“Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.” ~ Miguel de Cervantes: Don Quixote de la Mancha
What is portfolio diversification?
Portfolio diversification is the process of investing in various types of investments such as stocks, bonds, index funds, mutual funds, or real estate. Diversification considers the number of each of those assets in your portfolio. While investing always involves some risk, by diversifying your investment portfolio, and taking a more balanced approach, you reduce your financial risk and keep your financial future bright!
There are no guarantees when investing in stocks, bonds, and even some cash-like investments. As we have discussed in previous sections, there are several real life examples of individuals and businesses who have decided to invest a majority if not all of their money into one investment type and either incurred significant losses or gains.
It was losses like these that led to the idea of diversification. In 1952 Dr. Harry Markowitz developed the economic theory, Modern Portfolio Theory (MPT), which created an investment strategy that was meant to reduce risk and maximize returns by avoiding large proportionate investments in any one asset through diversification.
Let’s apply this concept in the following example:
As part of her financial plan, Mary Smith wants to invest her savings. After careful review, Mary decides to invest in Edwards Everyday Earbuds stock. Edwards manufactures state-of-the-art earbuds featuring proprietary technology and the company is growing rapidly as the demand for personal listening devices continues to increase.
Mary’s investment does well – the price of the company’s stock grows and her investment yields a healthy return for a period of time. Then the unthinkable happens. Federal product safety regulators and medical professionals denounce Edwards Everyday Earbuds products as unsafe for users. Sales plunge, inventory is pulled off the shelf, and the price of stock drops. Mary’s investment in Edwards Everyday Earbuds is now worthless.
Instead of investing all of her money in Edwards Everyday Earbuds stock another strategy to diversify her portfolio might have been for Mary to invest a portion in Edwards Everyday Earbuds stock, a portion in a mutual fund, a portion in a short-term certificate of deposit at her local bank or credit union, and a portion into a real estate investment trust. Diversification strategies could protect Mary against loss.
Industry Diversification
Industry diversification refers to broad investments made across different industries to reduce an investor’s exposure to risk. Industry diversification is generally related to:
- Business – An organization that offers multiple products and/or services. Companies such as Wal-Mart, Target, and Sam’s Club fit this profile. Multinational companies with multiple store sizes that offer groceries, tire changes, eye exams, toys, and dine in restaurants; all in one location.
- Economy – A country that exports goods and services across a number of different industries in order to generate economic growth and social well-being across its communities. In the Oxford Economics 2011 Global Diversity Report, their unique country index reflected the most diverse labor forces by industry in the world to be:
- Norway
- New Zealand
- Iceland
- Australia
- Switzerland
- Netherlands
- Canada
- Investment – A portfolio that is created by distributing or allocating capital across many different industries with an understanding of how each industry responds to the other throughout the business cycle. This includes investments in oil and the impact oil prices have on the airline industry.
Economies and businesses around the world continuously evolve. Industry diversification can provide enough stability and risk management in order to sustain periods of uncertainty and also provide the opportunity to generate explosive growth.
Portfolio Concentration
Portfolio concentration is many times described as the opposite of diversification. It means, all or a majority of investments are in one place. Portfolio concentration tends to occur due to the following:
- Intentional concentration: You may believe a particular investment or sector will outperform its peers or an index, so you make a conscious decision to invest more of your money in a given asset or asset class.
- Concentration due to asset performance: Maybe one of your investments has performed very well relative to the rest of your portfolio. For instance, in a bull market when investments are making money, you may find your stock holdings now represent a significantly greater percentage of your portfolio than before since your stocks gained more value than your bond holdings.
- Company stock concentration: Employees that invest a majority of their retirement savings in the stock of the company where they work.
Many investors may decide to concentrate their portfolios after experiencing positive returns. This has led to many investment strategies that apply a concentrated industry approach in an effort to actually reduce risk opposed to increasing it.
Concentration Risk
Concentration risks can be difficult to spot, particularly if an investor does not do research before purchasing an investment. Concentration risk can occur with any investment that makes up a greater share of an investor’s overall portfolio.
Greater concentration risks tend to occur within non-liquid assets, also known as illiquid assets. The most common examples of non–liquid assets are equipment, real estate, vehicles, art, and collectibles. These types of investments are difficult to sell and may have high fees to execute a transaction. Examples include:
- Non-traded Real Estate Investment Trusts (REITS): May be difficult to sell quickly.
- Variable annuities: May impose a surrender charge if you try to sell before a certain period of time.
- Reverse convertible note: Linked to the performance of a specific stock. You may be exposed to concentration risk if you also own the individual stock in a brokerage account. Similarly, you could own a mutual fund where the stock is one of the largest holdings.
Correlation
Correlation means what happens to one investment is likely to happen to the others. For instance, you might own a variety of municipal bonds, but all of them are in the same state or region. Or you may have investments in individual technology companies but also own a technology fund and have technology stocks represented in an index fund you own.
There are two types of correlation:
- Negative Investments are negatively correlated and do not move in the same direction during the business cycle. An investor who is attempting to reduce risk will want investments that are negatively correlated.
- Positive Investments are positively correlated and move in the same direction during the business cycle. An investor attempting to increase their risk with the hope of making a ton of money within one industry or asset class will positively correlate their investments, by going “all in.”
Divergence
Divergence is often used to describe correlation. It is important to note that they are not the same. In the world of investing, divergence is strictly used to describe price movements, based on technical indicators created using mathematical calculations.
Technical indicators are stock charts and graphs that are created using software, to measure the future of:
- price changes based on historical prices of a stock or asset
- number of shares traded for a publicly traded company
- derivative prices that influence a particular asset or industry
For anyone who is interested in learning more about technical indicators, please visit the additional resources page for more information.
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