Diversification
Written By: Milja Mieskolainen
According to a survey conducted in 2015, 46% of Finnish investment portfolios contain only one share and 16% two (source: Shareownership in Finland 2015). While owning just one or two companies may make it possible to know one’s portfolio thoroughly, the benefits of diversification are overwhelming. The ultimate idea of diversification is to gather the best of for example companies, asset classes and geographical areas, into your own investment portfolio and at the same time reduce its riskiness. In an efficient market, no one can know the best investment or predict the future.
Every investment has its good and bad times, which cannot be avoided due to different types of risks. However, diversification can reduce the impact of bad times by the good and bad times of different investment targets coinciding at different times and at different stages of the business cycle. This phenomenon is due to the different ways in which investment targets react, so it may not be necessary to find just the perfect target. Investment risks are divided into market risk and company-specific risk. Market risk refers to a factor affecting the entire target market, such as a financial crisis or sanctions, that cannot be diversified away. Company-specific risk refers to the risk factor for an individual investment that can be effectively diversified away.
Diversifying your own investment portfolio does not necessarily mean compromising. The general perception is that the best return can only be obtained by concentrating investments on the most attractive investment of all. The biggest problem with this idea is precisely that the best investment cannot be seen from a crystal ball. The investment with the highest return is usually also the most risky of all. The value of a poorly diversified portfolio fluctuates easily, which can make an inexperienced investor in particular act short-sighted. A well-diversified investment portfolio also provides an opportunity to take advantage of, for example, declining markets, and start buying when prices are cheaper.
It is important to remember that diversification is not a way to generate additional revenue. Its main function is to hedge against company-specific risks, thus reducing the loss of returns caused by the downturn. It is conceivable that the most important task of any investor is to allocate their assets so that the risk-return ratio of the investment portfolio is as close as possible to the efficient front. Its main idea is that the risk and return of an investment portfolio are optimal in relation to each other. Since this optimization is based on the correlation between investment targets, it is important to always look at the portfolio as a whole. In practice, this means that in addition to the high return expectation, the correlation of the investment object with other objects in the portfolio must be taken into account.
The theory of an effective front described above has also received criticism. It can be troublesome for the investor to calculate all the necessary figures, even though they are increasingly available pre-calculated. History is not a guarantee of future returns or behavior, so actual figures may not tell us anything about the future. In addition, the theory does not measure real-world risks, such as insolvency risk, and is very sensitive to changes in the expected return on any asset. These pain points should be kept in mind when planning your own strategy.
Diversification in practice
The general opinion is that the most important form of diversification is to choose investment targets between different asset classes. Asset classes include, for example, shares, interest, currencies, forest and housing. The correlation between these is usually low, and diversification may make it possible to achieve returns when the rest of the economy is weak. Diversification between asset classes is called allocation. For example, government bonds with good credit ratings can perform well when the rest of the economy is doing poorly. Gold is also generally considered a “safe haven” for investors.
Returns by asset class 2009-2018, on the left is the highest (Source: Evli, Bloomberg.Ltd)
For equity investments, it is a good idea to keep in mind diversification within asset classes. This can reduce the risk associated with an individual country, company or sector. If you only invest in a single stock, the investment is really sensitive to political decisions or natural disasters, for example. One of the easiest ways to diversify your investment within an asset class is to buy an ETF, which often invests in hundreds of stocks or funds.
When you start investing, you need to remember to remain patient. Time diversification is easily forgotten when one gets excited about how the market works. In the long run, the investor's return expectation is positive regardless of the start date. In the short term, a situation may have arisen where you have bought at the top of the market, and in the worst case, it may take years to recover from the decline. For example, investing a student loan should be spread over several years, allowing you to study the most important aspects of investing yourself and see how the market works. By investing in flat monthly amounts or on a quarterly basis, you will have bought in both ups and downs, resulting in more in the bear market and less in the rise market.
If an investor puts 30% of their assets in the stock market that doubles over the next few years, in the end, up to 60% of the investor’s assets are in shares. Diversification has changed over the years without being noticed. It is important to remember to rebalance the portfolio at regular intervals to avoid over-allocation in a particular industry, asset class or geographic area.
Diversification doesn’t have to be complicated - it’s worth focusing on the big picture. For example, a 1% change in weight from one asset class to another does not make a significant change. At any stage of investing, the investor can think about their own strategy according to their own preferences. If you have the time and desire to explore several different possibilities, you can do so or choose one, easy, strategy and stick to it for decades. An example of a simple strategy is to follow world market weights (Ari Kaaro, Seligson & co); 30-50% in North American index funds, 25-30% in European index funds, 10-20% in Asia and 5-15% in emerging markets of the portfolio's assets, and 0-10% in Finland. Diversification into different asset classes is not taken into account here.
A slightly more advanced strategy is to divide the portfolio into tactical and strategic components. The tactical component refers to the part of the portfolio that allows the investor to be active in the market with the aim of winning market returns. The strategic approach seeks to establish the most balanced risk-return ratio possible. The strategic component usually consists of equities, bonds or mutual funds and comprises 50-80% of the value of the portfolio, and the items selected for it are not changed frequently. The tactical part is used to look for undervalued stocks that may also involve high risk and that are more actively traded.
More information:
Podcast:
Money for the rest of us: Are You Over Diversified? (available on Apple Podacsts and Spotify)
Book:
Graham Kenny; Diversification Strategy: How to Grow a Business by Diversifying Successfully
Other investing-related books:
Benjamin Graham; Intelligent Investor
Peter Lynch; One up on Wall Street
William N. Thorndike; The Outsiders
Charles D. Ellis; Winning the Loser’s Game
Peter Thiel; Zero to One
Joel Greenblatt; The Little Book That Still Beats the Market
David Clark; Tao of Charlie Munger
Robert G. Hagstrom; The Warren Buffett Way
+Berkshire Hathaway’s Shareholder Letters read for free