Diversification is one of the investment world’s most long-standing watchwords – and for good reason. Picture: Pexels.com.
By Wendy Myers
Diversification is one of the investment world’s most long-standing watchwords – and for good reason. As a risk mitigation strategy, diversification is one of the most effective ways to bolster a portfolio against factors like market volatility, concentration risk and inflation. And while industry stalwarts agree on the power of diversification as a central principle of investing, it’s up to each individual investor to apply this principle in line with their unique needs and circumstances.
Master the asset mix
There are a number of ways to build a diversified portfolio that strikes the right balance between risk and reward. One of these methods involves achieving diversification through a risk-adjusted allocation of investment types, or the ‘building blocks’ of a portfolio.
Making informed decisions, relies on understanding the correlations between different assets, or the extent to which the performance of those assets is connected. Typically, for example, equities and bonds are fairly uncorrelated, so when one of these asset classes is performing well, the other might perform poorly, and vice versa.
A diversified portfolio should therefore aim to have a mix of shares, bonds and cash, as each will perform differently not only in relation to each other, but also in response to changing market conditions and economic climates.
A strategic approach to diversified returns
Another dimension of diversification involves looking at shares’ market capitalisation. Large-cap companies, characterised by good track records and high market values, are typically seen as stable investments. Mid-cap companies, with a history of strong market performance, are perceived as having a moderate risk profile compared to their larger counterparts. Small-cap companies, often startups with little performance history, are considered high-risk but have the potential for significant growth.
Additionally, stocks can be differentiated in terms of growth versus value. Growth stocks are projected to outperform the market, driven by their potential for substantial future returns and capital gain. On the other hand, value stocks are undervalued by the market and are expected to grow in value over time.
In principle, building a diversified portfolio that includes a mix of large, mid, and small-cap stocks, as well as a blend of growth and value stocks, is an effective way of mitigating the risks associated with different assets. This approach provides return prospects that encompass both growth and value, enhancing the overall resilience of the portfolio.
Keeping a close eye on geographic spread
Investments can also be diversified according to their geographical location, and deciding on the proportions for these allocations needs to be carefully considered. In principle, offshore diversification is important to local investors, but how investors go about achieving this will depend on each client’s individual needs. There are practical considerations like costs and estate planning implications which need to be considered, and which may require expert advice.
Balancing the spread of sectors
Within equities, there is also potential to introduce sector diversification into a portfolio. This is where portfolios can be ‘overweight’ or ‘underweight,’ depending on the risk exposure of particular sectors. The banking sector is a good example – when interest rates are high, investors may opt for slightly higher exposure to the banking industry, as the sector generally fares well in a higher interest rate environment. However, higher sector-specific exposures also hold potential downside risks. It is therefore prudent for investors not to build portfolios that are too heavily weighted in a single sector and to spread the risk out evenly.
Factoring in volatility
Volatility risk is another aspect that comes into play. In the investment world, volatility is a key concept that reflects the level of uncertainty or risk associated with the price movements of a financial instrument, such as a stock, bond, or index.
Creating a robust investment portfolio therefore depends on the investor’s ability to assess the potential impact of market fluctuations on investment returns and implementing strategies to manage and navigate through periods of uncertainty in the financial markets.
On funds and flexibility
Finally, investors need to factor in liquidity risk, or the potential for financial shortfall in the event that a portfolio does not align with the investor’s need for immediate access to cash resources.
Without proper liquidity in your overall portfolio, there is a risk of becoming a forced seller, particularly in emergency situations where one might be compelled to liquidate a position at an inopportune time, such as the bottom of a market cycle. This scenario could result in the crystallizing of losses, which generally should be avoided.
The role of financial advisers in effective portfolio management
Due to the highly technical nature of investing, building a close relationship with an adviser can bring a level of expert guidance to the process as well as a wealth of asset- and sector-specific knowledge. The significance of working with a financial adviser becomes particularly evident when considering the crucial practice of rebalancing a portfolio. Rebalancing is an essential aspect of portfolio management, but making these decisions can be challenging and is often complicated by impulsivity or emotional reactions to market shocks.
A financial adviser can play a pivotal role in guiding investors through this process, offering expertise and objective analysis. This might involve selling securities with profits, even those with losses, and acquiring stocks poised for long-term success. Through this meticulous process, a financial adviser can help ensure that the portfolio maintains a balanced and diversified allocation, contributing to the investor's overall comfort and confidence in their investment strategy.
* Myers is the head of securities at PSG Wealth.
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