Investment Portfolio Diversification Is Essential

Investment Portfolio Diversification

Diversification is essential to managing the risk in an investment portfolio. The underlying theory is that there are two types of risk -- systemic and firm-specific. Full diversification comes from investment breadth -- the underlying principle of which is that the more independent securities are in the portfolio, the better diversified it will be (Polakow & Gebbie, 2008). Different individual securities are exposed to a variety of different types of risk. The risks associated with one security can be counterbalanced by other securities that benefit under the same scenario that causes the first security to struggle. If a portfolio is sufficiently diversified, then the firm-specific risk is eliminated, leaving only the risk associated with the market as a whole. Thus, diversification reduces the total risk of the portfolio.

There are impediments to creating a fully diversified portfolio, however. A fully diversified portfolio should contain securities from a wide variety of sectors and industries, to take advantage of the differing performance of different industries under identical economic scenarios.

One impediment to achieving diversification across industries is lack of investor knowledge with regard to all industries. Some investors are more comfortable with certain industries or companies and weight their portfolios accordingly. Such portfolios may contain firms from a wide range of industries, but the weighting of the portfolio leaves it exposed to certain industries and firms with which the investor is familiar.

Another impediment to cross-industry diversification is profit-taking. As certain industries enjoy success or failure, the temptation is to buy or sell all of the holdings in those industries. This can result in a portfolio that lacks balance, as holdings of certain industries become distorted by profit-taking or by excessive buying.

Price fluctuations can also impact cross-industry diversification. If an industry experiences strong price movements, it can become either an abnormally large component of the portfolio or an unusually low component. These price fluctuations impact the total diversification of the portfolio. An investor may be hesitant to sell a firm still rising, or buy into a declining industry simply for the sake of maintaining diversification.

A related problem is that of transaction costs. Constant rebalancing may be necessary to adjust for rapid price movements in a given industry. However constant rebalancing can be cost prohibitive, either discouraging the investor from engaging in rebalancing transactions or negating the benefits of such transactions. It has been demonstrated that as transaction costs, calculated on a percentage basis, increase, portfolio reallocating decreases (Rowland, 1996).

There are unique issues associated with maintaining diversification across asset classes. One is the needs of the investor. Portfolios differ in asset allocation in part because investors have different purposes for the portfolio. An elderly couple needed steady income will not have a diversified portfolio as theirs will be weighted towards fixed income products. Likewise, a young investor may hold mainly equities.

Investor risk tolerance is another impediment to achieving asset class diversification. Investors will low risk tolerance, for example, are unlikely to hold high equity positions and even less likely to utilize more obscure securities like hedge funds. Yet, portfolios without equities may be highly susceptible to changes in the prevailing interest rates and therefore lack diversification. Indeed, for many investors a fully-diversified portfolio across asset classes is not desirable for their investment objectives, time frame and risk tolerance.

Lastly, asset class diversification can be hampered by knowledge of asset classes. Even without considering emerging asset classes, many classes require specialized knowledge - commodities, forex, real estate to name a new -- that may dissuade investors from utilizing them. Even relatively common asset classes such as preferred shares, zero coupon bonds or mutual funds can be sufficiently confusing. The degree of willingness of an investor to use an asset class is directly related to the investor's ability to understand the class.

Achieving geographic diversification also comes with its own set of impediments. There is, in particular, a domestic bias in equity holdings among investors (Rowland, 1996). Investors are more familiar with domestic firms, understand their operating environment better, and have better access to information about those companies. Moreover, domestic firms are all subject to the same reporting requirements -- the reporting methods and structures for international firms may not be familiar to the investor, resulting in a knowledge gap.

Transaction costs -- beyond those associated with rebalancing -- are also a factor unique to geographic diversification. Purchasing international equities is much more difficult than purchasing domestic equities and comes with higher transaction costs as a result. Investors may be hesitant to absorb these costs and seek to find geographic diversification in other ways, such as through mutual funds.