How Diversification Works

How Diversification Works

The principle of diversification as it relates to investing is perhaps widely quoted but not necessarily well understood. The principle comes out of portfolio theory and fundamentally refers to the concept of maximising return for a given level of risk. Many ‘diversified’ hedge funds (together with countless other investors) discovered in 2008, to their horror, that their investments weren’t nearly as well diversified as they thought. The mathematical concept underpinning the concept of diversification is correlation.  In this article we will discuss correlation and how it relates to diversification and then we will highlight some of the benefits of true diversification.

Correlation is a mathematical measurement of how faithfully the movement of one parameter (in this case, asset price) follows the movement of another parameter. With regard to stock price, a correlation of one implies that the two stocks follow each other perfectly while a correlation of negative one implies that the two stocks do the exact reverse of each other. A correlation of zero means that there is no relationship whatsoever between the two prices. A poorly diversified portfolio would consist entirely of stocks that have a correlation with each other of nearly one. As an example, buying the big four Australian banks (ANZ Bank, National Australia Bank, Westpac and Commonwealth Bank) would provide only very marginal diversification. This is because the correlation between the banks is very high (close to one) and therefore, if the price of one bank falls, it is very likely that the price of the other banks will also fall. It does, however, provide some protection in the case that one particular bank makes a bad decision. The strong correlation in this case comes about because all four of the banks are exposed to many of the same risks and economic factors.

 Slightly more diversification could be obtained by adding ASX stocks from other sectors, for example BHP Billiton and Rio Tinto. This would improve the diversity of the portfolio because the correlation between resources stocks and bank stocks is lower than the correlation between bank stocks. Continuing to add various ASX stocks would improve the diversity of the portfolio although a limit will eventually be reached where the risk adjusted returns can no longer be improved. This is because there is a certain degree of correlation between all ASX listed stocks arising from the fact that broadly speaking they are exposed to all of the same macroeconomic factors. At this point, further diversification can only be obtained by investing in another asset class or in overseas equities.

At this point we will take a break from the theoretical discussion and look at correlation in a real world example. During the early 2000’s, many banks, hedge funds, and other investors in the US were espousing the benefits of investing in the housing market. Products called residential mortgage backed securities (RMBS) were created that allowed investors to gain exposure to the broad US mortgage market. At the time, the risk of these portfolios was considered very low because it was assumed that the likelihood of default by, for example, a homeowner in Florida was completely uncorrelated to the likelihood of a California homeowner defaulting. As a result of this perceived diversification, the ratings agencies gave these products very high ratings. In reality, however, there will always be a degree of correlation within an asset class and this correlation will increase in times of crisis. As a result of this, when house prices started to drop, investors quickly discovered that all mortgages within those RMBS were highly correlated, thus causing large losses for anyone holding these products. This example highlights that even professional investors can misjudge the risk inherent in their portfolios.       

Returning to our discussion on diversification, the biggest gains for a portfolio, in terms of risk adjusted returns, come when assets are added that have either negative correlation or no correlation with the overall portfolio. Bonds are an asset class that typically have a negative correlation with stocks and some commodities, like gold, can be either uncorrelated or negatively correlated with stocks. When added to a portfolio of stocks, these investments can significantly improve the risk with only a small impact on the total return.

Now that diversification has been explained, the concept of risk needs to be explored. Most financial analysts use standard deviation as a measure of risk. When applied to stock (or asset) prices, standard deviation is a measure of how volatile the price is from day to day. For example, a stock whose price rarely changes would have a low standard deviation while a stock that regularly has large daily price moves will have a high standard deviation. A high standard deviation is typically associated with higher risk. Intuitively this makes sense; if a stock has large price swings, there is a higher probability of losing a large portion of the investment if the price drops. Using this information, we can then calculate the risk of a particular stock or asset and compare it to the return expected from that asset. In general, assets with a higher risk will also have a higher expected return. This is where an interesting mathematical result comes in. If a stock is added to a portfolio, and the stock has a low correlation to the portfolio, it is possible to reduce the standard deviation of the combined portfolio by more than the expected return is reduced.

As an example, Rivkin currently runs a portfolio called the Low Volatility Strategy (currently only available to wholesale clients) that holds a portfolio consisting of equities, bonds, gold and cash. The table below shows both the back-tested return and standard deviation of both the low volatility strategy and ASX 200 Accumulation index.


Average Return (% p.a.)
Standard Deviation (%)
Rivkin Low Volatility Strategy
6.8
4.59
ASX 200 Accumulation Index
9.48
16.32

From these numbers it is clear that while the ASX 200 has a higher return, the risk (standard deviation) is higher by a much larger amount. The benefits of the low volatility strategy come because the correlations between stocks, bonds, cash and gold are either negative or close to zero and therefore the standard deviation of the portfolio is greatly reduced. This implies that the day to day fluctuations in portfolio value of the low volatility portfolio are much lower than for the ASX 200. The low volatility strategy is great for people who cannot stomach the large swings in portfolio value that occur in the stock market. If you are a wholesale investor, and are interested in this strategy, please contact Thomas Silitonga at (02) 8302 3605 or Thomas.Silitonga@rivkin.com.au.

Having a basic understanding of portfolio diversification has the potential to enhance the performance of the average investor. The principles behind diversification are not too difficult to understand and all investors should include the concept firmly in any investing plan and use it when constructing a portfolio. 
comments powered by Disqus

DISCLAIMER: Rivkin aims to provide clear and simple information to those visiting our website. If any part of this disclaimer does not make sense, please phone Rivkin and ask to speak with a member of our Dealing and Relationship Management Team. Rivkin provides general advice and dealing services on securities, derivatives and superannuation (SMSF). Rivkin also provide SMSF administration and accounting services. Rivkin does not provide advice that takes into account your, or anybody else's, investment objectives, financial situation or needs. We strongly suggest that you consult an independent, licenced financial advisor before acting upon any information contained on this website. Investing in and trading securities (such as shares listed on the ASX) and/or derivatives (such as Contracts for Difference or 'CFDs') carry financial risks. CFDs carry with them various additional risks that differ from more simple securities such as fully-paid company shares. Some of these risks include not owning the underlying instrument from which a price is being derived, settling trades 'over the counter' with a financial institution rather than on a stock exchange, and using leverage to gain access to trades that may have a higher face value than your initial deposit. This risk of leverage means that it is possible to lose more than your initial investment. Our aim is to create more life choices for our clients, which means improving the wealth of clients throughout many market cycles by nurturing a relationship spanning many years. If you are not comfortable with your understanding of the risks involved before using a Rivkin product and service, please contact our office to seek further information or a Product Disclosure Statement, or make an appointment to sit with one of our friendly financial experts. It is in our interest for your Rivkin experience to be a rewarding and comfortable one. Rivkin is a trading name of Rivkin Securities ABN 87123290602, which holds Australian Financial Services Licence No. 332 802.