DIVERSIFICATION AND RISK

  • Diversification and risk management are two areas J. Bradford Investment Management helps add value to client portfolios.
  • With diversification, your overall portfolio will be less volatile, both on the upside and the downside.
  • Generally, investment professionals look for the investment or portfolio of investments that will achieve the highest level of return for a given level of risk.

Diversification is one of the fundamental concepts of investing. The research and practical application both suggest that a portfolio made up of many different kinds of investments (stocks, bonds, real estate, commodities, cash and others) will do better than a portfolio of just one stock or a few stocks. Diversification can get quite complicated once you get past the basics, so I've included links to some books below for those that want to explore the topic in more detail. We are covering the basic principals of diversification and risk here with two engineered examples.

 
 

With a diversified portfolio of many different investment types, you get a smoothing effect. The performance of the winners offset the performance of the losers and your overall portfolio will be less volatile, both on the upside and the downside. You'll get lower lows but also lower highs.

The key point is that diversification is a great tool for managing risk and smoothing out returns.

These charts are purely illustrative and for educational purposes only. This material is NOT a recommendation to buy or sell any of these securities and does NOT show or represent performance achieved or performance promised with J. Bradford Investment Management. Charts produced using the Portfolio Visualizer tool from Silicon Cloud Technologies.

Let's evaluate three simplified and fictional portfolios just to demonstrate the point. One portfolio is 100% Ford Stock. The second portfolio is made up of 2% Ford stock and 98% of the 30 Companies in the Dow Jones Industrial Average and the last portfolio is 4% Ford stock, 50% of the Dow Jones Industrial Average and 46% in Bonds.

These three portfolios generated some interesting results over the 10 year period from 2006 - 2015.

In this back-test example, all three portfolios ended up very close to the same final balance, within a few hundred dollars of each other, but got there along very different paths.

Portfolio 1 had huge swings up and down. There was a stretch where Ford lost over 80% of it's value and then came roaring back with a gain of over 300%. Most of us don't want that kind of volatility and risk.

Portfolio 2 was better, but still pretty rocky. There was a stretch where Portfolio 2 lost over 47% of it's value and it's best year was actually just a bit lower than the best year for Portfolio 3.

Portfolio 3 had the least volatility of the three portfolios. If you look at the graph below, you'll notice that Portfolio 3 has the "straightest path" from the starting value to the ending value. By adding the bonds to the portfolio, the worst stretch of this portfolio was only a 26.2% decline and by having more Ford stock than Portfolio 2, it's best year was slightly better than Portfolio 2.

All of those ups and downs get captured in the Standard Deviation calculation. Higher Standard Deviation means higher ups and downs which we equate to higher risk.

KEY TAKEAWAY: Generally, a diversified portfolio will have a lower standard deviation (i.e. less risk) than a non-diversified portfolio of one or a few stocks.

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Example 1 was a scenario of three portfolios with approximately the same return and different levels of risk. Now let's look at three portfolios with the same level of risk, but different levels of return.

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In this example, Portfolio 1 is 100% Microsoft stock. Portfolio 2 is 65% Apple stock and 35% of the 30 Companies in the Dow Jones Industrial Average and Portfolio 3 is made up of 75% Apple stock and 25% in bonds. In the chart below you can see that the standard deviation of each portfolio is within .5% of a percent of each other (24.58 - 25.10), but the returns are significantly different.

If we were willing to accept a level of risk roughly equal to a standard deviation of 25%, we would prefer portfolio 3 in this very limited example. It has a higher return, the lowest worst year and the lowest draw down all for the same amount of risk as the other two portfolios.

KEY TAKEAWAY: Generally, investment professionals look for the investment or portfolio of investments that will achieve the highest level of return for a given level of risk.

Since we engineered these examples, the simple act of adding bonds to the portfolio in each example helped illustrate our point because we knew the historical performance and historical risk of each investment.

In practice we don't know ahead of time what the performance or risk or any asset or portfolio will be, which is why portfolio construction is not an exact science.

Many professionals use historical information as a guide, but also combine that information with existing capital market expectations, diversification strategies, risk management strategies, correlation analysis, independent research and professional judgement to build portfolios.

If you want to discuss the diversification and risk of your portfolio or any other financial topic that matters to you, schedule a free consultation today.

Want to dig even deeper? These three books can offer a robust exploration of the topic and you can always schedule a free consultation to learn more.

Portfolio Selection: Efficient Diversification of Investments

Modern Portfolio Theory and Investment Analysis

Investors and Markets: Portfolio Choices, Asset Prices, and Investment Advice