Investment Diversification is a portfolio management strategy centred around risk management. Diversification looks to strike a balance between risk and reward by allocating capital to various asset classes to help reduce volatility within the portfolio. By diversifying a portfolio one can ensure positions that perform poorly are countered with other asset classes that outperform.

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What is Portfolio Diversification?

To diversify or not to diversify? That is a question that frequently comes up in the investing world. There are armies of loyalists on both sides either defending or opposing diversification. Let’s explain some of the core ideas behind diversification and whether it is the right approach for your portfolio.

Investment diversification is a portfolio strategy that allocates resources across a range of asset classes, industries, and geographies to help spread risk around. The philosophy behind Diversification can be summarised by the well-known quote “Don’t put all your eggs in one basket”.

To create a diverse portfolio, investors spread the capital around to ensure they are not exposed too much to any one asset class. By allocating across all the different financial instruments or segments within a market, an investor can limit the downside should an asset class perform poorly.

The concept of diversification is to not place all your capital in highly correlated positions. For example, assuming an investor places all their capital in the equities market, then the market has a downturn. The investor could have diversified into other asset classes to help bolster the portfolio during a downturn. Portfolio Diversification ensures an investor is not exposed too heavily to any one investment.

Diversification is the practice of spreading your eggs around to other “baskets”. Should you trip over, you would only lose the eggs in that one basket. The other eggs were safeguarded by being in another basket. If all your eggs were in one basket and you tripped, there would be no breakfast in the morning. The same principle applies to investing.

Why is Portfolio Diversification important?

Diversification is about balancing your appetite for risk alongside your time horizon and goals. Building an investment portfolio aligned with your goals is equally about generating wealth as much as it is about minimising risk.

Portfolio diversification must align with your investment strategy because it will be structured around your financial objectives. As we have laid out when developing an investment philosophy and plan, portfolio diversification will be largely determined before investing in any asset class. If you are young, for example, and you want a slightly more aggressive strategy. You may not diversify towards other asset classes and go 100% into stocks. You may be able to handle the risk and market fluctuations as there is ample time to recover capital.

If you are older, your diversification may be more conservative. An investor would spread capital between stocks bonds, cash and asset classes that hedge against one another. This can help to preserve your capital.

In investing and finance, different asset classes behave very differently from one another under various market conditions. Sometimes stocks are in favour, sometimes bonds are in favour, and other times holding cash becomes the better choice. By spreading your capital around you are less prone to complete capital destruction.

Another consideration is portfolio diversification can help to mitigate unsystematic risk, i.e. risks associated with the underlying traits of a security. However, systematic risk relating to economic and market conditions is unavoidable. This is where proper diversification can strike the right balance between growth and managing risk.

Diversifying across various asset classes.

Portfolio Diversification will be largely shaped by the following asset classes. Each asset class and subclass play an important role in determining your overall diversification strategy. As we discussed in rebalancing, your target asset allocation will have been outlined when you were laying out your investment plan.

By understanding each of the categories, an investor can determine how each one may play a role in developing a balanced portfolio. Each asset class moves in different directions depending on the economic and market conditions.

Asset Classes

Asset Classes refer to the different investment and financial products that are available. Whether it is stocks, index funds, bonds, cash, term deposits, REITs, or Exchange Traded Funds. Investors need to understand how each asset class correlates with one another. Stocks may generate higher returns over the long term but also come with a higher degree of risk when compared to bonds.

Bonds provide stable, secure returns however won’t help to appreciate your capital and may not keep up with inflation. I’m not for or against any asset class. Every investor has different needs, goals, time horizons, risk appetites and levels of experience. There is a time and place for every asset class. Educating yourself about each investment class and how certain market conditions impact them can help you to know how to place them within a portfolio.

Industry and Sectors

There are a lot of industries and sub-sectors within the equities markets. Industries can be broken down into Communication Services, Consumer Discretionary, Consumer Staples, Energy, Financials, Healthcare, Industrials, Materials, Real Estate, Technology and Utilities.

Within these sectors, there will be a lot of sub-sectors, such as Software as a Service as a sub-category of technology, or perhaps clean energy as a sub-sector of energy. Various industries move independently of other sectors. Mining has its own boom and bust economic cycles, real estate and utilities move in their way. By diversifying across different industries, you can develop a balanced portfolio that can ensure you are never exposed too much to any one sector. The idea is to invest in opposing industries that counterbalance one another. When one industry falls another one often comes into favour.

Market Capitalisation

Market Capitalisation refers to the market cap segments of the market. Mega-caps, large-caps, mid-caps, small-caps, micro-caps, and nano-stocks. Investors can diversify across larger, well-known mature companies that provide stable and consistent returns and counter this with smaller, emerging higher-risk companies. The idea is to ensure you spread capital across different market caps to capture the potential small caps that may one day be large caps. Like industries and sectors that fall in and out of favour so do companies within this sub-sector.

Small caps often come in and out of favour usually aligning with investor sentiment and optimistic market conditions. When the market goes through a downturn the bottom end of the market usually gets hit first as investors flock to well-known stable companies and away from higher risk smaller companies with uncertain futures.

Geography

Geography refers to foreign or domestic markets. Investors can diversify across the globe trying to diversify across various regions and the growth of different economies. For example, an investor may invest in the US markets, Europe and say Australia and then counter these stable larger markets by investing in emerging countries like Southeast Asia. Like everything else, economies and countries go through different economic cycles. Sometimes emerging markets are in favour and other times more established countries are the better choice.

It’s always about capturing the upside potential and minimising downside risk. If you believe the US economy is going to slow down, you may choose to diversify away from it into a geography that is performing well. For example, during the pandemic a lot of markets were flat, however certain regions like India did incredibly well.

Business Life Cycles

The business life cycle comes down to Growth and Value. Different market conditions and company life cycles present different opportunities. An investor may diversify into high-growth opportunities with the potential of compounding their capital and counter this with undervalued securities. These two philosophies counterbalance each other. This also comes back to the market cap size.

Investing in quality large companies that provide an undervalued buying opportunity and then placing them in a portfolio with some high-growth smaller-cap companies balances risk with reward. You are trying to create a balance of steady, annual returns with the opportunity of finding a multi-bagger.

Alternative Assets

Alternative assets are anything that does not fit into the traditional investment categories above. It could be gold, cryptos, or REITs. Some fall in favour during economic uncertainty, such as Gold. This becomes an inflationary hedge and a store of wealth. Some investors look to be exposed to crypto markets to ensure they diversify away from fiat currency.

These asset classes once again have a time and place. Property can play an important portfolio role, whether through Real Estate Investment Trusts or directly holding property. These are tangible asset classes. It could be to capture rising property prices or to capture rental income. This can counterbalance with higher risk opportunities that are more intangible.  

How much diversification is needed?

This is where diversification gets tricky. There is a fine line between a well-balanced diversified portfolio and an over diversified portfolio. If a portfolio becomes overly diversified it usually can result in portfolio drag. This means you will often get “average returns”. There are a lot of academic studies around diversification and portfolio structuring but it’s best to be realistic when investors approach it.

The biggest problem I see is investors just accumulate a lot of different assets. They begin collecting. Every new position does not necessarily result in greater returns. There is always a sweet spot in investing when finding the right balance. What happens is investors end up diversifying their returns away and at the same time it does not contribute to lesser risk.

They may invest in a handful of exchange-traded funds for example not realising there are a lot of crossovers in the underlying holdings. You want to ensure the cross-over, and weightings are all strategically in line with your target asset allocation. By cross over I mean portfolio OVERLAP. I see investors loading up on individual stocks, then some index funds and don’t realise those index funds have an allocation to the same securities. This then over-exposes those investors to those companies.

As this platform is focused on active investment, we will focus on equities. There are a lot of arguments and theories about how many companies are too many. A lot of portfolios are around 20-25 positions. I think around 15 uncorrelated positions is a good, sweet spot for most investors. It means they can understand their holdings and create a good balance across geography, industries, and market cap sizes.

Over diversification may mean you won’t lose much which is great for risk management, but it also means you won’t gain much.

Should all investors diversify their portfolios?

I think most investors who don’t want to be active stock pickers should practice diversification. Investors who are investing for a better future and want to take advantage of the powerful returns of the equities markets need to balance risk and reward intelligently. Even if you choose to go all in on one asset class, let’s say stocks, diversification within that asset class is sound practice.

Whilst the quote below is quite a big dig at the overall idea of diversification, it is grounded in his entire profession and life being a professional stock picker. For most private and retail investors who are not looking to develop a highly concentrated portfolio, still want reasonable returns, don’t want to take on unnecessary risk, and have better things to do than sift through thousands of companies, reports, articles, financial statements every year then diversification is a must.

Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.

Warren Buffett

It is hard to pick winning investments. Diversification is not designed to maximise portfolio returns but to smoothen the lumpy periods out over time and protect against large gyrations within a portfolio.

If you however want to perform better than the average, then diversification becomes counterproductive. More positions and even over-diversification can lead to weaker-than-expected risk-adjusted returns. Market theory suggests around 20-30 positions spread across various asset classes is a reasonable amount of diversification. Are you comfortable monitoring this many positions? Highly concentrated portfolios typically run 5-10 overall positions.

Diversification will be grounded in getting the portfolio rebalancing right, the management of the portfolio’s target asset allocation therefore becomes the focus. With a concentrated portfolio, all the focus lies on the individual holdings and how those companies are tracking in line with your thesis.

To Diversify or not will lie in your strategy.

Whether an investor should diversify will come down to that individual investor’s Investment Philosophy and strategy. It will be largely shaped around their appetite for risk, time horizon and overall financial objective. We are always going to come back to the strategy. Why? You shouldn’t be asking whether to diversify if you have not laid out a plan and strategy.

Often, I see this discussion come up about whether investors should diversify, how many positions are too many, whether they should be concentrated, should they buy a basket of ETFs. However, these are all wrong approaches. There shouldn’t be much confusion around this if an investor has adequately spent the time working through the Investment Philosophy and Strategy before deploying capital.

What are you trying to achieve?

Are you risk-averse or don’t mind a little volatility?

How much time can you leave your capital to work for?

Once investors start working through this and then define the overall return required to achieve their goals, they then need to look at target asset allocation. The asset allocation strategy then governs how diversified an investor needs to be to achieve the objectives in line with their risk appetite.

Look at your objectives and be honest with yourself. Will diversification be in line with not only your strategy but your personality and behavioural traits? Success lies in sticking to your plan. There are successful highly diversified investors and there are successful highly concentrated investors. They were not asking whether they should do this or that, they outlined what they were looking to do, and stuck to the plan. Avoid confirmation bias here, by only aligning with investors or studies reaffirming your ideas.

What are the drawbacks of Diversification?

Like everything in investing and life, there are drawbacks. There are a few cons to diversification which we will outline below. However, the biggest drawback for me is that it may smoothen out fluctuations and average out long-term returns, but it also caps the upside potential.

Whilst it protects the downside by balancing out different asset classes it also massively limits the chances of outperformance or generating Alpha. If you are sticking to a portfolio management strategy designed around diversification in combination with rebalancing, there is little chance of finding those long-term multi-baggers. The big compounders that can create a lot of wealth would be diversified away, either by rebalancing due to position sizing or by diversifying away the potential for having more capital allocated to those winners.

Here are some other drawbacks to diversification:

• It is hard to effectively monitor so many holdings across many asset classes. For newer investors, this may be challenging to start with.
• The cost to diversify can be expensive, with management fees, trading fees and then incorporating rebalancing, it can eat away at returns.
• Diversification does not truly eliminate risk, but it does limit the returns.
• Portfolios can verge on over-diversification unless sticking to a rigorous strategy. Spreading too thin damages long-term results.  
• It spreads your focus across a lot of asset classes rather than building up knowledge in the best ideas.

How do I look at diversification?

I’ve never been a highly diversified investor. This does not mean I do not believe in it; concentration aligns not only in my investing journey but in my life. I like to focus. As an entrepreneur, father, husband, and investor, I’ve spread incredibly thin in my life before. I diversified my attention away and it always impacted my performance and returns. If I am focused and concentrated, I perform better (I think, just don’t ask my wife). I take the same approach in investing.

“Behold, the fool saith, “Put not all thine eggs in the one basket” – which is but a matter of saying, “Scatter your money and your attention”; but the wise man saith, “Pull all your eggs in the one basket and – WATCH THAT BASKET.”

Mark Twain

I concentrate on the plan, looking for the best companies to hold long-term (doesn’t always mean I hold them long-term) and ideas that can create wealth. My goal is to compound my capital and increase my net worth. I do live by the phrase below.

Concentration Builds Wealth.

Diversification Protects it.

Is this contradictory? No. To me, I create wealth in highly concentrated ideas whether it has been from the stock market or from going all in on a start-up idea. The wealth I generate from that I try to protect it by either investing in other high-conviction ideas or buying real estate.

I do not diversify to create wealth or seek certain returns over a given period. There is no trying to beat a benchmark, what I am looking for is absolute returns as an asymmetric investor. I simply only diversify to protect the wealth that has been created in highly concentrated “bets” (and I love property).

How to diversify in a 100% stock portfolio?

You can still actively pick stocks and diversify, by picking non-correlating industries or market cap sizes. To develop a diversified portfolio, think about how each of the positions correlates with everything else. If you are bullish on a certain industry, think about the balance of this industry in line with an industry that negatively correlates with it. When one industry is up, there is always one that is down.

Even if you are a high-quality growth-focused investor. You can diversify into the best quality companies across a range of industries. This diversifies being too heavy in one industry. You could choose to allocate capital to large caps and small caps. This balances out the cycle that small-caps often go through.

Investors can choose domestic stocks and some companies that are in another country, diversifying away from home bias and domestic economic concerns. The art of diversification even in active stock selection is to ensure you are not leaning too heavily in one industry, market-cap segment, geographic region or even valuation metric. Balance some high growth with some undervalued companies.

Balance emerging small-caps with some large-cap quality dividend-paying companies. Developing a diverse portfolio does not necessarily mean spread across asset classes like bonds, REITs, ETFs, gold, cash, or fixed accounts. Even a stock portfolio of 10-15 positions can achieve diversification.

When trying to diversify a stock portfolio, always think about the correlation between positions. Think about it this way. Imagine an industry, market-cap segment or region went through a bull run and you were NOT in it. Then imagine that same industry, market-cap segment or region going through a massive bear market, and you were ALL in it. You are trying to strike the balance by participating in the rising tide, without being capsized at the same time.

In Summary…

I realise this blog may leave more questions than I’ve given answers to. Diversification and portfolio management are highly tailored to each investor’s objectives. One thing that I have not touched on is expertise and experience. If investors lack the knowledge, then diversification protects against this. Don’t take the “ignorance” comment to heart.

Some investors take these comments from super investors seriously. The idea of “average returns” offends them because they are anything but “average”. However, average returns over long time horizons still produce damn good results. Diversification to protect risk and achieve average returns does not make you ignorant or average. Everyone has different needs and financial circumstances and finding the lane that you are most suited to run is just logical and wise.

Independent thinking is the key to investing. Don’t just listen to someone (including me) without thinking how this fits in with YOUR goals and circumstances. When we touched on Investment Philosophy we discussed your alignment with certain ideas. You will gravitate to certain ideas such as value investing or growth investing. You will also find you develop a philosophy for diversification or concentration early on. This may evolve, as I get older for example, I may not want to take highly concentrated positions and diversify into other asset classes.

I do believe most private investors should diversify their holdings. There are a lot of economic and market uncertainties. Mitigating risk by diversifying across various asset classes helps to protect investors from the ups and downs. Many professional investors I know use the sleep test. If they are too heavy on a certain asset class and it is causing them to lose sleep, they diversify until they sleep at night 🛌.