 Personal Finance PowerPoint Presentation Diversification Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Diversification, which you can find online. Take a look at the references, resources, continue your research from there. This by Troy Siegel updated April 21st, 2021. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, and keeping those in mind we're now considering. What is diversification? Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. So we've all probably heard the term diversification. If we watch stock market channels, for example, they'll probably come up with all different kinds of words that basically mean the same thing as diversification because it is so central to most of our planning strategies for our investment goals and strategies in part used to mitigate risk while also hopefully attempting to receive the returns. As we think about our diversified portfolio, we will be considering our goals, our time horizon, our risk tolerance. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt to limit exposure to any single asset or risk. So clearly the idea being that if one market goes down for one set of assets, then hopefully it will not for the other, so we have basically a hedge against them. Note that this seems like a very straightforward concept and we hear it so many times that we just, we think it's like automatic, yeah, diversification. But when it actually happens, when time actually passes and the markets drop or something like that, we also, we often start to take actions that are not in coherence with the concept of diversification. So for example, if we see that equities have been doing quite well for a very long time, and we see say that bonds have not been doing much at all for a very long time, we often tend to want to then move into the equity so we can get a piece of those returns abandoning the concept of diversification and that gives us more exposures to a market dropping. So note that these concepts, although they're kind of mundane in that you've probably heard them quite often, there's still not things that many individual investors are able to do over the long-term as market conditions change, we tend to deviate from the diversification. So we wanna keep on drilling the core concepts, the fundamentals in our mind. So the rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security. So again, as time passes, you might be saying, hey, equities are doing great and I've got all this money that's over here and the bonds, right? What is going on here? If I just put it all into the equities, then I might be better or vice versa just depending on the market conditions if market conditions are going down. But then of course, whenever those market conditions change which nobody really knows, no matter what they kind of, we hear on the pundits saying then we might not be positioned to deal with any kind of changes in the market. Whereas if you're diversified, you're basically saying, I know that I don't know. You've got the power of Socrates, right? Didn't he say, said something like, well, at least I know that I don't know what's going on. So I'm gonna be diversified. So portfolio holdings can be diversified not just across asset classes, but also within classes by investing in foreign markets as well as domestic markets. The idea is that the positive performance of one area of the portfolio will outweigh negative areas of another. And again, you might be saying, well, yeah, but I'm shooting myself in my own foot because if I was weighted in the portfolio that does well, I'd be making more money. But the problem is, you don't know which one's gonna do well forever. That's why you need the diversification which hopefully is gonna be the thing that saves you over the long term. So the basics of diversification, studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stock yields the most cost effective level of risk reduction. The investing in more securities generates further diversification benefits, albeit at drastically smaller rate. So then, so when you get into the idea of diversification, you might say, okay, how much diversification would be optimal? And you can think about what will give you the big benefits. And then of course you can tweak from that point forward where you might have further gains, but the gains will not be as big as the gains as the prior moves, right? Diversification strives to smooth out unsystematic risk events in a portfolio so the positive performance of some investments neutralizes the negative performance of the others. So obviously as the market goes up for one thing, the other thing might be going down. Or in other words, if there's a market crisis in one area, possibly the other area will hedge against it and not be exposed to that same problem. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated. That is they respond differently, often in opposite ways to market influences. So if you're invested in a whole bunch of things that are similar, they're integrated in nature. And you can think about this as like different companies, right? If one company goes down and they're integrated with the other company, possibly the other company supplying like farming or something of supplying the restaurant or something like that or the food producers or something, then of course those are highly correlated. And you would think that if there was a crisis, both of them could go down. Whereas if there's something that's opposite to that, then that would be the hedge. You want something that's not gonna be the correlated item. Diversification by asset class, fund managers and investors often diversify their investments across asset classes and determine what percentage of portfolio to allocate to each classes can include stocks, shares of equity in a publicly traded company, bonds, government and corporate fixed income debt instruments, real estate, land, building, natural resources, agriculture, livestock, water, mineral deposits, exchange, trade funds, ETFs, marketable basket of securities that follow an index, commodity or sector. Commodities, basic goods necessary for the production of other products. And then cash and short-term cash equivalents, that's the treasury bills, certificates of deposits, money market vehicles and other short-term low risk investments. So they will then diversify among investments within the assets classes, such as selecting stocks from various sectors that tend to have low return correlation or by choosing stocks with different market capitalization. In the case of bonds, investors can select from investment grade, corporate bonds, US Treasury bonds, stock and municipal bonds, high yield bonds and others. So foreign diversification. Investors can reap further diversification benefits by investing in foreign securities because they tend to be less closely correlated with domestic ones. So then we can go outside to the foreign investing, which can be a little bit more difficult given the structure of publicly traded companies and so on, for example, but it's becoming more and more doable, which is nice. So for example, forces depressing the US economy may not affect Japan's economy in the same way. So note that more and more people have been arguing that it's a global economy and we have been going more towards a global economy with these supply chains that actually run across the entire world and so on just in time kind of management strategies that are dependent upon those kinds of things. But recently with the whole COVID pandemic, it looks like more and more people are decoupling a bit from that whole global supply chain concept, given the fact that they're seeing that the risk of a disruption in that supply chain can be quite costly. So at this point, you might see a little bit less of that and therefore exposure to other areas could be exposure that's not correlated more and more so. In any case, therefore holding Japanese stocks gives an investor a small cushion of protection against losses during an American economic slowdown, diversification and the retail investor. So time and budget constraints can make it difficult for non-institutional investors, i.e. individuals to create an adequately diversified portfolio. So everybody's heard this concept of diversification. Again, the question really comes into well, how exactly do I diversify? It seems like a very complex kind of structure, how can I basically simplify this and put a system in place that would be appropriate for my individual investments. So this challenge is a key reason why mutual funds are so popular with retail investors. Clearly the concept of mutual funds that we've talked about in prior presentations, allowing us to pool money into a fund that then can be used to diversify in some way is a key component for most investors. Buying shares in a mutual fund offers an expensive way to diversify investments. While mutual funds provide diversification across various asset classes, exchange traded funds, ETFs afford investor access to narrow markets such as commodities and international plays that would ordinarily be difficult to access. An individual with a $100,000 portfolio can spread the investment among ETFs with no overlap. Disadvantages of diversification. So everything has its pros, it's got its cons. Reduced risk, a volatility buffer, the pluses of diversification are many. However, there are drawbacks too. The more holdings a portfolio has, the more time consuming it can be to manage. So obviously if this comes into, okay, how am I practically going to do this? If I'm gonna diversify on my own using individual stocks, that's gonna be quite a lot of time taken up. If I use mutual funds, that might be a little bit easier, but mutual funds can still be quite confusing depending on how I'm setting up the mutual funds. I might have a targeted mutual funds that basically does some of this diversification for me, which would be the most simplified kind of way to do it. It really depends upon your level of sufficacy in investing and what your particular goals are and how much you want to be kind of participating in adjusting what is going on. So and more expensive since buying and selling many different holdings incur more transaction fees and brokerage commissions. So most people can't just buy and sell individual stocks because if they're paying a broker for those individual transactions, it will be quite expensive oftentimes. More fundamentally, diversifications spreading out a strategy works both ways, lessening both the risk and the reward. So this is where people start to say, hey, I'm diversified, but this is horrible. I'm shooting myself in the foot. Equities are crushing it and I got like 30% of my portfolio in bonds which are doing nothing. And again, so that's the hard part because the diversification should be a strategy that over time will be most beneficial given the fact that at some point, especially if you're saving for the long-term like retirement, there will be ups and downs. So you would think that having a diversified portfolio would be good, but in the good times, you're going to be saying, I want my money in the equities where it's crushing it. And in the bad times, you would think I want my money in the safe place like bonds and so on. So I'm not losing money in the system as the stocks go down, but we can't guess those things, right? That's the point. We don't really know what's going to happen. So therefore we default to I just, I know, I don't know. So I diversify. So say you've invested 120,000 equally among six stocks and one stock doubles in value. Your original 20,000 stake is now with 40,000. You've made a lot. Sure, but not as much as if your entire 120,000 have been invested in that one company. So oftentimes when we see these gains, we're like, well, that's okay, but what if I had my whole 120,000 there? I'd be like way better off, right? But you didn't know that that was going to go up like that, right? So by protecting you on the downside diversification limits you on the upside, at least in the short term, over the long term diversify portfolios do tend to post higher returns. So pros and cons. So we've got pros reduces portfolio risk, hedges against market volatility, offers higher returns long term. What are on the con side limits gains in the short term time consuming to manage, encourage more transaction fees and commissions, diversification and smart beta. Smart beta strategies offer diversification by tracking underlying indices, but do not necessarily waste stocks according to their market cap. ETF managers further screen equity issues on fundamentals and rebalance portfolios according to objective analysis and not just company size. Well, smart beta portfolios are unmanaged. The primary goal becomes outperformance of the index itself. So now we get into this whole idea of how much management should you be paying for, for example, and or should you basically be reliant more on the indexes which are trying to measure kind of market performance more in general using basically averages. For example, as of March, 2019, the ice shares edge MSCI USA quality factor ETF holds 125 large and mid cap US stocks by focusing on return on equity, our OE debt to equity DE ratio and not solely market cap that ETF has returned 90.49% accumulatively since its inception in July, 2013, a similar investment in the S&P 500 index grew by 66.33%. Real world example, say an aggressive investor who can assume a higher level of risk wishes to construct a portfolio composed of Japanese equities, Australian bonds, and cotton futures. So he can purchase stakes in the ice shares MSCI Japan ETF, the Vanguard Australian Government Bond index ETF, and the IPATH Bloomberg Cotton sub index total return the ETF, for example, with this mix of ETF shares due to the specific qualifications of the targeted asset classes and the transparency of the holdings the investor ensures true diversification in their holding also with different correlations or responses to outside forces among the securities they can slightly lessen their risk exposure for related reading, see the importance of diversification.