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What is the Meaning of Diversification?

blog, Financial Planning
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While the question is simple, the answer is not. Below I have listed several factors where diversification plays a role in reducing risk in an investment portfolio.

Asset allocation

Most people think of asset allocation when considering if their portfolio is properly diversified. We allocate our monies across the following three (3) asset classes: equities, fixed income, and cash. The decision to include an asset class is based upon their historical correlation with other asset classes. Correlation measures the strength of the relationship between two asset classes, where the value can range from +1 (perfectly correlated) to 0 (no relationship) to -1 (perfect hedge).

When working with my clients, we dedicate a significant portion of our time understanding their risk tolerance. Risk tolerance is a measure of comfort a client has with market volatility and their perception of the trade-off between potential gains and potential losses. The higher their risk tolerance, the higher the allocation to riskier assets (equities).

I am willing to introduce additional asset classes such as real estate, commodities, hedge funds, private equity, etc. if they meet two (2) criteria:

  1. Does the asset class have a return profile that has economic justification? As an example, I would not include baseball cards or postage stamps as an asset class.
  2. Does the new asset class provide any diversification benefits (is the correlation close to 0)?

Diversification within an asset class

When you start drilling down into individual asset classes, diversification takes on addition meaning.

Equities

  • Geographic: should you be invested in just your home country, or should you look towards other markets
  • Market capitalization: companies come in all sizes. To be properly diversified, you will want a mixture of large and small companies based on capitalization
  • Style: some securities are considered growth stocks; they derive their value based on future earnings expectations. Others are considered value stocks; they are established companies and investors are trying to find those companies who stock price is undervalued based on the industry fundamentals.
  • Sector: the stock market is broken into 11 sectors. You need adequate representation for each in order to be diversified.
  • Name: there are two types of risk that are assumed by investors: systemic risk which affects the market as a whole, and non-systemic risk which affects individual companies. Having a high concentration of your investment in a single name can derail your investment.

Fixed Income

In addition to geographic considerations, a portfolio needs to consider

  • Credit risk: what is the likelihood of an issuer defaulting on their obligation.
    • Government backed bonds are considered the safest. But not all governments are equally rated.
    • Other issuers are government agencies, municipalities, and corporate bonds.
  • Interest rate risk: bonds have maturities. Typically, the longer the maturity and the lower the coupon, the more volatile the price is for a change in interest rates.

External managers

My strategies make use of external managers. Diversification considerations require proper due diligence on the manager and the fund.

In addition to all the considerations mentioned above, I need to take into consideration:

  • How many different managers do I want to include in a managed portfolio?
  • Do I want active management (try to capture excess returns over a benchmark), passive management (mirror returns of a benchmark), or a combination in a managed portfolio?
  • How do the active managers add value? Are they good stock pickers, market timers, economic forecasters?
  • How much do I allocate to each manager/fund?

Disclosure

Michael Lewis, Registered Representative. Securities offered through Cambridge Investment Research Inc., a Broker/Dealer member FINRA/SIPC. Tutor Financial, LLC and Cambridge are not affiliated.

Investment Advisory Services offered through Independent Advisor Representatives of Cambridge Investment Research Advisors Inc, a Registered Investment Adviser

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