Diversification and Risk Management In a Volatile Market
Diversification in volatile and uncertain market conditions allows you to trade off losses from one security with gains from another. That said, think that your investment portfolio includes all the securities in which you invest, seeking to achieve optimum returns while accepting a lower risk.
What is Portfolio Diversification
Portfolio diversification is a risk management technique where investment products with different risk and returns are included in the same portfolio in order to reduce the risk and smooth out a significant portion of the portfolio volatility. Thus, by diversifying your portfolio what you are actually trying to do is level the impact of both systemic and unsystematic risk and absorb the losses that may result from underperforming individual securities.
Rational investors allocate their assets in such a way as to maximize their portfolio performance for any given level of risk. In doing so, they make sure that no other portfolio or single investment can offer a higher return at the same level of risk. So, put simply, a diversified portfolio allows you to invest in different securities with different returns, different correlations between these returns and different risk levels so as to reduce the portfolio risk, while sustaining the same returns.
Portfolio Risk and Return
The risk of an individual security is expressed in relation to the volatility of its returns. The volatility of stock returns is expressed by the variance (σ2) and the standard deviation (σ). The use of the standard deviation (σ), which is the square root of the variance, has prevailed because it is expressed as a percentage, making it easier to perform comparisons between different securities. Therefore, securities with a higher standard deviation tend to be more volatile and, therefore, riskier.
Given that a portfolio consists of more than one assets, the portfolio return is the weighted average of the individual securities included in the portfolio, such as equities, bonds, mutual funds, time deposits, foreign exchange, precious metals, and so on. Likewise, the portfolio risk is the weighted average of the standard deviation of each security included in the portfolio.
Correlation is a mathematical approach to determine the extent to which the value of a security can be affected by changes in the returns of other securities. A correlation coefficient of 1 indicates that two securities are perfectly positively correlated. Therefore, if the value of the one security increases, so will the value of the second security. A correlation coefficient of -1 indicates that two securities are perfectly inversely correlated. Therefore, an increase in the value of one security corresponds to the second security decreasing in value. A correlation coefficient of 0 indicates that there is no correlation at all between the two securities.
So, if you invest in a portfolio that consists solely of technology stocks, the correlation between the securities is very high because they trade in the same industry. Thus, negative news about the sector will cause your portfolio to decline severely due to the high positive correlation between the securities. To that end, you should select stocks that trade in different sectors so that the correlation coefficient between your investments is as low as possible. A low correlation allows you to achieve the maximum diversification. On the other hand, leveraging risk often comes with a lower portfolio return, but, by all means, the returns of diversification are better than the losses of an undiversified portfolio.
Types of Diversification
As an investor, you have different options for diversification across a wide range of cost, performance and risk options. For example, through horizontal diversification you invest in similar financial products, such as shares of different US banks. Although each company has its own strategy, a credit event will have a negative impact on the economy in general as well as in the stock market. Through vertical diversification, you invest in financial products that trade in different sectors or even markets. In doing so, you lower your portfolio risk, even in the event that a credit event affects the entire economy.
The Risk of Over-Diversification
A fully-diversified portfolio may include equities, corporate bonds, T-Bills, real estate, ETFs, index funds, equities that trade in international markets, foreign currencies and so on. However, you should make sure to avoid over-diversification, which occurs when an additional investment in your portfolio does not improve its risk-return ratio further. This means that there is a point where the marginal benefit of investing in a new security is lower than the loss of potential profits. This is known as the law of diminishing returns.
For example, as the number of your investments increases, the performance of your portfolio tends to mirror the S&P 500 or the Dow Jones Index. In practice, this means that the performance of your portfolio will be equal to the performance of the average market, but you will also incur management costs, trading fees and so on. Thus, the marginal benefit will be lower as you keep on adding new securities.
The Bottom Line
In general, the higher the degree of diversification, the lower the risk, both systemic and unsystematic for your investments. This happens because the probability that all your securities lose in value simultaneously decreases, thereby lowering the total variation of your portfolio. At the end of the day, diversifying your investments will allow to gain a higher return while leveraging risk.