectors in the US, or indeed to other regions entirely.
Using ETFs to diversify
ETFs have made portfolio diversification easier, as investors no longer need to buy a basket of securities to achieve a basic level of portfolio diversification. Instead, they can buy one share of an ETF and be instantly exposed to a number of underlying securities – in some cases, over 5,000 underlying instruments.
Given the wide world of indices, and ETFs tracking these indices, these types of products are perfect for achieving diversification easily. And, with ETFs ranging from focusing on very specific equity markets to ones tracking global bonds, investors are spoilt for choice when deciding how to diversify particular portfolio risks.
For example, if a region is going through a challenging time, an investor can choose to allocate to another region to diversify the risk away from a concentrated area. The combinations with which an investor can diversify is nearly infinite in today’s environment.
So, how do we measure how well a portfolio is diversified? Diversification is often measured by analysing the correlation coefficient of a set of assets.
Given the extent of the variables and assets to consider, it’s impossible to calculate the actual degree of diversification of a portfolio. However, there are some measurements which allow investors to get an approximate idea of how two assets behave relative to each other.
A correlation coefficient is a statistical measurement that compares the relationship between two variables. This statistical measurement tracks the movement of two assets and whether they tend to move in the same or different directions.
The correlation coefficient varies from -1 to 1.
If two assets correlate closer to -1, there are strong diversification benefits between the two assets as they move perfectly in opposite directions.
If two assets correlate closer to 0 there is moderate diversification as the investments do not correlate. Sometimes they move in line with one another, sometimes they do not.
If two assets move closer to 1 there is a lack of diversification as the two investments move in the same direction.
Over time, correlations are also subject to change as financial markets and conditions evolve.
Using the last 30 years as an example, we have seen bonds rally due to the decrease in interest rates (as yields decrease, the price of the bond increases) and equities also rally given the lack of yield in fixed income markets and the facilitated access to capital partly due to the central banks quantitative easing programs.
Blue line – Bloomberg Global Aggregate Total Return Index
White line – MSCI World Index
Purple line – The correlation of both equities and bonds over a 30 year period.
Dates: 31/12/1992 to 31/12/2022
If you’re considering ways to diversify your holdings in an attempt to reduce portfolio risk, there are plenty of ways this can be done.
Many of the ideas below can work in tandem to enhance the level of diversification in a portfolio.
While diversification in its most basic form (as highlighted above) can mean investing in different asset classes, it can also be enhanced by allocating into different types of companies and bonds at an asset class level.
At an equity diversification level, this can include particular sector exposures, factor tilts and a broad range of market capitalisation of the underlying companies.
With fixed income, this can include government and corporate bonds with different durations and credit qualities.
Not all risk is diversifiable
Despite most investors wanting to reduce portfolio risk on the whole, there are certain kinds of risk that exist regardless of how diversified any given portfolio is.
Exposure to a single stock has specific risk but putting a couple of hundred stocks together and you’re left with only systematic risk.
Specific risk may include for example business, financial, operational and regulatory risks that are specific to a particular entity.
Pros and cons of diversification
The primary goal of diversification is to mitigate risk.
By spreading your investments across different asset classes, industries and maturities, investors are less likely to experience market shocks that affect every single one of their underlying securities.
Diversification, if done well, reduces portfolio risk, hedges against market volatility and, over the long-term, may offer a path to higher returns.
On the other hand, a well-diversified portfolio can limit gains in the short term, may be more difficult to manage, and may incur more transaction costs.
Diversification at InvestEngine
At InvestEngine we build our portfolios with diversification in mind. We consider the correlations between our ETFs, and each asset class’ characteristics to construct portfolios which are appropriate for your long-term investment goals.
Each one of our model portfolios is made up of over 10,000 securities – from various government bond issuers, to corporate bonds, to equities in both developed and emerging markets.
Capital at risk. The value of your portfolio with InvestEngine can go down as well as up and you may get back less than you invest. ETF costs also apply.
This communication is provided for general information only and should not be construed as advice. If in doubt you may wish to consult a professional adviser for guidance.
Tax treatment depends on personal circumstances and is subject to change, and past performance is not a reliable indicator of future returns.