The investor's goal is to receive stable and, if possible, the highest income from the invested funds. But the stock market has a fair share of cunning, arranging the ups and downs of quotations, and periodically – deep crises when everything falls, and investors in a panic begin to save their investments.
The global stock market has been around for centuries. And during this time, several generations of investors (both venerable theorists and practitioners) have developed a lot of ways to "outplay" the market and avoid possible losses.
One of the basic principles of risk-free investments is the diversification of the investment portfolio. The term "diversification" comes from the Latin diversus "different" + facere "to do", in other words – to diversify the assets included in the portfolio. In articles on investments, you can also find portfolio differentiation. If we do not go into linguistic details, then for our case both terms mean the same thing.
The majority of specialists are convinced of the need for diversification. But the reasons for this need and how exactly diversification should be carried out are often explained in different ways.
To help investors understand all these nuances and develop their own approach to diversification, we will consider the following questions in the article:
- Portfolio theory of investments on portfolio diversification.
- Portfolio diversification by Ray (Raymond) Dalio.
- The value theory of investments on portfolio diversification.
- The main types of diversification:
- by issuers;
- by industry;
- by tools;
- by country;
- by currencies.
Portfolio theory of investments on portfolio diversification
Harry Markowitz is rightfully considered the founder of this group of theories (for more information, see the article "Markowitz Portfolio Theory"). His main ideas, on which all subsequent portfolio theories are based, are as follows:
- the profitability and risk of stocks are random variables, their values are determined based on the analysis of historical data on quotations;
- the yield is equal to the mathematical expectation, and the risk is determined by the degree of volatility of quotations: the higher it is, the higher the risk of the investor and vice versa;
- quotes of different stocks are interdependent, i.e. correlate with each other.
It is the latter conclusion that is the basis for portfolio diversification within the framework of portfolio theory. Let's focus on it in more detail.
Read more: Markowitz theory. Ways to select an investment portfolio
The economy consists of a number of interrelated industries, and the growth of profitability in some of them, purely due to the peculiarities of production, is accompanied by a fall in others, which affects the quotes. Let's say oil prices are rising. This pushes up the shares of oil companies, but increases the costs of transport companies, petrochemical enterprises. Or, in a crisis, the price of gold and the shares of gold miners usually rise, but the cost of raw materials and the shares of companies producing it fall. Etc., etc. We have recently observed these processes during the covid crisis, and they are well-known.
Let's say you have stocks of cyclical companies (long-term consumer goods) in your portfolio. During the period of economic growth, you can make good money on them. But these stocks tend to decline significantly in times of crisis. Let's add to them the shares of gold mining companies, which, as a rule, have the opposite trend. In this case, the fall in the shares of cyclical companies will be compensated by the growth of the shares of gold miners. The potential total return of the portfolio remains unchanged, and its cumulative risk, understood as volatility, decreases. I.e. the portfolio becomes more resistant to market fluctuations.
Therefore, Markowitz recommended selecting not just growing stocks in the portfolio, but those whose rates have a negative or the least mutual dependence (correlation). Hence, there is a requirement for intersectoral portfolio diversification, i.e. the selection of shares of companies from various industries, which in crisis periods work as if in the opposite phase: the fall in quotations of some is compensated by the growth of others.
Markowitz calculated the correlation between pairs of stocks, which greatly complicated their selection. His follower W. Sharp simplified this task by introducing the beta–beta coefficient, reflecting the correlation of stock quotes with the movement of the market as a whole. The β coefficient is already present in a ready-made form on many investment sites. By its value, one can judge the degree of interdependence of stock quotes and make the appropriate choice: the greater the spread of this coefficient in different stocks, the less correlated they are with each other.
Portfolio Diversification by Ray (Raymond) Dalio
R. Dalio set out to form an "all-weather" portfolio, which would be aimed at preserving the already accumulated capital. This portfolio should have a low, but higher than the rate of inflation yield, but have significant resistance to any, including the most extreme market fluctuations.
To form such a portfolio, Dalio borrowed Markowitz's ideas about the interdependence of stock prices, but extended them to large groups of assets. Based on many years of research, he was able to determine which of these groups behave differently depending on the growth and decline of the economy, the increase and decrease in inflation. In other words, which groups are least correlated with each other.
In addition, Dalio decided that the portfolio should be balanced not by the values of asset groups, but by their risks. In this case, assets with weak or negative correlation will best compensate for each other's risks.
Dalio's calculations led to the following structure of the all-weather portfolio:
With such proportions, the risks for these groups compensate each other to the greatest extent.
According to American researchers, the all-weather portfolio provides an average annual return slightly lower than that of the S&P 500 index. But its largest drawdown is 10 times less than that of the index.
Read more: What is the essence of the Sharpe Ratio and what is it for?
Cost theory of investments on portfolio diversification
Benjamin Graham is rightly considered one of the founders of this group of investment theories. A student of Graham and a consistent supporter of his ideas is the most famous investor W. Buffett.
Both portfolio and value theories prioritize investor risk reduction, but evaluate it differently.
Markowitz and his followers reduce the risk to the volatility of quotations. This approach has a number of disadvantages. Firstly, the relevant calculations are carried out solely on the basis of past data on the exchange rates of securities. As a result, they are poorly adapted for forecasting in crises, especially caused by unpredictable events, the so-called "black swans" like the covid pandemic. Secondly, if the value of a stock is constantly growing, then its volatility increases, i.e. the Markowitz risk. But, the question is, what under these conditions is the real risk of the investor?
Therefore, Graham argues that the risk is not in the volatility of quotations, but in the real loss of invested funds. Such a loss can occur if an investor panics and starts selling off his shares at any depreciation. For this case, Graham advises never to follow the market blindly, because later, when the situation stabilizes, the investor will have to purchase the same shares, but at a higher price.
Let's illustrate this reasoning with the example of Apple shares.
As can be seen from the chart, the volatility of stock quotes and the risk of investing in this Markowitz instrument are very high – prices have changed 14 times since 2010. But, in fact, the cost of an investor's investment in this paper has increased by 14 times. During the period under review, the shares experienced two major falls: at the end of 2018 by almost 1.5 times, and in March 2020 by almost 25%. Investors who panicked and sold off these shares suffered significant losses. However, the quotes recovered after the first fall in a year, and after the second – in just 2 months, having additionally increased by now almost twice.
This example confirms the correctness of Graham, who warned against selling stocks at any drop in their quotations and insisting that investors learn to calmly experience "bad times".
According to Graham, the real risk of losses arises if the investor is objectively forced to sell shares at a loss. This becomes possible if you blindly follow the market and invest only in growing stocks. Graham emphasizes that there are many examples when such stocks eventually fall, and sometimes irrevocably.
To illustrate, we can give an example of an Enel campaign.
It follows from the graph that if in 2006-2008 the stock was growing quite steadily, then it moved to an almost continuous decline.
To avoid such a situation, Graham introduces the concept of "safety margin", which is the difference between the real value of a security and its price on the market, characterizing the degree of underestimation of the stock by the market.
The real value is determined based on the analysis of the company's financial statements for several years, with mandatory consideration of the forecast of the issuer's financial indicators at least within the investment period. The shares should not be sold at any price fluctuation, but only when they exhaust the margin of reliability.
Graham considers the portfolio's overall reliability margin to be its diversification by including 10-30 stocks, since this avoids additional risks.
It would seem that portfolio and value theories occupy directly opposite positions. Markowitz recommends that only growing stocks be included in the portfolio – Graham doubts the validity of this approach and introduces a safety margin criterion. Markowitz reduces the risk of the portfolio to its volatility and recommends buying the least correlated stocks – Graham considers the risk of losses that an investor will incur as a result of buying overvalued stocks.
And what does practice show? Dalio made his fortune by adhering to portfolio theory and extending it to large groups of assets. Buffett also made his fortune by following Graham's advice.
Correlation of quotations of various assets is an established fact, based on which Dalio managed to create a successful and very stable portfolio. But the underestimation of a number of stocks by the market, which subsequently leads to their rapid growth, is also an irrefutable fact.
Each of the groups of theories covers only a part of the facts that really characterize the stock market. Markowitz talks about the formation of a portfolio of growing stocks, but does not give precise criteria for selecting from a variety of instruments whose quotes are rising. And Graham, insisting on the inclusion of undervalued stocks in the portfolio, does not establish the exact signs according to which 10-30 pieces should be selected from their total number in the portfolio.
Most likely, portfolio and value theories do not so much exclude as complement each other, assuming the following algorithm of actions: first, the circle of undervalued stocks is determined, and then those that have a negative or weak correlation are included in the portfolio.
Read more: Warren Buffett: 10 golden rules of domination
The main types of portfolio diversification
Diversification of the investment portfolio in a broad sense is the distribution of invested funds into different assets. But the concept of "different assets" can mean differences in both the type of securities, their currency, industry affiliation, etc. That is, there may be different types of diversification, depending on the principle of allocation of funds. We will consider the main types:
- diversification by issuers;
- diversification by industry;
- diversification by instruments;
- diversification by country;
- diversification by currencies.
Diversification of the investment portfolio by issuers
If we follow the conclusion of the previous section, then portfolio diversification is far from an easy task. Initially, we need to identify a circle of issuers with good financial performance, whose shares are undervalued or have growth potential. To do this, you will need to analyze the financial statements for recent years, study and compare forecasts for revenue, profit, etc. for several years ahead. Then - to identify the degree of mutual correlation between the stocks we have previously selected.
Moreover, this analysis needs to be kept up to date, because with each release of quarterly reports, the indicators will change.
Based on this data, investors have the opportunity to quickly select issuers to include their shares in the portfolio.
Read more: Recession in the US in 2022
Diversification of the investment portfolio by industry
Its necessity directly follows from the recommendations of the portfolio theory, according to which different industries have different degrees of correlation with the market, i.e. they react differently to the phases of the economic cycle. The advice of diversification by industry is also contained in all well-known articles on this topic. It is usually suggested to decide which industries you will invest in, then choose the best 1-3 stocks in each of them. Only here the question of how to select these industries, the authors of the articles in most cases answer quite abstractly. Firstly, promising industries can give a significant increase in quotations. But it is extremely difficult to predict exactly when this will happen. In addition, it is necessary to decide which specific issuer's shares are worth investing in. Secondly, the market tends to overestimate the shares of high-tech sectors, as evidenced by the so-called "dotcom crisis" of 2000. The initial euphoria of investors regarding the shares of Internet companies was replaced by disappointment in their real financial performance. As a result, if from May 1997 to March 2000 The Nasdaq index of high-tech companies grew by about 5 times, then by September 2002 it experienced about the same drop.
After the collapse of the bubble, it took more than 14 years for the quotes of high-tech stocks to recover to the level of 2000.
Therefore, investments exclusively in shares of high-tech companies are of unconditional interest, but also carry a high risk.
It is important to track not only stock prices, but also the actual economic indicators of the relevant industries.
These indicators can be used to judge how a particular industry is developing, what its prospects are, whether its companies are overvalued or undervalued, etc.
Portfolio theories recommend selecting shares of issuers of those industries that are weakly interconnected or negatively correlated, i.e. they move in "opposite phase" when the growth of some is accompanied by the fall of others. Here it is necessary to trace technological chains: prices for raw materials and metal are rising – shares of mining and metallurgical companies are growing, but builders and machine builders are having problems, as a result of which their shares are likely to fall, etc.
Read more: How to evaluate growing companies? PEG Ratio
Diversification of the investment portfolio by instruments
A number of instruments are traded on the market: stocks, bonds, ETFs, futures, options, etc. Derivatives (forwards, futures, options, etc.) have an increased level of risk. Therefore, their use is not recommended for novice investors. Consider two basic instruments – stocks and bonds.
The main problem is to establish their correct ratio in the portfolio. Stocks tend to bring investors higher returns, but have significant volatility and risk compared to bonds. Therefore, shares are classified as risky assets. It is recommended to include bonds in the portfolio as a protective asset. The protective properties of bonds are given by a known fixed coupon income in advance, which compensates for the drawdown of stock quotes. At the same time, the overall profitability of the portfolio decreases, but the risk of investor losses decreases.
In publications on diversification, you can find a wide variety of recommendations on the ratio of stocks and bonds, from 90% to 10%, to 10% to 90%. All these recommendations can be considered as reasonable and, at the same time, not. The fact is that more specifically, the required ratio of stocks and bonds is determined by the investor's risk profile. Depending on the level of risk, investment profiles can be divided into aggressive, balanced and protective.
- Aggressive portfolio has a bias towards risky assets: growth stocks and undervalued stocks, which make up about 100% of its structure. Such a portfolio has a high yield potential with a corresponding high level of risk.
- Balanced portfolio is aimed at ensuring an acceptable level of profitability with the lowest level of risk. Its structure has an approximately equal ratio of stocks and bonds, that is, 50/50%.
- Protective portfolio. Its main features are 100% protection of invested investments and a minimum of risky assets. The ratio of stocks and bonds is about 20% to 80%. Such a portfolio has an acceptable level of profitability with almost zero risks. The minimum risk parameter is achieved due to the predominance of protective assets (bonds) in the portfolio.
But agree that tips on the ratio of stocks and bonds, like 20/80, 30/70, more than 50, etc., etc. are quite speculative. After all, we are interested in very specific things: what kind of profitability, in numbers, the portfolio will give us, and what, also in numbers, will be our risk.
Portfolio selection begins with stocks, guided by the recommendations of the previous sections. From the received lists of securities, guided by indicators of potential, drawdown, taking into account the beta and the results of additional analysis of the current, future and investment evaluation of the company, we choose the best stocks of various industries.
Read more: Investment portfolio
Diversification of the investment portfolio by country
Its necessity is due to the fact that the markets of different countries are developing unevenly.
The desynchronization is caused by the peculiarities of the economy of different countries. Geographical diversification is also desirable to reduce country risks. By and large, such diversification can be made:
- Having gained access to international markets, subject to the status of a qualified investor;
- By opening an account with an international broker.
In addition, here you can buy shares of ETF investment funds, which usually cover the widest range of assets. There are index ETFs that invest in the corresponding index, for example, the S&P500, buying all the shares included in it in the required proportion.
It is also important that some funds have a small or negative value of the beta coefficient, i.e. their quotes are weakly related to the market as a whole, or are opposite to its movement. This allows the use of ETF data to reduce the overall risk of the portfolio.
Diversification of the investment portfolio by currencies
Changes in the exchange rate significantly affect the real profitability of the portfolio. Any investor who makes up a portfolio in domestic currency often does not think about what will happen to profitability if you bring it to some common denominator, which at present, despite many years of threatening forecasts, the US dollar continues to remain.
Read more: How Portfolio Investing Works
Conclusion
Portfolio diversification is an important way to reduce risks. It is advisable to conduct it in a broad way:
- by issuers, choosing the most promising and reliable assets;
- by industry, making a selection of the least correlated securities;
- by instruments, combining stocks, bonds and ETFs;
- by country and currency.