Investment portfolio diversification is the first and foremost principle of sound investing. This key feature of any good investment portfolio tracker states that no single stock, asset or industry should represent a disproportionate share of your portfolio. A well-diversified portfolio will provide you with a significant degree of downside protection.
In a well-diversified portfolio, assets that perform well will compensate for holdings that perform poorly. Over the investment cycle this is the key to solid investment returns. It is also key for your serenity and good night sleep as well. A well-diversified portfolio will maximize your chances of reaching your long-term financial goals while keeping investment risk in check.
The risks addressed by diversification.
In essence, your portfolio is exposed to two types of risk. Idiosyncratic risks, i.e. risk specific to a company or an industry, and market risks.
Idiosyncratic risk
Any company is exposed to a multitude of risks. These can come from the inside, for example from bad management, or from the outside, such as regulatory changes or natural catastrophes. These are a just a few examples of the many risks faced by any company. Against this backdrop, the need to diversify evident. Similarly, at the industry level, industries face risks as well. Structural change is one example. Think of the fate of Kodak cameras that were replaced by smart phones with integrated cameras.
Market risk
Expressed as market volatility, market risk affects all market participants and assets. Drivers are factors such as political conflict, inflation or interest rates. These factors will affect different types of asset classes, industries and even companies in different ways.
How to construct a diversified investment portfolio.
As always with investing, the right formula differs from investor to investor. If you are a risk averse investor, you need to start diversifying from the asset level on. You will need to build your portfolio on bonds, large diversified ETFs and large cap stocks. If you are young and prepared to take on some risk, you are likely to invest in stocks of high growth companies, which you can find with our ultra-fast free stock screener.
These are some of the key diversification categories:
- Geography. Global brokers, such as Interactive Brokers make it possible for any investor to add geographic diversification to a portfolio. This means that you can own stocks from outside your country or even continent at a very reasonable price thus adding geographic diversification to your portfolio. There are also many ETFs that focus on particular countries or regions.
- Asset class. As mentioned in the introduction, different asset classes come with their distinct risk and return profiles, which investors need to consider for their individual financial situation and degree of expertise. The main asset classes to consider are bonds, stocks, ETFs and increasingly alternative asset classes, such as crypto, crowdlending and-funding, or even collectibles. If you think bonds are two complex, you can easily get exposure to bonds via bond ETFs. You can check out our high yield bond ETF portfolio to view some of the best bond ETFs in the market.
- Industry. The Ziggma screener comprises 31 different industries. And, even industries themselves can be very heterogeneous. So please make sure that you spread your holdings across different industries.
- Stock. This is the most obvious one. No stock should make up a disproportionate share of the portfolio. As rough rule of thumb, no stock should make up more than 1/total number of stocks + 10%.
How does portfolio diversification reduce portfolio risk?
Diversification brings down portfolio risk in several different ways. It minimizes the risk of disproportionate losses as you hedge your bets. In the insurance world, this is referred to as limiting the maximum probable loss in an extreme loss event. Well performing assets or holdings will compensate for loss-making ones. Stocks in dynamic industries will compensate for stocks in industries held back by structural change (ideally you will own stocks in the most dynamic industries at all times).
Low volatility holdings, such as bonds provide recurring income and a valuation anchor.
Does a well-diversified portfolio increase returns?
Many academic studies have been carried out on this topic. Researchers have found it hard to reach a consensus because of the infeasibility to draw conclusions across different investment strategies, i.e. portfolios comprising different asset classes.
What is certain is that diversification done right reduces the risk of major losses. This is in line with Warren Buffett’s rule number one “Don’t lose money” and rule number two “Never forget rule number one.”
Benefits of investment portfolio diversification
Many academic studies show that portfolio diversification done right generates a number of valuable benefits.
- A more stable investment return, as gains offset losses
- Minimize downside risk in the event of adverse idiosyncratic events affecting a company or industry you have exposure to
- Minimize downside risk in the event of adverse market events.
- Increase your chances to own winners. By diversifying across a handful to a dozen of growth stocks you increase your chances to own one or several future champions.
How to monitor investment portfolio diversification?
Portfolio monitoring is crucial to achieving the expected long term investment return. Keeping close tabs on portfolio diversification is a key part of that. However, this can be very cumbersome. Most of us are short on time and let’s face it, looking for new investment opportunities is way more intriguing than monitoring.
This is why we help our users monitor diversification in two ways:
- Display. The Ziggma app provides well-designed charts covering your portfolio diversification by asset class, industry, single stock, top three stocks and geography. In addition, we help users monitor portfolio quality by providing charts on
- Alert. By setting a Ziggma Smart Alert you can let us do the monitoring for you. Simply set a threshold for maximum exposure to a single company, industry or asset class and let us take care of the rest. You no longer have to worry about this portfolio management aspect freeing up your time for other more interesting and fun things. Once the threshold is reached, we will send you a notification so that you can take the appropriate action.
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