Diversification is a risk management technique that combines a wide variety of investments within a portfolio. The idea that kind of technique pushes forward tells us that a portfolio built with different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
What really is Diversification?
Diversification is an attempt to smooth out unsystematic risk in a portfolio so that the positive performance of some investments neutralizes the negative performance of other assets. Thus, the advantage of diversification holds only if the securities in the portfolio are not perfectly correlated.
Studies and mathematical models have suggested 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 benefit, even if at a dramatically smaller rate.
Additional diversification advantages can be achieved by investing in foreign securities because they tend to be less closely correlated with domestic investments.
For instance, an economic downturn in the US economy may not affect Japan’s economy in the same manner. Thus, having Japanese investment gives an investor some small cushion of protection against losses because of an American economic downturn.
Most institutional investors have a limited investment budget and may find it hard to create an adequately diversified portfolio. This very fact can explain why mutual funds have been increasing in terms of popularity. Buying shares in a mutual fund can offer investors with an inexpensive source of diversification.
Diversification and ETFs
While mutual funds offer diversification across various asset classes, exchange traded funds offer investors access to narrow markets such as commodities and international plays that would ordinarily be difficult to access.
An individual with a portfolio worth $100,000 can spread the wealth among ETFs with no overlap. If an aggressive investor wishes to construct a portfolio composed of Australian bonds, cotton futures, and Japanese equities, he can buy stakes in different ETFs for each asset type.
The specificity of the targeted asset classes and the transparency of the holding guarantee true diversification, with divergent correlation among securities, can be achieved.
Diversification and Smart Beta
Smart beta strategies provide diversification by tracking underlying indexes but do not necessarily weigh stocks based on market capitalization. ETF managers further screen equity issues on fundamentals and rebalance portfolios according to objective analysis and not just company size.
While smart beta portfolio is unmanaged, the primary goal becomes outperformance of the index itself.
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 each. These can include stocks and bonds, real estate, ETFs, commodities, short-term investments, and other asset classes.
They will then diversify among investments within the asset 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, US Treasuries, state and municipal bonds, high yield bonds, and others.
