Diversification And Risk Factors

Diversification And Risk Factors

Diversification plays an important role in risk management. You can diversify your investments: first, by holding a broad range of asset classes, such as bonds, equities and real assets; and second, by holding a variety of sub classes within each class. For equities, that would mean holding stocks of various sizes (small or large-cap) and growth profiles (value/growth, cyclical/counter-cyclical) across various sectors (financials, energy, etc.) and geographies (domestic, international, emerging, etc.)

Fixed income assets can be diversified by maturity (short and long-term), credit quality (investment grade, high-yield) and issuer type (corporate, government). The point of diversification is to reduce non systematic risk in a portfolio. This refers to the kind of risk that pertains to any specific corporate investment: an unexpected drop in earnings, for instance, or a scandal involving management.

Systematic risk, meanwhile, stems from the broader market conditions that influence risk sentiment (such as monetary policy, fiscal policy and geopolitical tensions). These risks cannot be reduced through diversification. In theory, a perfectly diversified portfolio would only contain systematic risk.

When you’re diversifying your portfolio, it’s important to distinguish between naïve and optimal diversification. Naïve diversification refers to a random or unsophisticated approach that will, in theory, reduce risk, but not effectively because many securities are highly correlated with each other — meaning they move in the same direction and are vulnerable to the same risks. Holding several highly correlated securities is not significantly different from holding one security because they all move in the same direction. Optimal diversification, on the other hand, involves holding assets and securities that are chosen specifically for their weak or negative correlations (i.e., hedged correlations).

The lower the correlation, the greater the effect of diversification, given that a decline in one area of your portfolio may be offset by a rise in another area. During the market declines of 2008 and 2009, for example, diversification helped limit losses on the way down, and once the market had bottomed, diversification helped to capture gains on the rebound.

Going forward, however, diversification may become more difficult because some of the established historical correlations may be changing. The megatrend towards globalization has pushed prices down and moved business offshore, leading major countries to stimulate their economies unnaturally in order to avoid recession.

When monetary policy skews to the extremes, financial markets become distorted and established correlations are broken. For instance, when the “zero-rate” policies of the pandemic were lifted in 2022, stock and bond markets — both of which had been overstimulated — fell  simultaneously. This is a phenomenon that has only been experienced in three years over the past century. In short, diversification depends on understandings correlations, but these are not constant, and they are particularly vulnerable during crises.

Over the past decade, however, a more sophisticated approach to diversification has emerged that uses something called “risk factors.” Aside from asset class and sub-class diversification, risk factors can provide a third layer of diversification because they represent the underlying risk exposure that drives the return of an investment.

To provide a simple example, imagine a company with stockholders and bondholders. These two asset types are completely different from a perspective of legal obligations and powers (given that secured creditors can force bankruptcy), but from an investment perspective, the stock and bond holder share overlapping risks; if the underlying business fails or succumbs to a massive fraud, both investors would be affected.

This is an example of equity risk. Other risk factors include: volatility risk; real asset risk; income risk; liquidity risk; and foreign exchange risk. Risk factors are much less likely to overlap, allowing you to construct portfolios with enhanced diversification. By understanding the underlying risk factors within various asset classes, you can ultimately choose which asset classes allow you to obtain exposure most efficiently to that particular risk.

You’ve made good progress if you’re at this stage. Continue your momentum and dive in to lesson four which introduces Rebalancing.

Frequently Asked Questions

Q: Why do you need diversification?

A: Diversification is used to reduce volatility, balancing various investment vehicles that have weak or negative correlations.

Q: What is the difference between naïve diversification and optimal diversification?

A: Naïve diversification refers to a random or unsophisticated approach to selecting securities for diversification. Random selection can be ineffective because some securities are highly correlated with each other, meaning they move in unison and are vulnerable to the same risks. Optimal diversification, meanwhile, refers to an approach that aims to choose securities that have historically been shown to have weak or negative correlations.

Q: What considerations are required for diversifying a portfolio?

A: You should diversify among asset classes and sub-classes. For equities, you should consider regions, growth profiles and sectors. For fixed income, you should consider maturities, credit quality and issuer type.

Q: What are some of the limitations to diversifying between basic asset classes (stocks/bonds)?

A: The biggest limitation is that basic asset classes can still contain overlapping correlations (such as stock and bond investors within the same sector). These correlations, moreover, can change due to long-term economic trends, or they can break during financial crises. You can build a better portfolio by using an allocation strategy that diversifies among risk factors as well as asset class and sub-class