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Few investors hold a single security or asset for life, whether it’s one stock, one bond, or one piece of real estate. While it’s certainly possible to do so and make money, relying on one investment to consistently appreciate (and survive) over time is a big risk. That’s why most successful investors diversify their investments.
Diversification is one of the simplest ways to reduce risk in an investment portfolio. In general, investors are faced with two primary types of risk—systematic, or market risk, and unsystematic risk, or company or industry specific risk. Market risks are outside of our control and may include changes in inflation, interest rates, geopolitical events and natural disasters. These risks tend to affect all investments and cannot generally be diversified away.
Unsystematic risk, on the other hand, is the risk specific to an individual company, business sector, or geographic location. It can be reduced through proper diversification. As such, a diversified portfolio is typically allocated among various types of investments, which may differ from one another by asset class, business sector, size, geographic location, maturity, credit rating, or a different category altogether.
Ultimately, the purpose of diversification is to help investors meet their long-term financial goals by minimizing portfolio risk and maximizing long-term return potential. But, why does it work?
We believe diversification is effective for three primary reasons.
You’ve probably heard the saying, “don’t put all your eggs in one basket.” In broad terms, this means you shouldn’t concentrate all your efforts and resources on one venture, since its success is not guaranteed. In other words, you should always have a back-up plan.
The same advice is true for investing. Even if you know a company, a piece of property, or an industry exceedingly well, it’s difficult—if not impossible—to pick winning investments with 100% accuracy. Some of the most successful investors in the world are only right a little more than half the time. Therefore, it makes sense that splitting your assets among a variety of investments is less risky than putting all your eggs in one basket, so to speak. Certainly you might get lucky with the one investment you might make, but that is a very unlikely scenario, and a tough way to achieve your long-term goals.
Portfolio volatility is not simply a weighted average of the risk associated with each asset in an investment portfolio. The formula to calculate portfolio volatility is dependent on a third set of variables—the correlations among portfolio assets. When correlations are high, then adding additional investments has little benefit in risk reduction. Alternatively, when including investments with low or negative correlations, overall portfolio risk can be reduced.
How is this possible? Correlation measures how each asset in a portfolio moves in relation to one another. Ideally, the assets in a properly diversified portfolio react differently to uncontrollable market events, meaning they’re uncorrelated. Some investments may perform well in a certain situation, while others may lose value. Over the long run, these differences in performance should help to offset one another, reducing the large swings in overall portfolio performance that would occur if all assets moved in tandem.
By nature, investors are irrational. When left unchecked, we tend to let emotion dictate our decision-making. For many investors, this means falling victim to the fear and greed cycle—chasing high-performing investments as they appreciate and abandoning them after they fall in value. Unfortunately, this type of behavior usually results in subpar portfolio performance due to buying and selling investments at the wrong time.
On the other hand, a broadly diversified portfolio can help mitigate the natural tendency to chase performance. Since your portfolio will have exposure to a variety of asset classes and markets, you’re likely to already own the top-performing asset class at any given time. Similarly, when certain asset classes are underperforming, the outperformance of other investments in the portfolio helps minimize the impact. Reducing the magnitude of even temporary portfolio losses often helps investors stay the course in turbulent markets.
While diversification has many benefits—both practical and academic—it doesn’t guarantee you won’t see losses in your portfolio. There are times when assets become highly correlated to one another in the short term, and all investments seem to lose money (the end of 2018, for example).
These periods are inevitable, but they’re not the norm. Because of the role diversification plays in moderating portfolio volatility over time, we believe a diversified portfolio is critical for investors to meet their long-term financial goals.
You can learn more about our investment approach here.
Randy Joseph is a relationship manager for CIBC Private Wealth Management with more than 20 years of industry experience. He is responsible for business development and managing existing relationships for high net worth individuals and families. He joined Team Geneva Advisors in 2014.
July 30, 2019
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