What is diversification?
Definition: Diversification is the process of allocating capital in multiple assets, in order to reduce risk.
What is asset allocation and diversification?
You may see the terms asset allocation and diversification used interchangeably. However, they don’t exactly mean the same thing.
- The term Asset allocation usually refers to how capital should be allocated between asset classes in an investment portfolio.
- On the other hand, diversification usually describes the allocation of capital within those asset classes.
Let’s give an example, and say that you have $1000 to invest.
You decide to invest 50%, or $500 in stocks, 25%, or $250 in precious metals, and the remaining $250 in cryptocurrency. That’s asset allocation.
However, in your $500 invested in stocks, you decide to put half in Apple stock, and the other half in Tesla stock. That’s diversification.
Why would you employ these strategies?
In basic terms, the main idea behind utilizing risk-mitigation strategies comes down to not putting all your eggs in one basket. Combining asset classes and assets that are inversely correlated is the most effective way to build a balanced portfolio.
What makes these two strategies in combination very powerful is that risk is spread not only among different asset classes, but also within those asset classes. This is what the Modern Portfolio Theory (MPT), developed by the Nobel Prize winner Harry Markowitz in 1952 is largely based on.
What are some of the problems with MPT?
MPT suggests that by combining assets from inversely correlated asset classes, portfolio volatility can be reduced. This should also increase risk-adjusted performance, meaning that a portfolio with the same amount of risk will deliver better returns.
Investors have long looked at international markets as a tool for diversification, but the late 20th and early 21st centuries have seen a gradual and significant increase in correlation between global equity markets.
Perhaps even more worrying is the increase in the previously unprecedented correlation between equity and fixed income (bond) markets, which have traditionally been the pillar of asset class diversification.
Unfortunately, as recent events have shown, even crypto markets are becoming increasingly correlated with traditional equity markets, making asset allocation even more difficult.
Some key questions
What is diversification?
Diversification is an investment strategy which consists of investing in multiple assets, instead of just one.
What’s the difference between diversification, and asset allocation?
The former refers to capital distribution within an asset class while the latter refers to capital distribution between different asset classes.
What is the Modern Portfolio Theory (MPT)?
The modern portfolio theory (MPT) is a capital allocation theory aiming to maximize overall returns in an investment portfolio within an acceptable level of risk. The method was developed by American economist and Nobel prize winner Harry Markowitz in 1952.
Why use diversification?
The idea behind MPT, and diversification is to not put all your eggs in one basket.
When doesn’t diversification work?
Diversification only works if the assets across which capital is invested, are inversely correlated. Many asset classes are becoming increasingly correlated in recent times.
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