The power of diversification: Balancing risk and return for a smoother investment journey
16th November, 2023
Investing is a crucial part of achieving financial goals and securing a prosperous future. However, the road to successful investing is often paved with uncertainties and risks. In this context, diversification emerges as a key tool to manage risk and improve the balance between risk and return in a portfolio.
Diversification, simply put, is the practice of spreading your investments across a variety of assets to reduce exposure to any single investment’s performance. The basic principle behind diversification, and albeit slightly cliché, is "don't put all of your eggs in one basket." By not relying on the performance of a single investment, you can reduce the impact of market fluctuations on your overall portfolio. Harry Markowitz, a Nobel Prize winning economist, dubbed diversification ‘the only free lunch in investing.’ What he meant when he coined this phrase in 1952 was that diversification is the only tool which allows you to enhance your portfolio returns without taking additional risk. A diversified portfolio typically includes a mix of asset classes, such as equity, fixed income, real estate, commodities, and cash. The idea behind having a diversified portfolio is that each of the asset classes reacts differently to economic and market conditions, which creates a complementary effect on the portfolio's overall performance. As Harry Markowitz calls it, ‘the free lunch effect’.
We believe in the importance of having a diversified portfolio. Diversification allows an investor to better weather the ups and downs of the financial markets and can help to smooth the overall investment journey. It helps to avoid the pitfalls of becoming overly concentrated in a specific stock, sector, geography, or asset class. When times are good, and the economy is trending upwards, being overly concentrated mightn’t look like such a bad idea. But, when times are tough and the market is volatile, the need for having a diversified portfolio becomes more apparent. The idea is that by spreading your investments across a variety of assets, the impact of a single investment’s poor performance on your overall portfolio returns can be minimised. In doing so, diversification helps to reduce the volatility of your portfolio returns over the long term.
Volatility is a measure of the price swings of an asset over a specific period. High volatility can be unsettling for investors, leading to emotional decision-making and impulsive actions that can harm long-term financial goals. Diversification reduces portfolio volatility by combining assets with different risk and return profiles. For instance, during a market downturn, if stocks in the portfolio face losses, the impact can be partially offset by the stability of bonds or other assets that have a low level of correlation with each other (i.e., they don’t move in tandem very often). Consequently, this cushioning effect lowers the overall portfolio volatility and helps to provide a smoother investment journey. By tempering extreme highs and lows, diversification helps investors to stay focused on their long-term objectives and maintain discipline during market turbulence.
Diversification can help to achieve more consistent returns by investing in assets with different risk and return profiles. The graph below helps to illustrate this point. For example, if you pick an asset class and follow its returns over the past ten years from 2012 to 2022, you can see that an asset can be a top performer in one year, and a bottom performer in another. The diversified portfolio, however, performs more consistently over time, helping you to achieve a smoother investment journey.
While diversification may not shield your portfolio from all market downturns, it is a crucial element in generating consistent long-term growth. Over time, the compounding effect of returns from a diversified portfolio can be powerful, building wealth more steadily compared to concentrated investments. By being exposed to a wide variety of asset classes, investors position themselves to capitalise on various market conditions, including economic expansions and contractions. Diversification not only helps to mitigate risk but opens the door to a broader range of investment opportunities. For instance, investing solely in one sector or industry might yield significant gains if that particular sector performs well. However, if it falters, the entire investment could suffer severe losses. A diversified portfolio, on the other hand, ensures that you participate in multiple industries and sectors, giving you exposure to various growth opportunities. This way, you can benefit from the performance of successful sectors while minimising the potential losses from underperforming sectors.
Overall, diversification is a time-tested and essential investment strategy that improves the balance between risk and return in a portfolio. By spreading investments across various asset classes, diversification reduces exposure to the ups and downs of any single investment, providing a smoother investment journey. Embracing diversification as a guiding principle can help individuals to navigate the dynamic and often unpredictable world of investing. If diversification truly is the ‘only free lunch in investing’, as Harry Markowitz suggests, then it should be the foundation of any investors’ portfolio to help you to achieve your financial goals.
Warning: The information in this article is not a recommendation or investment research. It does not purport to be financial advice and does not take into account the investment objectives, knowledge and experience or financial situation of any particular person. Investors should determine whether an investment is appropriate to their own personal circumstances.
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