The Strategy of Portfolio Diversification

Portfolio diversification is the means by which investors minimize or eliminate their exposure to company-specific risk, minimize or reduce systematic risk and moderate the short-term effects of individual asset class performance on portfolio value. In a well-conceived portfolio, this can be accomplished at a minimal cost in terms of expected return. Such a portfolio would be considered to be a well-diversified.

Although the concepts relevant to portfolio diversification are customarily explained with respect to the stock markets, the same underlying principals apply to all types of investments. For example, corporate bonds have specific risk that can be diversified away in the same manner as that of stocks.

Unfortunately, there's no concise definition of asset class. The definition of asset class is dependent on the context in which the term is used, the investment strategy employed in the management of a portfolio, and to some extent, the person who is rendering the definition. Suffice it to say that asset classes are significantly different investments.

Eliminate Specific Risk and Minimize Systematic Risk

It is assumed that all investors are rational and will therefore hold portfolios that are diversified to the point where specific risk has virtually been eliminated and their only exposure to risk is to that which is inherent in the market itself. Thus, the residual risk of a portfolio should be equal to market risk, a.k.a. systematic risk, and systematic risk can be reduced by investing over a broader market, i.e., a larger universe.

International diversification provides a good example of the effects of diversifying across asset classes. A portfolio invested 50% in domestic large-cap stocks and 50% in international large-cap stocks would have approximately half the residual risk of a portfolio comprised solely of domestic large-cap stocks, assuming that the investments in each market were sufficiently diversified to eliminate specific risk.

Some investors may choose to be exposed to specific risk with the expectation of realizing higher returns. But this is contrary to financial theory and such investors are therefore deemed to be irrational. Deliberate exposure to specific risk is unnecessary and is essentially gambling...unless you are trading on inside information, but we won't go there, as trading on inside information is a flagrant violation of the securities laws.

Moderate the Effects of Individual Asset Classes

Moderating the effect of individual asset class performance on portfolio value is another benefit of portfolio diversification. This is desirable because the lower the variance of your portfolio value, the greater the certainty of its value at any given time, which is extremely important if you have a need to liquidate all or part of your portfolio for some reason, not to mention the fact that lower variation will reduce stress and anxiety.

If you're saving for retirement, you should have a targeted value at the date you plan to retire. That value is considered to be the terminal value of your portfolio, a.k.a. your terminal wealth, at the end of your holding period, and your holding period would be from the present to that future date. As part of your planning, you must make projections of the average rate of return and the standard deviation of returns over your holding period. Thus, your terminal wealth is uncertain and can be assumed to be a range of values rather than a fixed value. This range is known as your terminal wealth dispersion (TWD).

If you take this thought process a step farther, you'll realize that your holding period is made up of an infinite number of shorter holding periods and that each period has its own TWD. Your TWD at any point in time is the risk you are faced with when liquidation is necessary. Reducing this risk to an acceptable level can be achieved by diversifying across asset classes with only a minimal cost in terms of expected return.

If, for example, you blend five assets that are not highly correlated and all of those assets have expected returns of 12% and standard deviations of 10%, your expected return will be 12% but the standard deviation of your portfolio's returns will be significantly less than 10%. If the assets were only slightly correlated and/or negatively correlated, your portfolio standard deviation would be very significantly less than 10%. Individually, these assets are equivalent investments based on their risk and return, but together they form an investment that is superior to each of the individual assets, which can be attributed to the lack of perfect correlation between the assets. Portfolio diversification is a very good deal. So be sure you take full advantage of it.

Asset classes tend to go through periods of under-performance and over-performance which tend to offset each other in the long run. However, as we don't get to select our holding periods after the fact, it's desirable to insure ourselves against the probability of liquidating at a time when under-performance outweighs over-performance within our holding periods. This is where the correlation between asset classes really comes into play. Asset classes that are not highly correlated can be expected to under- and over-perform at different times. Thus, holding a variety of asset classes that are not highly correlated is insurance against the probability of having a low terminal value when liquidation occurs during or shortly after a period of under-performance of a minority of the asset classes in a portfolio. In such cases, the other asset classes should moderate or fully offset the effects of the under-performing asset class or classes.