Diversification – an introduction
The idea of diversification starts with a simple old saying “do not put all your eggs in one basket”, if you do that you could end up with a messy situation. In investing, diversification leads to not risking all your money on a single investment. The concept of diversification was born in 1950s that helped advent of mutual funds in 1970s and further development in the form of index Exchange Traded Funds (ETFs) in the 1990s. In a more formal way, “Diversification is the technique of spreading investments across several different assets to help minimize risk. This can mean mixing different investment vehicles, industry exposures and geographies of investments”. The purpose of investment portfolio diversification is not to maximise returns but to limit exposure to downside risks.
The role of risk and return in diversification
It all starts with the risk-return trade-off. Investors want to achieve high returns with the minimum level of risks. A well-diversified investment portfolio helps to mitigate risks and enhance returns when the investment horizon is long-term. As demonstrated in the table below, the total return for S&P 500 was +146.6% while for a diversified portfolio it was +166% from 2000 to 2018 period. Diversified portfolio earned $20,000 more than the broader market benchmark on $100,000 investment over that period.
It is important to note that diversification helps to mitigate security specific risks or Idiosyncratic risks. However, there are other types of risks that are not mitigated by diversification and are generally unavoidable. Here are few of those risks’ investors need to be aware off:
• Interest rate risk: it explains how changes in interest rates (Central banks’ policy rates) affect your investment portfolio. The value of bonds (sukuks), equities, and other investments are subject to interest rate movements. Bonds’ values drop when interest rates increase. Stock markets respond negatively to increase in interest rates as corporates struggle due to reduced demand for their products/services and the borrowing costs rise, thereby having an adverse impact on their revenues and profitability. Therefore, stock prices adjust according to fundamentals over time.
• Market risk: this is the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets. Investors’ sentiment trigger movements in the market and your investment returns can be impacted by the broader market volatility.
• Geopolitical/geographical risks: geopolitical risks, i.e., wars, also affect different asset classes returns and these risks are more heightened due to globalisation. A recent example is the Russian-Ukraine conflict that had an adverse impact on the financial markets and continues to do so.
Volatility and diversification
Volatility is part of the game when dealing with financial markets. Prices of individual assets can remain depressed longer than you can remain solvent. Financial markets move in cycles and any individual assets can go down significantly and can remain at those levels longer than expectations. For example, prices of many individual stocks in FY 2022 decreased more than 50% (some even more than 70%) due to the broader market conditions. However, diversified portfolios are not as down as individual assets. Diversified portfolios ride off the volatility to produce average returns that help to preserve and grow the capital over time. Moreover, diversification minimises portfolio drawdowns during periods of market turmoil like the one we are having most recently in 2022.
Achieving true diversification
A true investment portfolio diversification can be achieved by spreading the capital across and within the major asset classes i.e., equities, sukuks, gold, commodities, and alternative investment vehicles. Any portfolio that is invested just in equities or sukuks is not appropriately diversified portfolio because that particular asset class can perform worse than expected due to macro environment or other market/systemic factors beyond the control of investment managers. Within the equities, different strategies can be applied to make this asset class a well-diversified part of the overall portfolio. For example, investing in the stocks of different sectors/industries, markets sizes (small cap, mid cap, large cap), domestic and international equities, etc. Similar strategies can be applied within other asset classes to achieve diversification benefits. Then, the overall portfolio will be a well-diversified portfolio which is less prone to both idiosyncratic and systemic risks. Diversification provides a way to get exposure to a broad range of asset classes, which is not possible in concentrated positions.
Safety of investment capital
The purpose of investing is to mitigate risks and earn positive returns. Risk mitigation comes in the form of capital preservation. Portfolio diversification is the best way to achieve safety of capital as different asset classes behave differently (generally) to market and economic conditions. The pie charts below depict that as investment time horizon increases, the probability of negative returns decreases and vice versa.
Avoiding losses in a winning market
Picking winning (individual) investments is hard and almost impossible to do consistently over the long-term. Many stocks go down in prices even when the broader stock market is rising. For example, over the last five years, investors with diversified investment portfolios have been rewarded as U.S. stock markets have climbed over 50%. However, not all stocks increased in price along with the rise in broader stock indexes. 52% of US stocks climbed while 48% declined during that same period. Any stock portfolio not appropriately diversified could have lost value or at least underperformed due to lack of stock selection skills by investment managers. The average fall in prices was 51% among the stocks that dropped over the mentioned period. It could have been easy to be a loser in a winning stock market if holding un-diversified portfolios.
Achievement of long-term goals and peace of mind
And the last but not least, as highlighted by the above points, diversification provides a peace of mind – it is important to control your emotions and irrational behaviour during market turmoil. Furthermore, it helps to achieve longer term goals of investing that are to preserve and grow your capital.
To summarise, the purpose of investment portfolio diversification is not to maximise returns but to limit exposure to downside risks. In general, a diversified portfolio performs particularly better during periods of high market volatility, market downturns/turmoil and financial or economic crises. It is crucial not to over-diversify or under-diversify – the time of investing, prevalent market conditions and client objectives will determine the makeup of a well-balanced diversified portfolio.
And finally ….. have an open discussion with your Financial Adviser
Keeping calm and controlling your emotions during increased market volatility is difficult but it is the right thing to do. However, if you feel nerves and need assistance, talking to your Financial Adviser is always fruitful.
You can book a free consultation with one of our Financial Advisers to learn more about our investment approach and how we can help you.
Past performance is not a reliable indicator of current or future returns. This overview contains general information only and does not consider individual objectives, taxation position or financial needs. Nor does this constitute a recommendation of the suitability of any investment strategy for a particular investor. It is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy to any person in any jurisdiction in which such an offer or solicitation is not authorised or to any person to whom it would be unlawful to market such an offer or solicitation.