What Makes an Investment Portfolio Diversified?

Any typical investor holding a portfolio of assets, willing to achieve the maximum possible return for a given level of risk, will undoubtedly wish his/her portfolio of assets to be as diversified as possible.

But what does diversification really mean? The more, the better? We have all heard the saying of “putting your eggs in one basket” as a means of trying to visualise the concept of diversification – but in investment terms, how can we achieve the optimal diversified portfolio of assets?

Portfolio diversification is the strategy used by investors (of all types – from individuals to asset managers and hedge fund managers) to attempt to minimise and eliminate the exposure of the overall basket of assets to company-specific risk as well as even out the short-term effects of the performance of a particular asset class (such as bonds or equities) on the overall performance of a portfolio.

So in practice, portfolio diversification can be achieved through a number of strategies, or rather portfolio allocations. A portfolio is said to be diversified if it gains exposure to more than one asset class.

For example, a portfolio with 100 per cent allocation to bonds or 100 per cent allocation to equities cannot really be considered to be diversified; if the equity market goes down, a portfolio with 100 per cent allocation will be impacted by an equity downturn whereas if it had some sort of allocation towards bonds, the impact would have been somewhat limited, as exposures to different asset classes serve to cushion against market movements, both on the upside as well as on the downside.

Diversification by asset class is one of the key factors of diversification. There are also a number of key ways of diversifying a portfolio of investments, namely achieving diversification by adding 

• currencies, 
• diversifying exposures to sectors (or industries), 
• diversification by geography, 
• diversification by equity type (blue chip, small cap or micro-cap),
• diversification by investment style (aggressive, moderate, cautious appetite for risk), 
• diversification by interest rate risk (bonds having short or long duration, with duration being the exposure of a bond to interest rate fluctuations), amongst many others.

The key to diversification is that the underlying constituents of a portfolio are not highly correlated with each other. Research and studies conclude that assets which are not highly correlated can be considered to complement each other and on a risk-return basis will perform better during adverse market conditions.

One important thing, which investors tend to oversee, is that the correlations between asset classes is dynamic and is continuously changing; sometimes the size of change can be relatively large and could impact asset allocation decisions. The desired level of portfolio diversification will ultimately depend on an investor’s tolerance for risk, investment horizon, as well as targeted expected return.

A well-diversified portfolio should hence be diversified within asset classes to the extent that specific risk has been reduced. Asset Allocation strategies, in the form of mutual funds (collective investment schemes) offer investors the ideal investment vehicle to achieve their investment goals without the need of individually allocating and diversifying assets whilst serving as an optimal tool of gaining exposure to a wide array of asset classes, in a more manageable way than if the investor had to take key important asset allocation decision by him/herself. 

Source - timeofmalta.com