How diversification helps investors shield their portfolios against risk

Summary

• Diversification is allocation of capital into multiple asset classes, primarily to reduce the risk posed by a large investment.
• Over-diversification can also lead to loss of potential returns.
• Diversification also helps to vastly reduce the volatility of a portfolio.

'Don't put all your eggs in one basket’ – This is a 400-year-old adage, which was coined and popularised by Miguel de Cervantes, the author of Don Quixote. Over the years, the saying has taken on a significant meaning in the investment world. It is a piece of wisdom that advises against risking all your savings in one asset class.

Investing in financial markets comes with a plethora of options. Investors have the luxury of choosing from different asset classes to invest, helping them to reduce their bets on any single asset. This consequently allows investors to reduce the risk at the portfolio level.

This is the basic essence of diversification – to spread one’s investments across various assets/sectors so that any one of them should not impact the portfolio to a great extent. The underlying premise of diversification is that at any point of time an asset class such as equity may take a severe hit due to any fundamental or technical reason, however the same happening with other asset classes such as bonds, commodities, etc, at the same time, is highly unlikely.

Diversifications can also take place within a single asset class. For example, in equities, there are various sectors such as airlines, financials, technology, etc. which could also be looked upon for diversification to minimise the risk. Let’s look at a practical example of how diversification helps an investor mitigate or hedge his/her risk.

Read More: Is Diversification in Stocks still Relevant – PIN, BET, ENE and GSW?

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Let’s say an investor, X, has multiple oil stocks in his portfolio, having a direct co-relation to oil prices in the international market. Now, oil starts to fall and consequently oil stocks also start facing selling pressure. Now, if his entire portfolio were filled with oil stocks, there is a very high risk of loss. To mitigate or diversify this risk, X can opt to add stocks of those companies that may benefit from the falling oil prices, such as airlines industry (which lowers the cost of flying). Now, as oil stocks would take a hit, airlines stocks would see demand from investors at the same time, making them trade higher. This way diversification could help an investor to vastly manage his risk at the portfolio level.

Notably, although diversification helps in mitigating the risk, it has been done at the cost of minimised potential profit that could have been achieved on a concentrated bet. Taking the above example, had oil prices started to increase instead of decreasing, X would have made a good profit. Still, the benefits of diversification greatly outweigh its drawbacks, if an investor is not “overly-diversified”.

Related Article: Commodities As A Means For Portfolio Diversification

Some key benefits of diversification

Let us have a brief look at some of the key benefits of diversifying a portfolio.

1. Minimises the risk of concentrated bets

Diversification means investing in multiple asset classes in a portfolio. This inherently means the concentration of a single investment is reduced as the limited capital is now being deployed to different investments. However, the allocation of capital to various investments is decided by investors and can still be highly focused on one asset.  As diversification increases, the risk gets minimised.

2. Exposes to more opportunities

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Another advantage of diversification is that investors take exposure to other investment opportunities which reduces the opportunity cost. This helps investors to cash in on favoured price move in various assets at once.

3. Safeguards from adverse market cycles

It is a well-known fact that stock markets/financial markets move in cycles.  These are long-term economic cycles and diversification within one asset generally fails. For example, in a secular bear run, almost every sector takes a hit; there’s no safe zone to hide. But diversification into a different asset, starting for a secular bull run can be you saviour, like gold and equity markets generally have an inverse co-relation.  

4. Reduces volatility of a portfolio

Diversification vastly helps to calm down the volatility of a portfolio. Volatility is a measure of the magnitude of a price move of a security. This could be measured using Beta, Standard deviation or technical indicators such as Average True Range (ATR), etc. When the capital is deployed in multiple assets, the assets with lower volatility tend to offset the portfolio volatility caused due to higher volatile assets.    

Read More: Three things to focus on in bear or bull market