Diversification – What does it do for a portfolio?

When it comes to investing, utilising the concept of diversification is always the first step in building a sound long term portfolio.

Diversification starts at an asset allocation level and then cascades down to the selection of individual countries,sectors,and specific investment holdings.

In every portfolio there are two major risks, namely that of ‘Market risk’ and ‘Specific risk’ (please note that they are not the only risks).

’Market risk’ is a risk that affects everyone generally in the same way such as war,economic change,or the behavior of human sentiment. An example of this is where a particular share market decreases because of negative economic news or because of a negative change in economic activity.In this example most companies would be caught up in the decrease as market forces bear down on all companies regardless of how good or bad they are as individual businesses. Similarly, another example is the event of September 11th 2001 which caused markets to decrease significantly due to the uncertainty around how the tragedy would affect economies around the world.These are good examples of ‘market risk’ because they illustrate that the negative effects are being felt broadly across the market by most investors.

‘Specific risk’ is a risk that is specific to a particular country,industry,investment or company.By nature of the word ‘specific’,it’s effect will tend to be felt solely by an individual investment or a narrow sector of investments. An example of this is where one particular company in an industry does worse than its peers because its management team may be less skillful than its competitors. Imagine a hypothetical situation where there are two banks in competition with each other with both of them facing the same external challenges and business conditions. The bank with a weak management team would be expected to produce potentially less profit over time when compared with the bank with better management. In turn, a decrease in profit of the poorly managed bank may act as a negative influence on the share price decreasing the capital value of the share price[all other things being equal]. This is a good example of ‘specific risk’ because it illustrates that despite the two banks being exposed to the same business conditions, one bank performed differently to its peer due to the specific factor of poor management.

Market risk is very difficult to manage in a portfolio as it is impossible for investors to see into the future and predict random events.

To manage market risk, investment managers may either opt for a ‘risk avoidance’ strategy which means they ‘opt out’ from an investment or market, or they will simply weather the storm and fall back on their own skill to add value by ‘stock picking’ via a broadly diversified portfolio (there are other technical strategies that can be utilised but generally the options for the ‘management’ of market risk are limited).

To manage specific risk there is the tool of diversification. This tool is so effective that specific risk can be mitigated to a very high degree. Most managers of money will start by building a portfolio of between 20 to 40 individual holdings or shares to be properly diversified (this is not an absolute number-many different managers have variations on this theme to dial risk up or down). They know from experience that this tool is an inexpensive and effective way of reducing one of the two biggest risks in any portfolio.

In every portfolio there will always be individual losses along the way as this is part of the journey of being an investor. However, by using diversification the problem can be significantly mitigated such that no one negative ‘specific risk’ event makes the position of the portfolio untenable. This is because a single or occasional loss is absorbed into the pool of positive capital gains or at worst does not mean the portfolio is ‘broken’ by any single event. This benefit of diversification is illustrated by the example of having a share portfolio that is properly spread across individual stock holdings, geographic regions and industry sectors. By not being held ransom to one negative ‘specific’ risk event the portfolio is able to recovery from problems generated by this risk and move on to averaged longer term profits.[the important thing to remember here is that this does nothing to reduce the problem of market risk].

Classical investment theory says that having a broadly diversified portfolio with a long term investment horizon is the first step in building a portfolio.Diversification adds value to a portfolio inexpensively by mitigating one of the greatest risks to any portfolio namely that of ‘specific risk.

If you would like to discuss your current portfolio diversification strategy, please talk with Gregory Le Lacheur, Director and Principal Adviser of Paladin Wealth Advisers.