Diversification is the ultimate tool for avoiding complete investment losses. But how exactly do investors find the right assets to diversify into? And does diversifying come with any unintended consequences? Finally – is there such a thing as diversifying too much?
“Never put all of your eggs in one basket”
Unfortunate economic events have different impacts on different asset types. Which means that the investor who spreads their CHF 100,000 across multiple asset types exposes themselves to less risk than if they were to choose one alone.
Diversification is therefore important to most investors. But what is exactly is the process for finding assets that:
- Behave differently to an existing investment?
- Are likely to deliver a return?
Identifying assets that behave differently
When risk reduction is the goal, investors have little to gain from investing in an asset that behaves similarly to an existing one:
So, diversification begins with understanding the overlap between assets.
The overlap can be calculated quantitively by finding the correlation. But calculating correlation is both complex, and it can’t be relied on as a sole indicator asset behaviour. That’s because a correlation figure is calculated for a particular moment in time, and may not be relevant for long.
This means that rather than relying on correlation alone, it’s up to investors to thoroughly research the nature of potential assets and draw their own conclusions. For example:
My research shows that gold is likely to behave differently to my equities in the event of a recession, yet still provide an acceptable return.
Diversification comes packaged with a trade-off
Diversification has a strong effect on the range of return one can expect. It narrows it.
Overdiversification has another catch. Many authors suggest that we humans struggle with keeping many topics in mind at the same time. Investors are prone to this, and while there are tools for making it easier, they are expensive and often reserved for institutions.
For example, if you picked one security from the S&P 500 and held it for five years between 2016 and 2021, your annualized return may have been anywhere from -36% to +51%.
Had you chosen 100 securities, it would have been from -10% to +27%.
While diversifying provides you with reduced chances of losing your money to bad investments, it reduces your chances of making a fortune. Exceptional profits from your high-performing assets will be mixed with lower profits or losses from others.
Finding the optimal amount of diversity
Just as no diversity in a portfolio is dangerous, so is too much.
A portfolio built of too many small-weighted investments makes an investor hyper-sensitive to each one’s performance. It becomes easy to overreact to both good and bad performance, even when assets might have relatively insignificant weights of 1-2% in a portfolio.
Overdiversification has another catch. Many authors suggest that we humans struggle with keeping many topics in mind at the same time. Investors are prone to this, and while there are tools for making it easier, they are expensive and often reserved for institutions.
To see it in another way, consider this:
Imagine you’re conducting two boys’ choirs. The first has two boys, and the second has 80. How much harder will it be to find the source of false notes in the second scenario?
Before you diversify: a checklist
To identify the right assets for your portfolio, consider these criteria:
- Which assets behave differently to those I already have, and are still likely to generate a return?
- How much narrowing of my returns am I willing to accept to reduce my risk exposure?
- What is the limit I will set to avoid overwhelming myself with too many investment types?
