Diversification is a key component of any investment portfolio. Diversification can help to minimize unsystematic risk and greatly lower the volatility of a fund. Diversification can come in many forms, namely through sector diversification, geographical diversification, and diversification through other commodities. This article will break down each individual form of diversification along with the optimal size of a diversified portfolio including the number of stocks which should be invested into. Along with this, important terms such as Sharpe Ratios and Treynor Ratios will be discussed and why they are important to incorporate when diversifying your portfolio and assessing its performance.
Forms of diversification
Perhaps the most common form of diversification seen is sector or industry diversification. This involves investing in different sectors so as to minimise your portfolio’s exposure to one specific sector. Failing to diversify across sectors could lead to large swings in your portfolio when news emerges about a particular sector. A prudent strategy would be to select a handful of sectors that appear to have good future growth based on macroeconomic research and equally spread out your investments between these sectors. This will eliminate and reduce concentration risk from your portfolio and leave you only with non-diversifiable market risk. If the chosen sectors continue to grow at a faster rate than the others, such industry and stock diversification should have the capacity to consistently outperform the market.
In certain instances, an investor may choose to further diversify their portfolio through additional geographical diversification. This may be done to protect your portfolio from country-specific risks such as political tensions, trade wars, or, more recently, Covid-19 outbreaks. Geographical diversification may be implemented easily by choosing a world index and applying similar geographical weightings. Such an example would be diversifying your portfolio in the following way: 60% of investments in the US, 20% of investments into Europe, and the remaining 20% into Emerging Markets and Japan. This breakdown is similar to that of the MSCI World Index and would no doubt add a layer of protection to an investor’s portfolio in the event of negative country-specific news.
It is also possible to diversify your portfolio through different factors such as size, value, growth, profitability, investment activity, and momentum. It is possible to select a combination of these factors such as favoring small companies with high momentum and then to focus your investments on the companies that fit these requirements. The decision on which factors to focus on can be based on historical evidence (small-cap companies have historically outperformed large-cap companies due to their increased capacity for growth) or may simply be chosen so as to diversify your portfolio. Including multiple factors will reduce your portfolio’s exposure to risk affecting specific factors. The process of setting aside factors and metrics for your portfolio is made easy through the Aikido Finance website who has a variety of pre-made investment strategies with a history of consistently outperforming the market. These strategies have a variety of different metrics such as ranking by dividends or momentum so as to suit each individual investor’s preference. Additional portfolio rebalancing services will also soon be available on the website to make portfolio management even easier for beginner and advanced investors.
Building your Diversified Portfolio and Assessing its Performance
Along with diversifying your investments across sectors, countries, and factors, there are additional considerations required for diversifying your portfolio. An important consideration is the number of stocks to be included in your portfolio. This is important as it will affect how you will weigh your portfolio between sectors and geographical regions. The ideal number of stocks to include in a diversified portfolio is around 20 stocks. It is commonly agreed that after this point adding more stocks to your portfolio will have no effect on increasing diversification and that you will always be exposed to market risk regardless of how diversified your portfolio is. Non-diversifiable market risk may include recessions and other market-wide dips. Once your portfolio is sufficiently diversified it is important that you assess its performance in a way that incorporates both risks being taken in the portfolio. Particular measures of performance such as Sharpe Ratios and Treynor ratios should be used when assessing the performances of diversified portfolios. Instead of simply looking at the return of a portfolio which does not account for the volatility of a portfolio, the Sharpe measure is the best indicator of performance as it incorporates both returns and risk together. A higher Sharpe ratio indicates a higher return achieved for a given level of risk taken. The Treynor Ratio is very similar to the Sharpe Ration but instead of using the standard deviation as a level of risk, it uses the beta. This means that this measure is better when using a portfolio that has not been diversified or is highly correlated.
As can be seen from the above paragraphs, there is a variety of options available to investors who are looking to diversify their portfolios. Additionally, once you have decided how to diversify your portfolio, this article breaks down the correct ways on how to measure the performance of the portfolio in a way that incorporates both return and risk in conjunction with each other. Aikido Finance serves as a useful online tool for this area of investing with a variety of pre-made diversified investment strategies available on their website with the above-mentioned performance indicators such as Sharpe Ratios included.