The holy grail of investing is to diversify a portfolio. The key purpose of a diverse portfolio is to dilute the risks by spreading investment into different investment vehicles. However, most investors do not understand it and make mistakes in their diversification, which negatively affects their returns in the long term. This is the result of a sub-par diversified portfolio.
Most investors either misunderstand or misinterpret the information available on their investments. It leads to either over or under-diversification of their portfolios, which ultimately hurts the ROI. To diversify your investment optimally, you need to research and manage the assets you have chosen to invest. In reality, this suggestion is vastly misapplied.
Why is it important to diversify your investment portfolio
According to modern portfolio theory, diversification was not meant to prevent losses, but rather that would minimise them while keeping your expected ROI unchanged. One of the most obvious benefits of diversification is the spread of portfolio risk, so if one asset fails, it will not bring the rest of your investment assets down with it. Market conditions might impact all asset classes, whether they are correlated or not, so you do not want to put all of your eggs in one basket.
International investment diversification has been shown[1] to have considerable benefits that far surpass any potential drawbacks. Increasing a portfolio's number of securities only makes sense if its marginal gains outweigh its marginal costs.
What does it mean to diversify your portfolio?
Diversifying your portfolio means including a wide range of different asset classes in your holdings. You can diversify your portfolio in two ways:
- Investment across different asset classes
- Investment within the same asset class but through several different investments
Investing across different asset classes means you are incorporating stocks, bonds, real estate and many other assets from different asset classes.
When you invest in a wide range of assets within a single asset class, it just means you are investing in one kind of asset but from different issuers. For example, you want to invest in stocks only, and there are several ways you can do this:
- Invest in a wide range of companies from different sectors of the stock market
- Have a diverse stock portfolio from a wide range of businesses (large-cap, mid-cap, and small-cap)
- Buy both domestic and global stocks
Investing in many funds with the same holdings might be a costly blunder if you're not careful.
Mistakes you are making in diversifying your portfolio
You don't want to make certain financial blunders. This is especially true when it comes to your investments. Here are a few frequent mistakes to steer clear of when attempting to broaden your investment portfolio:
- Naive diversification strategy
- False diversification decisions
- Not adjusting risk-exposure
Naive diversification strategy
A study conducted by Econstor[2] found that a majority of the investors diversified their portfolio based on an accepted yet elementary approach that is only sufficient to reach a financial goal but not to achieve investment growth. For example, investing in different types of stocks, funds, and real estate is a common allocation strategy used by most investors that creates a below-average portfolio with poor returns, not losses necessarily. In this situation, the investor only looks to diversify across into various assets because the golden rule says so. This is widely known as a naive diversification strategy[3] or diversification heuristic.
The investor has not studied those individual assets well enough to find a positive or negative correlation between them. A positive correlation means the assets fluctuate together, and the investment income in both will be affected simultaneously by a market boom or crash. A negative correlation usually removes the risks of combined assets. Lack of this understanding could lead to both over and under-diversification because the conclusion is based on a simple rule and not research relevant to the investment blueprint. Your investment blueprint should outline your investments' goal and establish each step to facilitate you to achieve it. It should avoid including any measures and assets that would contradict the financial aim - in this case, putting two assets together that positively correlate and has the risk to suffer losses at the same time. Here, you need to analyse whether the assets are dependent on each other to avoid more significant losses when the market crashes.
False diversification decisions
People look for patterns in places where there are none, and if there are any, it is not supposed to be admitted as of actual value. The same goes for investments. For example, investment brokers repeatedly disclaim that "past performance cannot guarantee future returns, " yet investors still cannot help but use the information to their basis for investment. They misinterpret any input and look for patterns only to end up with useless information. This is because investors prefer some amount of data, no matter how small or irrelevant they are. The same study by Econstor found that investors use any resource available as justification for their poorly diversified investment portfolio even though the information is incomplete or invariable. It leads to false diversification decisions and an inferior portfolio. Here, you need to take this information with a grain of salt before making a decision. If you are unsure about that specific asset class, then invest in the ones you have more concrete information on.
Not adjusting risk-exposure
Investors often forget that every single asset has its level of risk exposure which needs to be adjusted. To diversify investment portfolio is to diversify risk. Instead of taking a few asset classes with the proper amount, investors tend to gravitate to taking a slice of each. Carnegie Mellon University[4] has found a diversification bias where people tend to choose more varieties, thinking it would maximise output. In terms of diversification in an investment portfolio, an investor may choose several asset classes in equal amounts without understanding their volatility. For example, if someone invests in a real-estate-backed platform with a high default rate and a business-based platform with a mild default rate - the results do not even come close to covering the losses. Hence, the risks taken are not worth investing in, in the first place. This results in an investor making a naive diversification of his portfolio. An investment with high volatility will not be counterbalanced with a low volatility asset. Instead, you need to choose another highly volatile asset with a low correlation to other assets.
How to diversify your portfolio properly
To properly diversify your portfolio, you will need to observe the options you have that suits your financial goals. Diversification has no standardised list that one can check out. Therefore, the following are some examples of how you may diversify your portfolio:
Invest globally
Looking beyond the borders is essential while developing your investment portfolio. This is called "home country bias"[5], where investors prefer to invest in companies from their own country over those from other regions. Studies found[6] that Denmark, Sweden, and the UK have a lower home country bias compared to the rest of the EU member states.
While local investing has its advantages and global investing has its risks, the opposite is also true. You will miss out on opportunities in areas that have been outperforming recently (technology, for example), and you may not be able to adequately diversify your investments across the economy if you limit yourself to local markets. Consider the recent underperformance of Canadian stocks[7] due to their high energy exposure and the recent drop in oil prices.
Invest across different asset classes
Invest in a variety of asset classes to diversify your portfolio rather than multiple assets within the same class. This is because of asset correlation, which moves in tandem. Different assets with a correlation score below 1 reduces portfolio risks[8] overall. Although correlation shifts over time, it does not negate the fact that it is safer to invest in different asset classes with lower correlation. The common assets from different groups include stocks, bonds, cash and real estate. Each as its own advantages and risks. Even though they aren't closely related, due to globalisation, a shift in one asset may impact another regardless. Therefore the best course of action would be to rebalancing your portfolio whenever you see that there is a shift in the market and the adjustment is necessary.
Determine your sector allocation
Sector and industry also matters for sophisticated investors when it comes to diversification. Some sectors will do better than the others and some worse. For example, the tech sector boomed during the pandemic whereas, oil/gas, retail and transportation sector suffered throughout.
You can also take it a little further and add varieties of assets within the same sector. For example, if you want to invest in real estate, you may diversify your real estate portfolio between residential and commercial properties. You may also want to add REITs to your portfolio.
As with every strategy, there are advantages and disadvantages. However, if the portfolio is not overly reliant on a single asset, the risks will be minimised.
Summary
The vast majority of investors will misunderstand the information they have access regarding their financial interests. Over or under-diversification of their portfolios is the consequence of such. To get the most out of your investment, you must do your homework and keep track of the assets you've selected. Of course, even the best diversified portfolio will suffer losses from time to time. When diversifying a portfolio, many investors make the error of picking a wide range of assets without examining their link to each other. They try to look for patterns in the market when there is none and as a result, investors can't modify their risk exposure as needed. The best way to diversify your portfolio is to look at the possibilities that are available to you based on your financial needs. There is no one-size-fits-all approach for a well diversified portfolio. Investing abroad, across numerous asset classes on the basis of correlation, and according to different sectors helps reduce your portfolio's risk. Despite the fact that it will not completely prevent losses, it will significantly reduce them.
The mistakes discussed above are not an exhaustive list, just those not frequently explored in diversification. Many financial experts have studied investors' tendencies to better understand their mindset behind their investment choices to improve decision making. They have found that investors feel a lot better if there are resources for them to rely on because it gives them the security of certainty. However, what investors need to do instead, is understand the past information and try to connect it with the current market situation. If the results make sense, then investors should accept the information as the basis for their decision.
List of References
- Source: researchgate.net
- Source: econstor.eu
- Source: investopedia.com
- Source: cmu.edu
- Source: investopedia.com
- Source: bruegel.org
- Source: morningstar.co.uk
- Source: morningstar.com
