4.4 - Importance of a Diversified Investment Portfolio

An Examination of Calculated Investing


Question: Why do successful investors have an extremely diversified investment portfolio?

1. Introduction / Overview

Why is this topic important in Investing? 


Diversification is the most fundamental principle of calculated investing. It helps investors manage risks and increases the likelihood of steady, long-term investment returns. Not only do diversified portfolios protect you from market drops and recessions, but also displays your investment strategy, your risk appetite, and financial discipline.


Which area of finance does it belong to? 

→ Asset Management, Investment Strategy, Portfolio Management, Personal Finance


By the end of this lesson, you will be able to… 

  • The purpose behind diversifying your portfolio and its importance

  • Understand the different sectors of diversification

  • Explain how diversification mitigates risk while investing 

  • Learn how to properly manage your portfolio

  • Apply diversification strategies to real world investing



2. Key Concepts & Vocabulary


Diversification

Definition: Spreading investments across multiple different sectors and assets in order to reduce risk and provide steady returns. 

Example: Instead of only investing in transportation stocks, you spread your investments across different sectors like technology, healthcare, and bonds.

Analogy: Think of diversification as a balanced meal- you need a variety of different nutrients and food on your plate in order to receive the maximum health benefits, not just a particular one.


Correlation

Definition: A statistical measure of how two assets move in relation to each other.

Example: Bonds and Stocks have an inverse correlation between each other, when stock prices go down, bond prices increase and vice versa. 

Analogy: Correlation is like the weather in different cities, just because it snows in New York doesn’t mean its snowing in Philadelphia 


Systematic Risk vs Unsystematic Risk

Definition: Systematic risk affects the entire market(e.g. Interest rates) whereas unsystematic risk affects a certain sector or company.

Example: An economic recession affects the entire stock market but a scandal or lawsuit only affects a company or a sector. 

Analogy: Systematic risk is like a nationwide food shortage, whereas unsystematic risk is a fridge being empty in someone's house.


3. Use in Today’s World


Why investors use diversification today:

  • With there being extreme volatility in today’s markets, investors want to make calculated investments that will guarantee them steady returns over a long-term period. Investors can do this by diversifying their portfolio which acts as a cushion for economic crashes or downturns in a specific sector.

  • With ETFs and Mutual Funds becoming extremely popular, it's now easier and cheaper to diversify your portfolio. 

  • Portfolio rebalancing is a key investment strategy backed by diversified holdings.

  • Diversifying your portfolio not only mitigates risks, but can also generate extremely high returns if each sector you invested in provided a positive return.


How Professionals Diversify:

  • Financial Advisors - Use models and statistics to find current trends in the market and allocate their clients assets across different risk levels. 

  • Wealth Managers - Balance client’s portfolios using a combination of different investments like equities, bonds, fixed income, real assets, and mutual funds to enhance client returns and long term portfolio stability.

  • Institutional Investors - Diversifying the portfolio by investing into foreign currencies, industries, and geographies.

  • Individual Investors - Leverage index funds, sector-specific ETFs, mutual funds, bonds, and treasuries for a diversification that will provide a source of passive income as these investments are very risk-averse and always provide steady returns.


Real-World Application Example:

  • Imagine you, a portfolio manager and client came up to you and asked for you to make them an investment portfolio with the returns from the portfolio being put into their 3 year old child’s college fund.

  • This gives you a 15 year timeline to invest before the child goes to college, so you would want to generate steady returns over the 15 years.

  • This should make you want to invest in a multitude of low risk, steady stocks, as 15 years being a very long time, leads to lots of room for the market to fluctuate and to crash.

  • To combat this, you would spread out your investments, better known as diversifying your client’s portfolio across ETFs, mutual funds, bonds, and other sectors to mitigate risk and provide stable returns for a long period of time.


4. Reflection


Why is this concept sometimes overlooked?

People often want to lean towards sectors that perform well. For example, when a certain sector, like tech, is booming, people often over invest into it which exposes many investors into concentration risk. If the tech industry were to fall, many investors would lose copious amounts of money since they went “all in” on one sector. Another reason diversification is overlooked is because many people think it limits upside or is the “easy way out” for investors. While this can be true, diversification is a perfect balance between risk and return which is a core principle for long term investing.


Questions to ask yourself or as a group:

  • Am I exposing myself to concentration risk by investing a lot into this specific sector?

  • Am I diversifying my asset class or just holding different stocks in the same sector?

  • When the market drops, do all my assets lose value as well?

  • How often should I rebalance my portfolio? 

5. Takeaways / Final Summary


5 Key Takeaways:

  1. Diversification is a key principle for long term investing and consistently provides steady returns while reducing the volatility in the market

  2. It helps protect investors from concentration risks and unsystematic risks. 

  3. Modern investing has made diversifying your portfolio much easier with rise of ETFs, mutual funds, and global markets

  4. At its best, a diversified portfolio should not have assets that are highly correlated with each other.

  5. Diversification is an amazing risk management strategy that spreads investments across multiple sectors/areas.

Helpful Tip:

Think of P.I.E.S when reading and analyzing a 10-K:

  • Public Equity(Stocks)

  • International Investments

  • Exchangeable Trade Funds(ETFs)

  • Strategy 


Remember: Don’t put all of your chips into one pot, even if the pot seems very profitable. Diversification is a form of protection.




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