Importance of Diversification
Diversification is the act of spreading your investments across a range of assets. This will help reduce your risk, diversify the portfolio and help lower volatility since no one asset will have a sizable impact on your overall result. A diversified portfolio is basically a collection of different investments combined to reduce the investor’s overall risk profile.
About The Speakers
Fall Ainina, Ph.D., CFA
Deputy Director of Research / Vice President
Investment Committee Member
Client Relationship Manager
Fall Ainina: Excellent.
Neil Craft: Well, thank you so much in advance for your time. We really appreciate it. It's always a pleasure to have you with us. We're going to talk a little bit about diversification and why it's so important to discuss some techniques, potentially for our listeners and their own portfolio.
But to get started Fall, I think a lot of people are familiar with the old adage don't put all your eggs in one basket, right? Can you begin with your simple interpretation of what it means to be diversified and I'm sure our conversation will evolve from there.
Fall Ainina: Sure Neil. Ultimately the investor diversifies their portfolio to help reduce risk and minimize the bumps in their investment journey. Diversification is the act of spreading your investment across a range of assets and can help reduce your risk. Diversifying the portfolio can help lower volatility since no one asset will have a sizable impact on your overall result. Neil, a diversified portfolio is basically a collection of different investments that is combined to reduce the investors overall risk profile. Diversification includes owning investments from different asset classes such as stocks, bonds, commodities, and real estate, to also include owning stock from several different sector, industry, country and risk profile. All these various assets together help reduce an investors risk of loss of capital and reduce the portfolio’s overall volatility. In exchange the returns from a diversified portfolio tend to be lower than what you might earn if you were lucky and picked a single successful stock.
Neil Craft: Right. Well, thank you for those initial insights Fall. What can you share with our listeners as it pertains to portfolio theory in general, how it's evolved into modern portfolio theory and, how that relates to kind of properly diversified portfolio?
Fall Ainina: Well, Neil, the primary notion of portfolio theory is that by combining different assets, one can achieve better results than by simply investing money to a single asset. One of the earliest recommendations in financial literature about asset allocation was written in the fourth century. Basically he said, put a third in land, a third in merchandise, a third in cash.
Also the idea of diversification has been around before. It changed during the 1950s with Markowitz modern portfolio theory that became a central part of the efficient portfolio construction. In fact, before the emergence of modern portfolio theory, investors used to construct their portfolio without considering the degree of correlation between return on different investments.
It was Markowitz who first demonstrated the importance of the correlation between the return of individual security and a lower correlation coefficient value of imply greater benefits from diversification. The founder of this modern portfolio theory favors efficient diversification instead of simple diversification.
Neil Craft: Sure, that makes a lot of sense Fall. Let's back up for a minute and I'm going to ask you if you could share a few thoughts on how our listeners could begin building a diversified investment portfolio. If, if that's the position that they find themselves in.
Fall Ainina: Of course, well, creating an investment policy statement for themselves is a place to start. One’s investment policy statements should include retirement objectives, ability and willingness to take risk, liquidity needs and any other pertinent information. This is a really good starting point. Once an investment policy statement is created and implemented, first being a diversified portfolio should include investing across several asset classes, as I said earlier. Equity, fixed income, cash, or risk assessment can help diversification. Let's take, for example, equity, you would include buying 30 to 40 different stock across several sectors, multiple industries and different capitalization. Rebalancing the portfolio is also an important step along the way to monitor the alignment to the original investment policy.
Last is the important concept of correlation. As you know, correlation is a degree to which investments move in tandem with one another. If all your investments tend to go up or down together, then your portfolio is not diversified. For instance, if you have high yield bonds and stocks in your portfolio, since high yield bond and stock have a positive correlation, you can say that your portfolio is not diversified.
Neil Craft: Sure. That makes sense. Fall, from modern portfolio theory to a proper investment policy statement and learning about correlation, I want to say thank you for your time. I appreciate it and I know our listeners do as well.
Fall Ainina: No problem, Neil. It was my pleasure. Thank you.
Neil Craft: If you have any questions about our podcast or diversification in your portfolio, please visit us at www.jamesinvestment.com for more information.
James Investment, Your Future, Our Purpose.
We understand that preservation of capital and long-term growth are critical to our clients. For this reason, we use strategic asset allocation techniques to create balanced portfolios custom-tailored to meet each individual's investment needs and risk tolerance.
Typical Allocation Range
Equity: 40% - 70%
Fixed Income: 30% - 60%
Cash: 1% - 15%
The Balanced strategy has a target range of 40% - 70% in equities, with a mix of small, mid, and large capitalization stocks. We weight the stock exposure toward the most advantageous market capitalizations based on our research.
Sector analysis in an important part of our portfolio management process. Changes in sector weightings are made based on our analysis.
We believe that having the maximum flexibility to follow our research is the key to adding value to our clients' accounts.