What is investment diversification

Diversification is well explained by the famous saying: “Don’t put all your eggs in one basket.” The term is used in many areas. They are talking about diversifying production, business, savings, investments and even the economy as a whole.

The first goal of diversification is to reduce risk. When it comes to the stock market, the more different assets you acquire, the less you will be affected by a decline in the price of each of them. And the higher the likelihood that you will compensate for this drawdown by increasing the value of other assets.

The second goal is to search for new profitable directions and occupy promising niches. However, this approach is fraught with dangers, and one must take the path of diversification very carefully. It is not always the case that a company’s success in one type of activity can ensure its success in another. And, moreover, sometimes attempts to expand activities can undermine the company's position in its main market.

Diversification Basics

Diversification seeks to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments offsets the negative performance of others. The benefits of diversification only apply if the securities in a portfolio are not perfectly correlated, meaning they move the market differently, often in opposing ways.

Research and mathematical models have shown that maintaining a well-diversified portfolio of 25-30 stocks provides the most cost-effective level of risk reduction. Investing in a larger number of securities creates additional diversification benefits, although at substantially lower rates of return.

Expand and conquer

Investment diversification. Reduces the risk of an investment portfolio, most often without reducing profitability. The greatest effect from diversification is achieved by adding assets from various industries and regions to the investment portfolio in such a way that the fall in the value of one asset is compensated by the growth of another.
Diversification of loans is the distribution of invested or loaned funds between various investment objects in order to reduce the risk of possible losses of capital or a drop in income from it. The activities of investment companies and funds are based on the principle of loan diversification; in the banking sector, the principle of diversification is manifested in the distribution of loan capital among a large number of clients.
Diversification of production. The simultaneous development of many types of production, expansion of the range of products produced by the enterprise, and the development of new types of production are carried out in order to increase efficiency and obtain economic benefits, and prevent bankruptcy.

Diversification of production is divided according to its connection with the main activity and further - according to its focus.
There is related and unrelated diversification, vertical and horizontal. Related diversification is a new area of activity for an organization that is related to existing areas of business; unrelated diversification is a new area of activity that has no obvious connections to existing areas of business.

Often, related diversification is preferable to unrelated diversification, since the company operates in a familiar environment and takes less risk, but if the accumulated skills and technologies cannot be transferred to another structural unit, they move on to unrelated diversification.

Unrelated diversification is more difficult than related diversification. The organization is entering new territory, working with new partners and new competitors, it must master new technologies, forms, methods of organizing work and much more that it has not encountered before.

Such a transition of a company to a new area is aimed at obtaining greater profits and minimizing business risks. With the help of this strategy, specialized firms turn into diversified complexes, the components of which have no functional connections with each other.

Let's return to types of diversification. Related diversification is divided, as mentioned above, into vertical and horizontal. Vertical is the production of products and services at the previous or next stage of the production process. For example, a manufacturer of finished products begins to produce components for it (down the chain) or a metal remelting plant produces fences, gratings, and forged furniture (up the chain).

Horizontal diversification is the expansion of the range of the same production stage. For example, a company that produces irons launches the production of kettles, microwave ovens and hair dryers. A new product can be launched under an existing brand (resulting in a brand extension) or under a new brand.

What leads firms to diversify?

There are many reasons for diversification - from excess funds to the plight of almost completely bankrupt production. Here are some of them:

the formation of excess financial resources beyond what is necessary to maintain competitive advantages in the initial areas of business;
the desire to survive and strengthen one’s position in a competitive environment;
an attempt to reduce business risks by distributing them between various areas of activity;
the opportunity to make greater profits than by simply increasing production volumes;
the need to respond to changing conditions;
transformation of a branch into a legal entity, etc.

There are many other reasons, including subjective ones. For example:

Fear of export. An increasingly common reason among Russian companies is that some businessmen are so afraid of entering the world market that they prefer to create something new in Russia;
Curiosity. Very often you come across a new project that seems interesting and profitable, there are resources for it, so why not try it?

Is diversification the path to success?

Diversification helps a business survive over the long term, and it can also help make efficient use of excess resources, expand its reach, capture new markets, and minimize risks. But despite all the advantages of diversification and the doors that it opens for businessmen, it cannot be called a panacea. Like all other financial instruments, if in the wrong hands, it can lead to losses.

There are many examples when the owner extracted money from the main business to develop a new direction and left current projects without proper financing, without giving clear indications of priority, confusing managers. Chaos began in the company, and employee motivation fell.

If we talk about investing, then there are some erroneous strategies. “Naive diversification” is a strategy in which an investor simply invests in a series of random assets and hopes that the likelihood of receiving income from this portfolio thereby increases. Using this strategy does not necessarily reduce the risk associated with the portfolio; it may even increase it.

What to do?

To avoid risks and increase your profits when diversifying, you need to follow a few simple rules:

any diversification must be preceded by the development of certain experience in a specific area, even with unrelated diversification;
it is best to start with adjacent, related diversification, as it is less risky;
diversification requires additional, redundant resources; you should not start it unnecessarily, without free funds;
you need to have several diversification options so that you can compare them and choose the most effective one;
it is necessary to correctly identify the most promising areas of future activity;
it is necessary to make a forecast of the development of the organization; the more ideas and plans for possible types of diversification, the higher the likelihood of choosing the most profitable and competitive method of new production;
before embarking on significant changes, you need to spend time, effort and money on preparation and experiments, it is necessary to create an experimental base, a testing ground for research;
it is necessary to use the opportunities associated with the creation of various strategic alliances and a wide base of business connections.

Diversification across asset classes and funds

Fund managers and investors often diversify their investments across asset classes and determine what percentage of the portfolio to allocate to each. Classes may include:

Shares of various companies.
Bonds are government and corporate debt instruments with fixed income.
Real estate - land, buildings, natural resources, agriculture, livestock, and water and mineral deposits.
Exchange traded funds (ETFs) are a commodity basket of securities that track an index, commodity, or commodity sector.
Cash and short-term cash equivalents (CCEs)—Treasury bills, certificates of deposit (CDs), money market funds, and other low-risk short-term investments.
Read also: What is hedging: about minimizing risks with examples

They will then diversify investments within asset classes, for example by selecting stocks from different sectors that tend to underperform, or by selecting stocks with different market capitalizations. For bonds, investors can choose from investment-grade corporate bonds, Treasuries, state and municipal bonds, high-yield bonds and others.

How to diversify your investment portfolio

The main principle of diversification is to make the investment portfolio as wide as possible. Simply put, do not invest all your funds in a single economic sector, and buy several assets from different countries, sectors, and companies. To balance the investment portfolio, there are investment rules:

Add assets to your portfolio, reducing the risk class.
Use assets that correlate with each other.
Hedge risks, use different asset classes.
Rebalance your investment portfolio - the proportions of shares should be brought to the original level.

Diversification by country

Investors may obtain additional diversification benefits by investing in foreign securities because they tend to be less closely related to domestic securities. For example, the forces that weigh down the US economy may not affect the Japanese economy in the same way. Thus, owning Japanese stocks gives an investor a small cushion against losses during a US economic downturn.

Mechanisms

Diversification mechanisms are used to neutralize the financial consequences of specific (unsystematic) risks. The main types of diversification of financial risks of enterprises are the following areas:

Direction of diversification	Actions
Types of financial activities	Alternative opportunities for making a profit are used: • Short-term financial investments; • Drawing up a loan portfolio; • Real investment; • Formation of a portfolio of long-term investments, etc.
Currency portfolio of the enterprise	For foreign economic transactions, several types of currencies are selected. This ensures a reduction in the financial losses of the enterprise due to currency risks
Deposit portfolio	Large amounts of available funds are stored in several banking organizations, which reduces the level of risks of the deposit portfolio without affecting the level of its profitability
Loan portfolio	The circle of buyers of the company's products is expanding
Securities portfolio	Reduces the level of unsystematic risks of the portfolio without reducing its level of profitability
Real investment programs	The program includes investment projects with different industry and regional focus, which reduces overall investment risks

Proper implementation of a diversification strategy helps maintain the company's performance and income during an economic downturn or a sharp change in the direction of the industry. Strategic mechanisms increase business stability. However, it will require in-depth knowledge of market trends, a careful assessment of the company's internal resources and various external factors.

Diversification is also considered one of the tools for reducing innovation risks. This process neutralizes innovation risks by distributing research and capital investments across multidirectional, functionally unrelated innovation projects. Diversification is the dispersion of innovation risk.

Diversification for retail investors

Time and budget constraints may make it difficult for non-institutional investors, i.e. individuals, to build an adequately diversified portfolio. This problem is the main reason why mutual funds are so popular among retail investors. Buying shares in a mutual fund offers an inexpensive way to diversify your investments.

While mutual funds provide diversification across different asset classes, exchange-traded funds (ETFs) give investors access to niche markets, such as commodities and international trading venues, that would normally be difficult to access. A person with a $100,000 portfolio can allocate investments among ETFs without overlap.

Nuances

There are basic rules of diversification, following which you can minimize investment risks to the maximum.

Divide the portfolio by assets, that is, use different financial instruments - futures, stocks, bonds, deposits, funds.
For example, it is often suggested as a guideline that the share of bonds should be equal to your age (for example, if you are 30 years old, the share of stocks is 70%, bonds is 30%), and as you age or get closer to your investment goal, the share of bonds should increase.
Break down your portfolio by country and currency. This will allow you not to become dependent on the economic situation in a particular state and the exchange rate of one currency.
Break down your portfolio by economic sector, etc.

Disadvantages of Diversification

Reduced risk, volatility buffer: the benefits of diversification are many. However, there are also disadvantages. The more holdings in a portfolio, the longer it takes to manage and the more expensive it is, since buying and selling many different investments requires more transaction fees and brokerage commissions. More importantly, a diversification spread strategy works both ways, reducing both risk and reward.

Let's say you split $120,000 equally between shares of six companies, and one of them doubles in value while the others stay the same. Your original $20,000 bet is now worth $40,000. Sure, you made a lot, but not as much as if you had invested all that $120,000 in this company. While protecting you from downturns, diversification limits you, at least in the short term. Over the long term, diversified portfolios typically have higher returns.

Limit to the effectiveness of investment diversification

Every investor sooner or later has a question: how many assets should there be in a portfolio for diversification? Maybe just 5 or 10 is enough? Or do you need to strain yourself and collect a large briefcase? But I wouldn’t want this, because many problems and difficulties arise:

the more assets there are, the more difficult it is to keep track of them;
a large portfolio requires a lot of money;
you will have to spend a lot of time analyzing and accounting for investments;
the number of quality assets is often limited.

And yet, is there any point in collecting a large portfolio? As always, we will answer this question using calculations. As an example, I decided to take the well-known Dow Jones stock index, which contains shares of a wide variety of sectors of the American economy. It includes 30 companies, just enough to test the diversification of both small and large portfolios.

To solve the problem, I built random portfolios of 1,2,3...30 shares and, by searching, looked for the range in which the risk value of a portfolio of N shares fell. First of all, we considered the standard deviation, which shows the spread of returns (the larger the spread, the riskier the investment method is considered):

What do we see? As the number of shares increases from 1 to 4, the RMSE quickly falls from 1.4% to 1% and even lower. Then, quite quickly, at a portfolio size of 7, the value of 0.9% is reached, but it was not possible to reach the next goal of 0.8%. Progress almost completely stops at 15-20 shares. To further significantly reduce risk, dozens of companies must be added, which may require too much analytical work from the investor. It's better to just invest directly in an index, but that's a completely different story. A similar picture can be seen in the drawdowns:

The maximum drawdown of portfolios begins to decrease sharply when moving from 1 to 5 shares and reaches -22%. Then it is possible to win another 2% only by 14, and the next 2% is not possible even by 30. Best performance on about 20 stocks.

In simple terms, the following conclusions can be drawn from these diversification calculations:

the minimum portfolio size to significantly reduce risks due to diversification is 4-5 assets;
the acceptable limit of diversification efficiency is achieved at 15-20 assets.

From a mathematical point of view, there is most likely no specific limit to the diversification of investment risks, since the risk reduction is a little bit, but still occurs even after 20 shares in the portfolio. How advisable it is to invest in tens or hundreds of assets at the same time is probably something each investor must decide for himself.

I wonder what size the portfolios of blog readers are? Take the survey:

We could end here, but finally I want to share with you one more interesting thought.

Intelligent beta versions of investment portfolios

Smart beta strategies offer diversification by tracking fundamentals, but do not necessarily weight stocks according to their market capitalization. ETF managers further analyze stock issues across fundamentals and rebalance portfolios based on objective analysis, not just company size. Smart Beta highlights the need to address investment factors or market inefficiencies in a rules-based and transparent manner. Smart beta strategies can use alternative weighting schemes such as volatility, liquidity, quality, value, size and momentum. In 2022, smart beta funds will have total assets of $880 billion.

For example, as of March 2022, the iShares ETF holds 125 large- and mid-cap US stocks. By focusing on return on equity (ROE), the debt-to-equity ratio, and not just market capitalization, the ETF has returned 90.49% on a compound basis since its inception in July 2013. Similar investments in the S&P 500 Index rose 66.33%.

conclusions

Formal application of the principles of diversification will not only not be beneficial, but will also significantly reduce the profitability of the investment portfolio. However, there is no universal formula for allocating investments to reduce risks. It would be optimal to use an individual approach, implying the use of a degree of diversification appropriate to the type of investor. There are three such types - conservative, moderate and aggressive.

Conservative investors

prefer a minimum of risks even at the expense of high returns.
The main thing here is the safety of investments, which means that diversification should be as much as possible in all areas. A moderate
investment temperament allows for additional profit through calculated risks.
Therefore, diversification here may not affect part of the assets on which the bet is made. Aggressive
investors can sometimes risk their entire capital for the highest possible return. Those who choose this path often do not diversify their portfolio at all or enjoy “narrow” diversification within the chosen financial instrument. Based on the above, the investor needs to decide on the desired level of profitability and risks, and then choose his type of investment portfolio and the degree of its diversification.

Real world example

Let's say an aggressive investor who can take on a higher level of risk wants to build a portfolio consisting of Japanese stocks, Australian bonds and cotton futures. For example, he can buy shares in the iShares MSCI Japan ETF, the Australian Government Bond Index ETF and the IPT Bloomberg Cotton Subindex Total Return ETN. Through this mix of ETF shares, the specific qualities of the target asset classes and the transparency of the investments, the investor achieves true diversification of his holdings. Additionally, with different correlations or reactions to external influences among securities, they may reduce risk exposure slightly.

Usage examples on "Secret"

“For 12 years now I have been investing in the stock market, which I still consider to be the optimal means of preserving capital. You can earn the same income as in a regular business by investing in stocks and bonds with high liquidity. With the right strategy, risks are minimized through diversification .”

(Venture investor Denis Beloglazov talks about his experience of investing in startups.)

“We must focus on achieving energy independence by investing in diversifying our energy supply and reducing Europe's dependence on gas exporting countries as quickly as possible.”

(Quote from a statement by the ministers of five EU countries, who called for an investigation into the cause of the record increase in gas prices.)

Ways to reduce risks when investing

Risks are not a reason to refuse investments; they can and should be managed. To reduce financial losses when investing money, adhere to the following rules:

Diversify your investments. One of the most important rules of investing is: you should not invest all your money in one instrument - it is better to choose several. If one asset makes a loss, others can compensate. If you don’t have time to deal with asset distribution yourself, you can invest in mutual funds. Mutual funds include many investment instruments at once, which reduces the portfolio’s dependence on changes in exchange rates and market conditions.
Always stick to your chosen strategy. The market situation changes quickly, and investors are always tempted to adjust their portfolio to suit the current environment. But such spontaneous decisions often lead to losses, so during times of high volatility in the market, it is important to follow the original strategy.
Invest only in tools that you understand. If you are unclear about how a particular financial instrument works, it is better to refuse it or study it carefully before investing money.
Carefully study the terms of investment. If, when concluding an investment transaction, a corresponding agreement is drawn up, then it must stipulate the conditions for the use of invested funds.

How to correctly assess investment risk

By properly assessing the risks, you can reduce the likelihood of their occurrence. All assessment methods are divided into two large groups: qualitative and quantitative.

Qualitative risk assessment methods include:

The method of analogies takes into account the experience gained during the implementation of similar investment projects.
The Delphi method involves studying the opinions of experts on specific issues.
Method for calculating the appropriateness of costs - possible threats to investments are studied for each stage of investment, which allows you to promptly stop investments if difficulties arise.

Quantitative assessment involves the use of one of the following types of analysis:

Monte Carlo method - building a risk-increasing model to study consequences.
Analysis of possible options for the development of the project by changing its significant parameters.
Determination of the maximum stability of the project.
Analysis of the sensitivity of the project to changes in individual parameters.

To calculate investment risks as accurately as possible, several assessment methods should be used at once. In addition, risk analysis can be entrusted to experts - for example, financial advisors.