Portfolio diversification

Portfolio diversification is a risk-management strategy that involves trading or investing in a variety of different assets in order to reduce the risk of poor returns or losses. Portfolio diversification can be achieved in different ways, mostly relying on balancing investments in terms of market sector, maturity, risk level, return and more.

Simply stated, diversification avoids putting “all eggs in one basket”, as financial markets can be unpredictable. Diversified portfolios help to limit your exposure to risk and make your investments safer by including different types of financial assets. Portfolio diversification is based on complex mathematical theories, including the concept of correlation, variance, expected return and expected value.

Types of diversification in portfolio management

Diversification can take place at different levels, depending on the risk you want to mitigate, and can be as follows:

Currency-related: obtained by including instruments in the portfolio with different reference currencies.
Geographical: obtained by investing in various geographic areas around the globe.
Sectoral: obtained by focusing on various cyclical and defensive sectors.

Importance of portfolio diversification

The mistake that traders often make is to excessively focus on technical analysis and fundamental analysis at the expense of diversification, which could be a great tool in reducing the risk of large losses.

While the absence of losses cannot be guaranteed, effective diversification can help protect your portfolio from individual bankruptcies and, in part, from larger market shocks. Owning a diverse range of assets can also expand your chances of identifying potential earnings. Building a diversified portfolio is not always an easy task and it requires financial resources and knowledge.

The value and income of different assets in an investment fund might in fact increase or decrease, leading to upward or downward movements in the overall value of the investment itself. There is no guarantee that the financial objective of the fund will be achieved and it is actually possible that the initial amount invested might never be recovered.

Portfolio diversification and correlation

By following certain criteria when making an investment, it is possible to ensure that the overall yield does not stray too far from what was forecasted and expected, which are the following:

Expected value: the average value of a random phenomenon.
Variance: it indicates how much an actual value, in the form of a variable, deviates from the forecasted value.
Correlation: the relationship between two variables, where each value on the first variable regularly corresponds to a value on the second variable.

It should be noted that the importance of correlation in portfolio diversification stems from the necessity of creating baskets with little or no correlated securities, meaning that the securities should not influence each other. The reason for this is that, if a specific stock does decrease in value, it will not cause another asset to also decrease in value, unless already forecasted in the investment plan. Any adverse event would generally cause as little damage as possible to the portfolio as a whole.

This is why for each stock, historical data is collected and statistical studies are conducted as part of company analysis, focusing on the expected values and distance between them and the actual data. Furthermore, a study on the correlation between multiple variables and data is also added. All of this is important because it allows you to get more information on the return that you can expect.

Portfolio diversification strategy

Diversifying your trading portfolio means choosing different types of financial instruments in order to minimise the risks normally associated with any investment, and this can be implemented when building your trading plan.

In fact, unexpected events should always be taken into account, such as the value of a security undergoing sudden changes and reducing to a tenth of its original value within a few days. If all your investments were concentrated on that particular security, you would suffer a substantial economic loss. The reverse is also possible: that a single security might grow beyond expectations, but such a prospect is definitely too much of a gamble to rely on, and is one of the mistakes to avoid when trading.

The main types of portfolio diversification investments include the following securities:

Diversification entails identifying different investment targets and selecting the ones that better suit your financial objectives. When doing so, it is extremely important that you evaluate the level of correlation existing among your assets, that is, how one affects the other.

A carefully planned portfolio diversification strategy decreases volatility, meaning the changes in asset prices over time, as well as the related drawdown or the loss of the invested capital. Consequently, profitability tends to increase, thanks to a significant degree of value protection, even in times of crisis, and to the possibility of seizing opportunities from different markets and financial environments.

CFDs and spread betting are both leveraged products that can be used to trade on the above assets on our platform as part of your diversification strategy. Learn about the differences between spread betting and CFDs.

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Portfolio diversification example

There are many examples of portfolio diversification, depending on the type of strategy that you want to apply. One of the best-known examples is provided by Harry Browne, an American scholar and financial analyst who developed a very popular theory based on maximum diversification.

Browne’s theory uses the principles of the well-known communicating vessels experiment. When a system of connected containers is filled with a fluid and is subject to the same atmospheric pressure, the fluid will settle at the same level, without any of the vessels being subjected to excessive weight. Transported to the financial market, this experiment basically means that investing simultaneously in all asset classes could ensure a well-balanced investment portfolio.

What a diversified portfolio looks like

An example of a portfolio based on the Browne model is one divided into four parts:

25% shares
25% gold
25% short-term government bonds
25% long-term government bonds

Although it might appear simple enough, this model still requires a trader to carefully select what shares and securities to invest in and to consider numerous factors when choosing a course of action. However, this is an excellent example for structuring a diversified portfolio.

Beta and systemic risk

In the context of the stock and index markets, beta refers to the behaviour of a security (or a portfolio) in relation to the volatility of its benchmark index, or reference index, meaning the change in the share compared to the change in the market.

It should be noted that the market has a Beta value of 1.00 as a base. A Beta value of 1 indicates that the security or portfolio is moving hand in hand with the market. If the value changes, on the other hand, it means that the security is deviating from the market trend. This is why when the Beta value exceeds 1, it means that the security is going in the same direction as the market but with higher degree of variation (essentially, it is moving faster than the market).

It is essential to know that the Beta value can also be negative. In this case, it means that the security or portfolio is moving in the opposite direction as the market. In other words, if the market is overall going up, the security in question is going down.

In regard to portfolio diversification, the Beta value is very important because it helps to understand how much a security is really exposed to the so-called systemic risk. A high beta value implies that the security is greatly influenced by markets trends, whereas a low beta value indicates that it is moving with a certain degree of “independence” from the market and therefore has lower volatility.

When the beta value on average approaches 1, it means that the security is following the direction of the index very closely, and this is how ETFs are studied. Learn more about calculating stock beta.

ETF portfolio diversification

ETF trading is an effective portfolio diversification tool that can be used in a few simple steps, without resorting to purchasing multiple equity lines.

Most ETFs track the performance of an index. By purchasing an ETF, you will have direct access, with a single transaction, to all the securities in the related index, which is representative of a market or of a defined smart beta strategy. The investor will then be able to build a diversified portfolio consisting of several ETFs rather than having to buy dozens of shares or bonds. Read our “what is an exchange-traded fund” article for more information.

Advantages of a diversified portfolio

The portfolio risk is reduced
It provides hedging against market volatility
There is a possibility for higher long-term returns

Disadvantages of portfolio diversification

Equal chance of lower short-term returns
Managing a portfolio requires more time
Higher trading costs, since a higher number of transactions equates to higher commissions