Wednesday 25 August 2021 by FIIG Investment Strategy Diversity-900 Education (basics)

The benefits of diversification

The Risk series of The Wire looks to help investors improve the way they assess and measure risk within their portfolios and to also help manage those risks more proactively.

In this article we focus on the benefits of diversification and why creating a more diversified portfolio helps mitigate risk in your fixed income portfolio.

Why diversify your portfolio?

A number of investors construct portfolios consisting of relatively few bonds. This is a strategy which, at times, can produce apparently high returns (and is also called a concentrated portfolio) but will likely result in an unobservable and outsized risk that may not become apparent until after a major correction event has already occurred.

The major reason to diversify your holdings comes out of a number of years of academic research that revealed the more you diversify your holdings the less likely you are to experience sell-offs in all of your investments simultaneously. This is explained by the existence of “specific risks” or “unsystematic risks” in investment markets.

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Specific risks are risks that are not inherent in investing in markets generally but instead are attached to one particular company or investment and so these risks can be minimised via the use of diversification. However, “market risks” or “systematic risks” are those risks that come with investing in any asset market and so cannot be diversified away – they are risks inherent to any kind of investing.

There are company, industry and economic (or political) risks to consider, amongst a variety of others, for any investor who has the opportunity to access international markets. Here are a few examples of each type demonstrating why an investor might experience a hidden specific risk which could cause a fall in a bond’s price:

Company risk: A manufacturer experiences a fire at one of its factories which stops production and causes a fall in their revenues, increasing their credit risk. A company makes an ill-advised investment that generates losses for their business which also increases their credit risk.

Industry risk: The price of iron ore falls which impacts all iron ore producing companies as revenues drop alongside the commodity’s price reduction. An industry becomes technologically obsolete due to a better and cheaper alternative being invented (e.g. traditional film versus digital cameras).

Economic (or political) risk: A country experiences a broad recession which causes customers to spend less money at most companies based inside that country. A country’s government decides to increase corporate tax rates across the board which reduces the profitability of all companies in the country.

Importantly, you can reduce each of those specific risks by diversifying your holdings across one (or more) of those categories (e.g. by buying US bonds to avoid Australian political risk and vice versa). The more the investments vary across different categories, the more efficiently you can reduce specific risks.

If you own bonds in two companies in the same industry for instance you will no longer be fully exposed to the risk of one company having a specific risk occur. But if you own bonds in two different companies across two different industries in two different countries, you will no longer be fully exposed to industry risk, company risk or political risk.

Each additional diversifying bond will reduce your exposure to one or more risks, with the greatest benefit achieved early on as you add your first few bonds. Two equal sized bonds will reduce any individual exposure to 50%, three equal sized bonds will reduce the exposure to 33%, and four equal sized bonds will reduce the exposure to 25%. Therefore, investors can be rewarded very quickly for even a small effort at diversification.

Diversification-risk-chart-1
Source: FIIG Securities

Better diversification, better long-term performance

An extra benefit of diversification is that you tend to not only reduce the risk in your portfolio but also actually improve the overall long-term performance of your portfolio as a result.

You might expect that creating the optimal portfolio (defined as the portfolio which offers the highest expected level of return for a specific level of risk) would normally require diversification across a variety of bonds.

Logically it makes sense that the wider your universe of possible investment, the better your chance is to find the best possible return for your preferred level of risk. Such diversification within bonds might include looking across investment grade bonds, high yield bonds, inflation-linked bonds, hybrids, government bonds, corporate bonds, and foreign currency bonds.

This theory was first introduced in 1952 by the Nobel Prize for Economics winner, Harry Markowitz, who concluded (and supported by decades of financial research since) that diversification improves returns and lowers risk. This research demonstrated that the greater the variety of assets (including bonds) that are held within portfolios, the likelier an investor is to achieve an optimal portfolio at any given level of risk, the so-called efficient frontier. This efficient frontier provides a set of all optimal portfolios for different levels of risk that an investor might want to consider, whether that is low, medium or high risk in nature.

Diversification-risk-chart-2
Source: FIIG Securities

In financial research, this risk is typically measured or defined as the volatility of a security or portfolio. We discuss this in greater detail and consider its relevance to bonds in our article on volatility in the Risk Edition of The Wire.




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