A Look At Diversfication Theory
The old saying “Don’t put all your eggs into one basket” has been used to encapsulate the notion of diversification ever since the inception of Modern Portfolio Theory. Diversification theory is perhaps the most widely embraced investment strategy and is practiced by retail and institutional investors the world over. Put simply diversification theory espouses that by assuring your portfolio is exposed to a broad base of securities and asset classes you are able to reduce the volatility of your portfolios returns. In the current market climate of seemingly ever increasing volatility diversification now appears more attractive than ever - But how exactly does diversification theory work?
Well before we can understand diversification we first have to understand a statistical concept known as correlation. The term correlation refers to the relationship between the price movements of two different assets. Correlation is measured on a scale of -1.0 to +1.0, on the low end a correlation of -1.0 means the returns of the two assets are perfectly negatively correlated whilst on the high end a correlation of 1.0 means the returns of the two assets are perfectly positively correlated. For example if Asset A and Asset B have a correlation of -1.0 a 10% decrease in Asset B’s price would mean Asset A’s price would also decreases by 10%; the converse is true for two assets with a correlation of 1.0. Also importantly a correlation of 0 means there is no relationship between the returns of the assets so a 10% increase in Asset A’s price would give you no indication on what would have happened to Asset B’s price. So what has all this got to do with Diversification?
Well the goal of Diversification is not simply to have a portfolio that is invested in a large number of securities but rather to construct a portfolio where the correlation between the returns of the various assets is negative. Let consider two portfolios, Portfolio A which is a broad based index like the ASX200 and Portfolio B which is a portfolio of 5 randomly selected ASX200 shares. While most investors would hail portfolio A as a well diversified portfolio and criticise B for failing to eliminate diversifiable risk the two portfolios are still essentially 100% long equity. Given the two portfolios are 100% exposed to the same asset class we can deduce the correlation between the returns of the assets in each portfolio will be relatively high. This relatively high correlation means both portfolios are entirely exposed to the full brunt of equity market volatility and thus carry a higher risk than what many investors would perceive.
However investors do not simply have to accept this higher level of risk as even at the retail level there are a host of tools available that can help reduce the correlation of returns and thus the level of risk in your portfolio. The first and perhaps most obvious is to invest in asset classes with 0 or negative correlation to equities. This will ensure that when markets start moving into the red that the losses on your equity positions can potentially be offset by gains from other assets such as managed futures, bonds, commodities and FX. By spreading risk not only across different securities but also across different asset classes you may be able to reduce your portfolio's overall downside risk. Being able to move into cash during poor market conditions can also help reduce portfolio risk as you may be able to preserve long term returns by avoiding the dramatic price falls that highly correlated 100% equity portfolios experience with relative frequencey.
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