The cliché of portfolio diversification is to not put all of your eggs in one basket.
But that’s only part of the challenge. And if you get the rest of diversification wrong, your entire portfolio can be at risk.
The idea behind diversification is simple. It means you spread your risk across different types of assets, so that a decline in value in any one holding isn’t so bad – because there will likely be other holdings that rise to help balance out the losses.
If you own a mutual fund or an ETF, it’s almost certainly broadly diversified. Most funds hold hundreds of stocks in their portfolios, with each individual security making up a small percentage of the entire portfolio.
Diversification can limit risks that are specific to a company or industry. For example, bad (or fraudulent) company management is a firm-specific risk. An airline employee strike, which has an industry-wide impact, is an industry risk. These are called “diversifiable risks” because they aren’t directly related to the broad financial market system.
But market risk (also called “systematic risk” because it relates to the financial “system” as a whole) is unavoidable for anyone investing in financial markets. Market risk is affected by things like interest rates, exchange rates and recessions. Diversification can’t reduce market risk.
The graph below shows these two types of risk. Every investor is subject to systematic risk. Diversifiable risk is higher if a portfolio includes a small number of holdings. And diversifiable risk declines as the number of holdings in a portfolio increases – to a certain point. Having a portfolio with five or ten securities has a lower level of diversifiable risk than a portfolio of just one security. But diversifying beyond 30 securities doesn’t bring any additional benefits in reducing overall portfolio risk.
A good diversification strategy increases your potential return for each “unit” of risk in your portfolio. But you’re still exposed to systematic risk.
Many investors think they’re “diversified” because they hold a large number of securities, whether directly or through funds. But the problem is that this approach doesn’t take into account correlation.
As we wrote recently, correlation is the relationship or connection between two or more assets. Correlation doesn’t mean that one asset directly affects, or causes, the other one to move. It just measures what generally happens to the price of one asset when the price of another asset changes. A positive correlation means that two or more assets move together and in the same direction in response to the same event.
For example, in 2015 oil prices dropped and the share prices of energy companies declined. But the collapse in oil prices affected far more than oil futures and energy-related shares. The currencies of oil-producing countries like Russia fell, as economic growth forecasts were reduced. And the share prices of Russian companies that had nothing to do with oil prices fell too, as the economic outlook clouded. So positive correlation can exist even across different industries, asset classes and countries.
Think of diversification and correlation like this: Although your eggs may be in different baskets (diversified), they may be in the same truck (they’re positively correlated). The problem is if the truck crashes, eggs will break in all the baskets in that truck.
So, the best diversification strategy focuses on putting your eggs into different baskets – as well as different trucks.
This involves diversification by asset class (like stocks and bonds), and then by sector and company. You can also diversify across markets and economies. These are different “baskets.”
Next, look at putting your baskets into different “trucks.” Look at assets, industries and countries that have a negative correlation – ones that won’t all move in the same direction at the same time. There are a number of online tools to help you do this, like Sector SPDR’s asset correlation tracker (click here), or Portfolio Visualizer’s asset class correlation matrix (here). (Both of these work best for U.S.-listed securities). Also, many investment companies and brokers have correlation tools.
Diversification isn’t as easy as it looks. But if you can ensure that your portfolio has some pickles and ice cream, all of your investment eggs won’t be in the same truck.