Importance of Investment Portfolio Diversification

Importance of Investment Portfolio Diversification

Diversification in financial markets is often referred to as “Free Lunch.”

Since its conception, diversification has been considered one of the most important ideas in financial markets. 

Diversification is a tool that helps us deal with the uncertainty and risk that accompany financial markets, while at the same time continue growing our investments.

In financial markets, it is very uncommon that different assets with various sources of risk and return to undergo immense declines or increases at the same time.

For instance, if the stock market slumped 25%, it is highly unlikely for government bonds to follow the same price action. On the contrary, assets with more safe-haven appeal tend to move the other way around when risky assets such as equities suffer a drop.

If your investment portfolio was concentrated on equities, your overall investment will suffer the full brunt of the market crash.

We will give a simple example of two differently diversified portfolios: 

Let us say you have a wallet of USD 1 million and news broke that the government is acting against a new variant of the coronavirus, which would include heavy lockdown measures. On this news, the stock market tanks 15% over the course of three consecutive sessions (all else equal).

Below you can see two different portfolios, one of which is heavily concentrated on the stock market with a small part of it distributed across risk-free government bonds and cash. We will call that portfolio A.

The other portfolio is widely diversified across safe and risky assets across multiple regions. Let’s call that portfolio B.

Let us see how this drop affects the value of each portfolio.

Portfolio A

Since this portfolio is heavily concentrated towards equity, a drop of 15% in equities has caused the value of this portfolio to decrease from USD 1 million to USD 881,650, a near 12% slump.

Let us take a look at the other, more widely diversified portfolio, Portfolio B.

Portfolio B

The same drop that happened in equities reduced the value of this portfolio by 4.5%.

As you can see, without factoring in how other assets might react to the fall in a relatively risky market, such as the stock market, we can see how more diversification managed to mitigate the loss this investor might have taken if he had chosen Portfolio (B) over Portfolio (A).

The Benefits of Diversification:

Minimizes the risk of loss on your overall portfolio.

Exposes you to more opportunities for return.

Safeguards you against adverse market cycles.

Reduces volatility.

Creates more stability and protects your investments against downturns.

Provides more opportunity for growth at a lower level of risk.

Preserves wealth for those who are approaching retirement.

Protects against liquidity issues.

Stocks thrive when there is low inflation and low interest rates, while bonds do worse. Diversification helps you take advantage of the fact that different assets thrive under different business cycles and conditions. 

Another example of how diversification can create benefits is by investing in different countries. 

An economic slump in the U.S. economy may not affect Germany’s economy in the same way, therefore, having German investments would allow you to alleviate the losses incurred by the investment loss from the downturn in the U.S. economy.

A good portfolio should be structured based on your comfortable risk level, while at the same time, it should be structured to perform as well as possible in almost all circumstances that would affect the market.

There are potential downsides to diversifying your portfolio as well.

The opportunity cost that comes along with more diversification is that there is a chance you will miss out on profit and growth opportunities that you have less or no exposure to.

Additionally, there is an emotional aspect. In a bull market, diversifying your portfolio can feel chastising, as you feel that concentrating your portfolio towards a certain market can pull more return.

But the goal of diversification is sustained growth with minimal losses.

Commitment to a balanced portfolio in the long term is one of the better safeguards to maintain that goal.

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