What is ‘Diversification’
Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
BREAKING DOWN ‘Diversification’
Diversification strives to smooth out unsystematic risk events in a portfolio so the positive performance of some investments neutralizes the negative performance of others. Therefore, the benefits of diversification hold only if the securities in the portfolio are not perfectly correlated.
Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. Investing in more securities yields further diversification benefits, albeit at a drastically smaller rate.
Further diversification benefits can be gained by investing in foreign securities because they tend to be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan’s economy in the same way; therefore, having Japanese investments gives an investor a small cushion of protection against losses due to an American economic downturn.
Most noninstitutional investors have a limited investment budget and may find it difficult to create an adequately diversified portfolio. This fact alone can explain why mutual funds have been increasing in popularity. Buying shares in a mutual fund can provide investors with an inexpensive source of diversification.
Diversification and Exchange-Traded Funds
While mutual funds provide diversification across various asset classes, exchange-traded funds (ETF) afford investor access to narrow markets such as commodities and international plays that would ordinarily be difficult to access. An individual with a $100,000 portfolio can spread the investment among ETFs with no overlap. If an aggressive investor wishes to construct a portfolio composed of Japanese equities, Australian bonds and cotton futures, he can purchase stakes in the iShares MSCI Japan ETF, the Vanguard Australian Government Bond Index ETF and the iPath Bloomberg Cotton Subindex Total Return ETN. The specificity of the targeted asset classes and the transparency of the holdings ensure true diversification, with divergent correlations among securities, can be achieved.
Diversification and Smart Beta
Smart beta strategies offer diversification by tracking underlying indices but do not necessarily weigh stocks according to market cap. ETF managers further screen equity issues on fundamentals and rebalance portfolios according to objective analysis and not just company size. While smart beta portfolios are unmanaged, the primary goal becomes outperformance of the index itself. As of February 2018, the iShares Edge MSCI USA Quality Factor ETF holds 125 large- and mid-cap U.S. stocks. By focusing on return on equity (ROE), debt-to-equity (D/E) ratio and not solely market cap, a the ETF returned 78.8% cumulatively since inception in July 2013. A similar investment in the S&P 500 Index grew by about 58%.
Standard Diversification in a Portfolio
Fund managers and investors often diversify their investments across asset classes and determine what percentages of the portfolio to allocate to each. These can include stocks and bonds, real estate, ETFs, commodities, short-term investments and other classes. They will then diversify among investments within the assets classes, such as by selecting stocks from various sectors that tend to have low return correlation, or by choosing stocks with different market capitalizations. In the case of bonds, investors select from investment-grade corporate bonds, U.S. Treasuries, state and municipal bonds, high-yield bonds and others.