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Portfolio Diversification: What Is It and Why Is It Important?

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Harry Markowitz, Nobel Prize laureate and economist, once stated that “diversification is the only free lunch” in investment. But what does this mean?

Diversification is essentially a risk management strategy that aims to balance risk and reward within an investment portfolio.  

Diversifying your investment portfolio can help limit your exposure to any single type of asset, therefore helping to reduce the risk and volatility of your portfolio. The primary goal is to spread your investment portfolio across many different asset classes to mitigate the risk of each. 

This type of diversified portfolio aims to ensure long-term returns and lower risk over time. Essentially, the best way to look at portfolio diversification is to think about the phrase ‘don’t put all of your eggs in one basket’. You want to ensure that, should the public market be experiencing volatility, you have alternative investments that can withstand this and offer multiple sources of return at the same time.  

What Is Portfolio Diversification?

Portfolio diversification involves spreading investments across different asset types in order to reduce the volatility and risk involved with investing. 

The purpose of having a diversified portfolio is to try and balance risk and reward as well as ensure the longevity of your investment portfolio. Diversification involves spreading investments across different asset types or classes in order to limit exposure to any one asset or risk. 

The reasoning behind portfolio diversification is to yield long-term returns whilst lowering the risk of individual investments. According to Investopedia, mathematical models and studies show that a diversified portfolio of approximately 25 to 30 stocks provides the “most cost-effective level of risk reduction”. 

Strategically investing in multiple different asset types ultimately means that the positive performance of certain investments neutralises any negative performance of others. Whilst this may be tipped in one way or the other, over time it yields long-term, stable returns and lower risk. 

A 60/40 investment portfolio is a strategy that has been recommended by many financial advisors over the past half-century. It is one way of ensuring portfolio diversification. The 60/40 strategy refers to having an investment portfolio split of 60% equities and 40% bonds. The purpose of the 60/40 split is the same as the reasoning behind portfolio diversification — lower overall portfolio risk as the asset classes are uncorrelated with each other. The equities perform during periods of growth and government bonds provide growth when markets are down. And over the past 50 years, a backdrop of low inflation and low volatility has seen both asset classes perform. 

However, in recent years, the traditional 60/40 split has been under pressure. Bonds have failed to dampen equity market volatility. Investors have sought access to alternative investments in order to provide further diversification and target higher performance. 

Understanding asset correlation 

Asset correlation refers to how different investment assets move in relation to one another. 

When assets move in the same direction at the same time, they are considered to be positively correlated. However, when they move in different directions, they are negatively correlated. 

When it comes to portfolio diversification, you ideally want to have assets that do not move in correlation as this means there isn’t enough diversification in your asset types. It is important to have a number of negative or non-correlated assets to mitigate risk. 

For example, if you only invest in traditional assets such as stocks, bonds and cash, and all of these decline at the same time, your risk is significantly higher than if you had alternative, uncorrelated investments in your portfolio, such as private equity. 

How Alternative Investments Improve Portfolio Diversification

Alternative investments are any investments outside of the public market - anything aside from stocks, bonds and cash. Due to sitting outside of the public market, alternative investments are met with different risks and returns that are largely uncorrelated to traditional assets. 

Some examples of alternative investments are: 

  • Private Equity investing in private companies
  • Hedge Funds pooling capital with other investors and investing across many securities
  • Real Estate investing in residential, commercial or retail locations
  • Collectibles investing in rare items such as rare wines

Alternative investments are not directly impacted by the public market and so they are not affected by the same volatility and are uncorrelated to traditional assets. Therefore, having a mix of traditional and alternative assets in your portfolio can mitigate risk and smoothen the volatility of the public markets. 

Example of Portfolio Diversification

Take an investor, who is typically comfortable with a higher level of risk. They already invest in stocks and bonds but, as the market becomes more volatile, they want to spread the risk. 

So, they decide to invest in international markets as well as their home market. They choose Australian stocks and US bonds for example. They are already diversifying their portfolio internationally. However, they are only investing in the public market. 

Next, they choose to invest in Japanese real estate and pool some funds into private equity where possible. 

Now, they have a diversified portfolio, across international markets, with both private and public assets that are uncorrelated and therefore reduce concentration risk overall through access to multiple sources of risk and return. 

How to Build a Diversified Portfolio

Building a diversified portfolio comprises different strategies and steps: 

1. Understand the risk and return within your portfolio 

The first step to diversifying your portfolio is to understand your current portfolio’s risk and return. It is important to understand where the biggest risks lie and where your best returns come from. Then, you can consider how to spread the risks and increase your potential returns. 

2. Consider diversification from existing portfolio holdings 

Once you have looked at your existing portfolio holdings, consider different asset classes and strategies to diversify your portfolio and diversify the sources of risks associated with your existing portfolio. 

3. Accessing these strategies and managers through experts 

Building a diversified portfolio and specifically adding institutional-quality alternative investments is not straightforward. For one thing, the minimum investment is often prohibitively high to individual investors. At Connection Capital, we have a number of alternative investment opportunities that aren’t usually available anywhere else. Our approach of syndicating investment from our network of private investors means you can build a diversified portfolio and target attractive returns outside of your traditional investment assets. 

Benefits of Portfolio Diversification

Portfolio diversification has many benefits, including reducing concentration risk whilst increasing the likelihood of long-term results. 

Reduce risk 

The primary reason for portfolio diversification is to reduce the market volatility risk associated with traditional investments as much as possible. By investing in alternative assets and international markets, you may be able to reduce the chance of your investments all being impacted by the same market shocks. 

Smooth volatility 

The public market is volatile. It is prone to shockwaves and changes that can impact a variety of assets all at once. However, by investing in international markets that are not affected by the same shockwaves or in alternative assets that are separate from the public market, you can help to smooth out this volatility in your own portfolio. 

Opportunity for additional sources of return 

Finally, diversifying your portfolio not only means you have alternative investments to mitigate risks, but you have more investments that can lead to additional sources of return. 

Having multiple investment streams in your portfolio — especially ones that are not correlated — means you can be far more likely to increase your sources of return and yield long-term results. 

To find out more about how Connection Capital can help you diversify your portfolio and invest in alternative assets, get in touch with our team. 

Please note: 
Alternative investments are high risk and speculative which means there is no guarantee of returns and investors should not invest unless they are prepared to lose all of their money. Past performance is not a reliable indicator of future performance. This type of investment is illiquid so can’t be easily accessed until the exit point. The investor is unlikely to be protected if something goes wrong.  

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