True Diversification

 

Diversification is of obvious importance to any prudent investor today! But unfortunately, very few financial professionals understand how to effectively diversify a portfolio, and most people end up with a “bunch of stuff,” which is not really diversified.

 

What you must understand is that

“bunch of stuff” ≠ Diversification

True diversification stems from its purpose which is to reduce risk, and there are two specific types of risk that diversification addresses. The first type of risk diversification addresses is the Risk of Loss. The Risk of Loss could be more clearly defined as the risk of “total” loss. Most portfolios are diversified adequately to address this type of risk.

However, another type of risk that diversification is meant to address is volatility risk. Volatility Risk is the risk of up and down movement in the portfolio value. Portfolio volatility not only causes an uneasy feeling in the stomachs of most investors, it can also negatively impact overall portfolio return (See Cost of Volatility). And, unfortunately, many investor portfolios are very poorly equipped to minimize Volatility Risk. To minimize Volatility Risk involves some complex portfolio construction utilizing multifactor regression analysis of asset classes to determine ideal mixes for reduced correlation (See Negative Correlation) . Amazingly, a suitably constructed portfolio can reduce its overall volatility and increase its return by properly adding more volatile parts. A simple example of this is that a portfolio of 30% equities and 70% bonds is generally less volatile while providing better long-term returns than a 100% bond portfolio, even though equities by themselves are “more” volatile than bonds. This seems counterintuitive to add something “riskier” to a portfolio to “reduce” risk, but this is the result of negative correlation.