How can you determine the appropriate diversification level for your portfolio?

1 What is diversification?

Diversification is the practice of spreading your investments across different asset classes, sectors, regions, and strategies to reduce the impact of any single factor on your portfolio performance. Diversification can help you lower your portfolio risk, enhance your returns, and achieve your financial objectives. However, diversification is not a one-size-fits-all solution. You need to consider your personal circumstances and preferences when deciding how much diversification you need.

2 Why diversify your portfolio?

The main reason to diversify your portfolio is to reduce your exposure to unsystematic risk, which is the risk that affects specific securities or industries due to factors such as company performance, product quality, or regulatory changes. Unsystematic risk can be diversified away by holding a large number of securities that are not correlated with each other. By doing so, you can reduce the variability of your portfolio returns and avoid large losses from a single event.

Another reason to diversify your portfolio is to capture the benefits of different asset classes, sectors, regions, and strategies that may perform well in different market conditions. For example, stocks may offer higher returns than bonds in the long term, but bonds may provide stability and income in times of market stress. Similarly, emerging markets may offer higher growth potential than developed markets, but also higher volatility and political risk. By diversifying your portfolio, you can take advantage of the opportunities and hedge against the risks in various markets.

3 How to measure diversification?

One way to measure diversification is to use the portfolio standard deviation, which is a measure of how much your portfolio returns deviate from the average. A lower standard deviation means less volatility and risk, and a higher standard deviation means more volatility and risk. A diversified portfolio should have a lower standard deviation than the individual securities or asset classes in the portfolio.

Another way to measure diversification is to use the portfolio correlation, which is a measure of how closely your portfolio components move together. A correlation of 1 means perfect positive correlation, meaning that the components move in the same direction and by the same amount. A correlation of -1 means perfect negative correlation, meaning that the components move in the opposite direction and by the same amount. A correlation of 0 means no correlation, meaning that the components move independently of each other. A diversified portfolio should have a low or negative correlation among its components, meaning that they do not move in sync and offset each other's movements.

5 How to avoid over-diversification?

Diversification can be beneficial, but too much can be counterproductive. Over-diversification occurs when you hold too many securities or asset classes that have similar characteristics and performance. This can reduce portfolio returns, increase costs, and dilute the focus of your portfolio. Signs and consequences of over-diversification include holding more securities than you can monitor and manage effectively, holding securities with high correlations and low returns, incurring higher transaction costs, management fees, and taxes from frequent trading and holding multiple funds, as well as losing sight of your portfolio objectives and strategy. To avoid over-diversification, you should review your portfolio regularly and eliminate any securities or asset classes that do not add value or align with your goals. Additionally, limit the number of securities or asset classes you hold to a manageable level that reflects your risk tolerance, time horizon, and financial goals. You should also consider the trade-off between diversification and returns, focusing on quality rather than quantity.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?