The Benefits of Diversification
JP Osseward | July 7, 2014
While the creation of wealth can often by attributed to taking concentrated risks, the preservation of wealth is usually accomplished by diversifying risk. Commonly, we find that investors hold a significant portion of their savings in one concentrated position, often the stock of the company where they are employed. We think that it is inadvisable to pin so much of a person’s retirement savings on the performance of only one or a couple companies. Diversification can reduce the risk of an investor’s portfolio being unnecessarily volatile.
One of the reasons for diversification is the minimizing effect it has on portfolio volatility. Reducing volatility is beneficial to portfolio returns through time as it maximizes compounding returns. Due to the nature of volatility in asset returns, a portfolio’s average return serves as a misleading representation of return over time. For instance, take the two theoretical portfolios in Figure 1.
Portfolio 1 and Portfolio 2 both have average returns of 5%. Portfolio 1 has a constant 5% return and Portfolio 2 returns 25% in one year and -15% the next. Over the course of twenty years, Portfolio 1 returns $165,329.77 on the initial investment of $100,000 while the more volatile Portfolio 2 returns $83,353.58, just over half the return of the more stable Portfolio 1. The fundamental reason for this difference is that a loss of X% is not offset by a corresponding gain of X%. If a portfolio starts at $100,000 and decreases by 25%, it is then worth $75,000. However, a gain of 25% does not increase the value of the portfolio to $100,000 but rather $93,750. Percentage losses have a more powerful effect on the portfolio than equal percentage gains.
Diversifying the portfolio over numerous holdings reduces the volatility of the portfolio. By increasing the number of holdings in the portfolio, the effect of any one position is minimized. This is one of the main benefits of a mutual fund compared to holding individual stocks. The volatility of a mutual fund that has thousands of positions is typically muted compared to the individual stocks that comprise the underlying mutual fund. While the minimization of volatility for one asset class can be accomplished with a single mutual fund, holding several mutual funds that have exposures to different asset classes can further reduce portfolio volatility by increasing the type of positions that the portfolio invests in. Many investors are aware of large companies domiciled in the United States but often underutilize international diversification that can further improve returns and reduce the volatility of the portfolio. Allocations to small capitalization, international markets, emerging markets, bonds and absolute return asset classes can significantly improve an investor’s portfolio whose core equity holdings are in the United States.
Diversification is a powerful tool available to investors to reach their financial goals. The sensible dispersion of risk over many assets, asset classes and risk types can both improve portfolio return and help mitigate the volatility that is inherent when investing. Reducing overly concentrated positions and diversifying the proceeds allows investors to decrease portfolio volatility and increase the probability of reaching their financial goals.