Throughout our career as professional investors, we have received more often than not questions like “is it now the right time to fill up my portfolio of Tesla (or any other trendy stock)?”, rather than asking for a solid, long term asset allocation.
The reality of retail investing is that people want to get rich fast and believe that there’s a magic formula. But a magic formula does not exist (avoiding the illegal activities of insider trading). The issue here is that if we concentrate our entire investment portfolio in just a few assets, yes we may do well if we have luck, but we could also lose everything.
And that’s bad. The solution to avoid concentrated losses is called “diversification”.
Let's take a look.
Diversification
Suggested by Markowitz in 1952 for the first time (winning a Nobel prize in economics later), diversification is a way to mitigate risk without sacrificing returns.
In summary, diversification is the name of an investment strategy where several different assets and investment vehicles enter an investment portfolio (then named a diversified portfolio), so that if one fails losses will be limited. The proven logic is that a portfolio constructed with different kinds of assets will, on average, perform better than individual holdings or securities in the long term.
Why diversification is key
If it is true that a single company can fail, an entire sector can fail or lose much of its value, and also an entire market can eventually suffer significantly for a plethora of reasons, why not spreading our investment portfolio around several markets and regions, several industries or sectors, and subsequently several companies?
Diversification in practice
A well diversified portfolio should own different asset classes that behave differently in different economic conditions...
... and should own different securities within each asset class:
=> stocks:
=> bonds:
=> other assets:
Check out a good example of a well diversified (and famous) portfolio here: Ray Dalio's all weather fund.
Watch out that diversification has an efficient limit. An investment portfolio needs a minimum set of assets to work properly in several market conditions, but not too many assets to make it costly and impossible to manage, not to mention complete performance dilution and lower returns.
A great and simple way to diversity is to invest in fair number of ETFs, which are funds tracking an entire market, or index, or asset class, by investing in an efficient number of underlying securities.
How to measure diversification
We measure correlation by analyzing the relationship between asset pairs: the lower the correlation, the higher their diversification power, meaning that the two measured assets tend to perform in very different market conditions. For example, when stock prices are rising, bond yields are generally falling, showing consistent negative correlation, which is good.
Correlation measure goes from 1 to - 1: when two assets show a correlation of 1, it means that they move in sync, while a correlation of -1 means that they also move in sync but in opposite directions: a correlation of 0 instead denotes zero relationship between the two assets, which would be perfectly diversified.
In fact, the benefits of diversification hold only if the assets in the portfolio are not perfectly correlated among them.
Read here more insights on correlation here.
More information
Remember that there are many ways to build a suitable and well diversified portfolio.
On top of what reported so far, it is important to understand your risk profile, and you can find a detailed article that we have written here on the topic.
In you are interested to have a deeper dive on the topic, these articles can be a useful reference: here, here and here
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And you can find well-known books on diversification here:
US, available via Amazon.com
Unconventional success: fundamental guide to investing
SPAIN, available via Amazon.es
Invertir en bolsa a largo plazo
Estrategicas de diversificacion
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