Portfolio Diversification: Or how to stop worrying and love risk

We’ve all seen them: the stock photos portraying investing as a balancing act between risk and reward. Whether a scale, a seesaw, or some guy on a high wire, these investing analogies pit the potential for gain (reward) and the potential for loss (risk) against each other as diametrically opposed forces. When one goes up the other must go down, and vice versa. But that isn’t entirely accurate, at least not when looking at your investing portfolio as a whole. 

Rather than just balancing the risk and reward of each investment individually, portfolio diversification recognises that varied investments work together to mitigate risk and maximise reward through the magical process known as ✨diversification✨. 

The Myth of Riskless Investments

Let’s get one thing out of the way first. While some investment classes are lower risk than others, there’s no such thing as a risk-free investment. Even keeping all your assets as cash puts you at risk of losing value to inflation. Before you can understand the value of a good portfolio diversification strategy, you need to understand what it is you’re diversifying against: risk. 

Now, imagine you're holding a hot potato. Risk is the chance that this potato either cools down (bummer), stays hot (yay), or explodes and covers you in molten potato lava (we’ll try to avoid this). Different investments are like different potatoes. Stocks? They’re like those delicious patas bravas that could really heat up or just explode in your face like a starchy grenade. Bonds? These are more like those warm, comforting mashed potatoes that won't let you down too hard, but don’t really taste much of anything. 

While you want a little bit of heat in your potatoes (investments), the higher the heat, the higher the chance things blow up on you. However, even though the mashed potatoes are less risky than the patas bravas, extenuating circumstances can change this. Alas, even the safest government bonds aren’t immune to the effects of bad political and monetary policies. 

Source: https://www.realvantage.co/insights/investing-in-real-estate-know-your-spectrums-first/

Why Tolerate Risky Investments? The Rewards, Of Course

We hinted at it in our extended spud metaphor above, but there’s a reason people put up with risky investments. And that’s because of the (potential) rewards! In the case of investments, this reward is the money you could make from your investment. In the case of potatoes, this reward comes in the form of flavour. More risk? More potential spicy reward. Remember though, with great spice comes great responsibility...and the potential for financial heartburn. 

Source: https://www.quantifiedstrategies.com/historical-returns-asset-classes/

When we talk about investing, higher potential returns are usually associated with higher risks. For example, stocks have historically provided higher returns compared to bonds or savings accounts, but they also come with greater volatility. So while that high-risk stock could see you 10X your initial investment, there’s also a chance the whole thing goes kaput and you’re left with nothing more than an empty chip bag for your efforts. Similarly, while you might not consider the bland taste of mashed potatoes particularly appealing, the reliable (if somewhat smaller) reward of government bonds offers a reassuring fixture for your investment portfolio. 

What is Portfolio Diversification, Exactly?

Simply put, diversification is the process of selecting investments that behave in a complementary manner, so as to minimise risk while maximising rewards. This both means incorporating a variety of risk profiles in your investments, as well as incorporating investments with different maturity timelines, reactions to certain macroeconomic trends, associations with industries, and other factors that will influence how they perform over time and in different stages of the economic cycle. 

Source: https://napkinfinance.com/napkin/asset-classes/

Creating a Diversified Portfolio

So how do you pull off this balancing act between risk and reward without falling face-first into financial ruin? Well, we’ve talked about potatoes, but now it’s time for eggs. Namely, not putting all of your eggs in one basket. Rather than looking at the individual risk and reward profile of your investments in isolation, you need to see them as working together. And the way you do this is by taking a few steps to add diversification to your investment strategy. 

Source: https://neebank.com/the-importance-of-diversification.html

1. Introducing Portfolio Diversification: The best way to begin diversifying your investment portfolio is to invest in a wide variety of assets. Spreading your eggs across many different kinds of baskets helps you avoid major losses if one investment tanks. Diversification doesn’t just mean buying different stocks though. It can also mean holding a mix of asset classes, such as stocks, bonds, real estate, and perhaps even commodities like gold. By investing in a variety of asset classes, you can protect your portfolio from significant downturns in any single sector.  Each of these asset classes behaves differently under various economic conditions, which helps to smooth out your overall returns. For example, if the stock market crashes, having bonds or real estate in your portfolio can help cushion the blow.

Source: https://www.americancentury.com/insights/the-surprising-truth-about-diversification/

2. Incorporating Strategic Diversification: As with all aspects of investing, you need to know what you're getting into when diversifying your portfolio. Before you go dumping your eggs in any basket you happen across, do a bit of research. Knowing how market forces affect different assets and asset classes will help you to ensure everything in your portfolio works together. Look into historical performance, understand the market conditions, and consider the economic factors that could impact your investment. A mix of cyclical and countercyclical assets can help you ride out recessions with ease. While a blend of innovators and stalwarts will have you sailing through both sides of industry paradigm shifts. 

3. Max Out on Rewards: Diversification’s most famous role is in reducing risk (sounds like a Netflix movie already), but it also plays a part in helping you increase your potential returns (not as catchy of a title). Given that different sectors perform differently, when one is down another might be up. Diversified investment allows you to benefit on both ends. For instance, when technology stocks are underperforming, healthcare or consumer staples might be doing well. This spread helps to keep your overall portfolio stable and growing. When it comes to diversification, loyalty is overrated and playing a double agent in your investment choices is the smartest move you can make.

4. Adapt Over Time: As much as most investors would prefer to set and forget their investments, maintaining the right mix of diversification requires the occasional tune-up. While spreading your investments across a strategic mix of assets classes and assets within those classes is a good start, you can’t stop there. Keep an eye on your investments and adjust as needed. Some will grow faster than others, so reallocate to maintain balance. Regularly reviewing your investment portfolio ensures that you remain diversified and aligned with your risk tolerance and financial goals. Beyond maintaining the right mix, you also have to consider whether your investments still fit the same category as when they were purchased. What was once a lower-risk bond might become riskier over time and what was once a high-flying stock may start to level off eventually. Even the interactions that different assets have with various current events can affect the way they work within your portfolio. 

Source: https://www.miraeassetmf.co.in/knowledge-center/how-does-portfolio-rebalancing-happen

5. Make Peace with Risk: Diversification mainly works to eliminate one type of risk: specific risk. This type of risk applies to particular companies, industries, or sectors. However, it can’t eliminate all risk. Market risk comes for all and even the most diversified portfolio will feel the pinch of a big downturn.  But some of the risks you’ll deal with will be your own doing. Within your portfolio, each asset comes with its own risk profile. So while diversification will help to dull the overall risk of your portfolio, you shouldn’t lose sight of those individual assets and the risks they bring. Choose investments that align with your risk tolerance. Some people are more risk-averse, preferring safer, more stable investments like bonds or savings accounts. Others are more risk-tolerant and are willing to take on the volatility of stocks for the potential of higher returns. Wherever you land on the risk spectrum, be honest about how much you can take. If you can't handle the heat, maybe stick to the less spicy potatoes.

Source: https://images.app.goo.gl/wevRpdERnFkubYs18

The Final Word

Of all those stock photo metaphors about risk and reward, the most relevant when incorporating diversification is probably the seesaw: fun, occasionally scary, and reliant on ups and downs to make it work. Like the seesaw, diversified investing also goes much more smoothly when you know what you’re doing. So grab your metaphorical potato and figure out what works for you on a scale of government bonds to meme coins. By reducing risk and increasing reward through diversifying your investments, you can make bank without going bankrupt!