Portfolio Diversification

Portfolio diversification is the means by which investors minimize or eliminate their exposure to company-specific risk, minimize or reduce systematic risk and moderate the short-term effects of individual asset class performance on portfolio value. In a well-conceived portfolio, this can be accomplished at a minimal cost in terms of expected return. Such a portfolio would be considered to be a well-diversified.

Although the concepts relevant to portfolio diversification are customarily explained with respect to the stock markets, the same underlying principals apply to all types of investments. For example, corporate bonds have specific risk that can be diversified away in the same manner as that of stocks.

What is an asset class?

Unfortunately, there's no concise definition of asset class. The definition of asset class is dependent on the context in which the term is used, the investment strategy employed in the management of a portfolio, and to some extent, the person who is rendering the definition. Suffice it to say that asset classes are significantly different investments. Here are some examples:
  • Stocks, bonds, real estate, commodities, precious metals and collectibles. But here the classes are already starting to blur, as many investments in real estate, commodities and precious metals are in the form of common stock.
  • Market capitalization: micro-, small-, mid- and large-cap.
  • Style: Value, growth, aggressive growth, blend, and growth and income.
  • A combination of market capitalization and style: small-cap value, large-cap growth, etc.
  • Market sectors or industries.
  • Industry groupings such as consumer staples and consumer durables.
  • Geography and type of security: Domestic stock, international stock, emerging markets debt, etc.

Regardless of how you define "asset class," the important thing is that you hold a variety of significantly different investments that are not highly correlated with each other and your diversification within asset classes is to the degree at which specific risk has virtually been eliminated within each class. Assets that are not highly correlated are considered to be complementary, as they complement one another as constituents of a portfolio, forming a unit that dominates the individual assets on a risk-to-return basis.

Eliminate Specific Risk and Minimize Systematic Risk

As was explained in Investment Risk and Return, it is assumed that all investors are rational and will therefore hold portfolios that are diversified to the point where specific risk has virtually been eliminated and their only exposure to risk is to that which is inherent in the market itself. Thus, the residual risk of a portfolio should be equal to market risk, a.k.a. systematic risk, and systematic risk can be reduced by investing over a broader market, i.e., a larger universe.

International diversification provides a good example of the effects of diversifying across asset classes. A portfolio invested 50% in domestic large-cap stocks and 50% in international large-cap stocks would have approximately half the residual risk of a portfolio comprised solely of domestic large-cap stocks, assuming that the investments in each market were sufficiently diversified to eliminate specific risk.

Some investors may choose to be exposed to specific risk with the expectation of realizing higher returns. But this is contrary to financial theory and such investors are therefore deemed to be irrational. Deliberate exposure to specific risk is unnecessary and is essentially gambling...unless you are trading on inside information, but we won't go there, as trading on inside information is a flagrant violation of the securities laws.

Moderate the Effects of Individual Asset Classes

Moderating the effect of individual asset class performance on portfolio value is another benefit of portfolio diversification. This is desirable because the lower the variance of your portfolio value, the greater the certainty of its value at any given time, which is extremely important if you have a need to liquidate all or part of your portfolio for some reason, not to mention the fact that lower variation will reduce stress and anxiety.

If you're saving for retirement, you should have a targeted value at the date you plan to retire. That value is considered to be the terminal value of your portfolio, a.k.a. your terminal wealth, at the end of your holding period, and your holding period would be from the present to that future date. As part of your planning, you must make projections of the average rate of return and the standard deviation of returns over your holding period. Thus, your terminal wealth is uncertain and can be assumed to be a range of values rather than a fixed value. This range is known as your terminal wealth dispersion (TWD). (TWD is described in detail in conjunction with the inappropriately named concept of time diversification.) See Dealing with Terminal Wealth Dispersion to learn how to factor TWD into your financial plans.

If you take this thought process a step farther, you'll realize that your holding period is made up of an infinite number of shorter holding periods and that each period has its own TWD. Your TWD at any point in time is the risk you are faced with when liquidation is necessary. Reducing this risk to an acceptable level can be achieved by diversifying across asset classes with only a minimal cost in terms of expected return.

If, for example, you blend five assets that are not highly correlated and all of those assets have expected returns of 12% and standard deviations of 10%, your expected return will be 12% but the standard deviation of your portfolio's returns will be significantly less than 10%. If the assets were only slightly correlated and/or negatively correlated, your portfolio standard deviation would be very significantly less than 10%. Individually, these assets are equivalent investments based on their risk and return, but together they form an investment that is superior to each of the individual assets, which can be attributed to the lack of perfect correlation between the assets. Portfolio diversification is a very good deal. So be sure you take full advantage of it.

Asset classes tend to go through periods of under-performance and over-performance which tend to offset each other in the long run. However, as we don't get to select our holding periods after the fact, it's desirable to insure ourselves against the probability of liquidating at a time when under-performance outweighs over-performance within our holding periods. This is where the correlation between asset classes really comes into play. Asset classes that are not highly correlated can be expected to under- and over-perform at different times. Thus, holding a variety of asset classes that are not highly correlated is insurance against the probability of having a low terminal value when liquidation occurs during or shortly after a period of under-performance of a minority of the asset classes in a portfolio. In such cases, the other asset classes should moderate or fully offset the effects of the under-performing asset class or classes.

How many asset classes are enough?

The number of asset classes required to achieve the desired level of portfolio diversification depends on the degree of correlation between the asset classes which comprise your investment universe. The lower the degree of correlation, the greater the potential for diversification and the fewer the number of asset classes required to achieve the desired level of diversification. And the broader your universe, the higher your expected rate of return for any given level of risk, although this does have some limitations. If your universe is very broad, it's quite likely that optimizing your asset allocation at a given level of risk will result in a zero allocation for one or more of the assets. In such cases, further diversification would lead to over-diversification. So it is indeed possible to have too much of a good thing. Over-diversification is addressed below.

Your investment universe is the group of asset classes from which you will select your investments. Those investments will be the assets that form your portfolio. At this point it's important to realize that the correlations of individual assets may vary considerably from the correlations of their respective asset classes. So, although asset class correlations provide a good means of defining your universe, the final selection of assets must be based on the correlations of the individual assets.

One thing to keep in mind about asset correlations is that they are by no means static. Correlations can and do change over time, and sometimes the magnitude of change can be relatively large. But even a relatively small change can have a significant impact on portfolio models. This is one case where using a long time series can work against you unless you adjust for any trends that may be present in asset correlations. Therefore, it's better to use correlations calculated from recent data and update regularly. Changing correlations will affect the dynamics of your portfolio and need to responded to by changing your allocations and in some cases, replacing some of the assets in your portfolio.

The desired level of portfolio diversification will be defined in part by your risk profile, i.e., your risk tolerance. At the level of risk that is right for you, a properly blended portfolio of complementary assets will have a higher expected return than any individual assets with the same level of risk drawn from the same universe except in the special case where your desired level of risk is equal to that of the riskiest asset in the universe, in which case you would hold a single-asset portfolio comprised solely of that one risky asset. Unusual, not very likely but theoretically possible. (A better way of investing at higher levels of risk is explained at the end of this section.)

Over-Diversification

Over-diversification can occur when two or more investments overlap. For example: If you hold an index fund that tracks the Wilshire 5000, investing in any other actively traded U.S. stocks will result in overlap and over-diversification. Owning a Wilshire 5000 index fund and a U.S. technology fund wouldn't necessarily double your investment in U.S. technology stocks, as the Wilshire 5000 is capitalization weighted and most non index funds are not, but you would have a significant overlap in the technology sector. This is more likely to happen with mutual funds but it also can occur with the securities of large diversified corporations.

Overlap is a problem only if it's done inadvertently. Some investors desire additional exposure to one or more sectors and achieve this by deliberately creating overlap in their portfolios. Although this is contrary to financial theory, deliberate overlap is a matter of choice and as such is a part of some investors investment strategy.

A Well-Diversified Portfolio

I know I've left the definition of a well-diversified portfolio a bit hazy. But the definition is highly dependent upon factors that are unique to each investor. Only when those factors are defined can the term be clearly defined. Those factors include: risk tolerance, targeted terminal wealth, investment horizon (planned holding period) and the universe an individual is willing to accept as the pool from which they will select their assets.

As I stated above, a well-diversified portfolio should be diversified within asset classes to the degree at which specific risk has virtually been eliminated, and diversification across asset classes should be such that the residual risk of the portfolio is consistent with the investors risk tolerance. The residual risk of a portfolio will diminish as asset classes are added to the investment universe, but there is a point of diminishing returns and there is a finite number of asset classes, which implies that there is a point beyond which no further reduction of residual risk can be achieved. A portfolio would be fully diversified at this point.

Well-conceived portfolio diversification will result in the construction a well-diversified portfolio that will serve you well in achieving your long-term investment goals. And selecting an investment universe that is sufficiently broad to ensure that the highest level of diversification consistent with your risk tolerance can be achieved is the single most important step in constructing your portfolio.