Portfolio diversification: potential return up, risk down
Diversification across stocks, countries and assets should reduce risk so investors can earn the same return with lower risk, or higher return for the same risk.
A portfolio's risk is not defined by the average riskiness of its individual assets, but by the extent to which the returns on those assets are correlated (i.e., move together). The lack of correlation is very important for diversifying a portfolio, because if stocks are not correlated – that is their performance does not depend on one another – the risk that investor will lose on all fronts is typically lower.
Therefore, investors should consider diversifying across stocks, countries and asset classes. The latest Credit Suisse Research Institute Global Investment Returns Yearbook examines each of these in turn.
Diversifying across stocks
Adding more stocks to the portfolio reduces risk rapidly at first, then more slowly. The risk that it reduces is known as diversifiable risk, or residual risk. The horizontal line shows the risk of an equally weighted portfolio of all stocks. This irreducible risk is known as market or systematic risk.
Diversifying across countries
Risk can be reduced rapidly not only by diversifying across individual stocks: diversifying internationally rather than domestically appears to reduce risk even further. While we have seen that globalization has increased the extent to which markets move together, the potential risk reduction benefits from international diversification appear to remain significant.
With a very few exceptions, such as the US (where, over the last half-century, investors would likely have been better off investing domestically rather than investing globally), it has been beneficial to diversify across different countries – or even better, to diversify among developed and emerging markets.
Diversifying across asset classes
Many investors diversify across many asset classes and hold stocks and bonds, as well as cash and other assets, which helps them to reduce risk.
For example, while the 50:50 equity/bond blend experienced a lower return than the all-equity portfolio, it also experienced a lower volatility.
Diversification during market turmoil
Cross-asset correlations may offer benefits by being more effective during periods of market turmoil. The stock-bond correlation tends to be negative in such times. This makes government bonds extremely valuable diversifiers which increase the benefits of portfolio diversification when they are needed most.
There is evidence that the higher correlations arising from market turmoil are quite short-lived. The extent to which international diversification can fail investors during these periods may thus be limited to rather short intervals, and then likely only if these coincide with the timing of realizations where the investor is effectively a forced seller. For long term investors, the enhanced correlations are likely of less consequence.
Golden mean between underdiversification and overdiversification
There can be major costs to being underdiversified. The average individual with a concentrated portfolio is likely to receive a lower return than that of the overall market. Despite the longstanding and widespread advice to hold well-diversified portfolios, many studies find that most investors hold very concentrated portfolios. On the other hand, investors sometimes overdiversify their portfolios. The potential issue with overdiversification is that it is difficult to surpass the market's return by holding such position.
Diversification should be the default, in our view, as it typically allows investors to increase expected return while reducing risk. We believe that a failure to diversify could be viewed as the equivalent of a self-imposed tax.