Importance Of Diversification: Explained

Uncertain economic environments may bring unexpected changes in economic conditions, geopolitical environments and personal circumstances. To weather such changes, it is important to diversify assets and sources of income. A portfolio of investments reduces dependence on the income from your career or business, ensuring that the financial risk is not concentrated in one stream of income or your own physical assets. A diversified portfolio of investments absorbs unexpected shocks and allows wealth to compound amidst different economic environments.

Nov 3, 2020|Education- 4 min

Traditional Diversification: Balanced Portfolios

An investment portfolio must be balanced. Concentrating in one geographical region may result in overexposure to a given currency, sector, local monetary and fiscal policy, and the geopolitical risks of that region. For example, an investment portfolio comprised exclusively of Saudi public companies listed on Tadawul is affected by changes in oil prices, the Saudi riyal and the Saudi economy. An investor who invested in Tadawul 10 years ago would have achieved a 5.5% annualized return with annualized risk of 20.5% (see Figure 1).

Single-country risk can be mitigated by diversifying across multiple regions or countries, balancing exposure between developed and emerging markets, and different economies reliant on different industries.

A traditional balanced portfolio includes 60% in liquid fixed-income securities (e.g. bonds, or sukuk), which generally feature lower risk and regular coupon payments, and 40% in equities. Figure 2 shows that a portfolio split equally between Tadawul and a traditional balanced portfolio would have earned a higher annualized return of 6.7% with an annualized risk of 14.6%.

Modern Diversification: Private Investments

Private investments can provide additional diversification due to their historically low correlation to liquid assets and multiple sources of return. Low correlation provides stability and minimizes losses in times of market stress.

Just like spreading investments across geographies and liquid asset classes increases returns and reduces risk through diversification, adding illiquid investments such as private equity (PE) and real estate (RE) improves diversification further. Figure 3 shows that an investment portfolio split equally between (a) Tadawul, (b) a traditional balanced portfolio and (c) PE and RE investments would have achieved an annualized return of 8.7% with annualized risk of 10.2%. The three portfolios illustrated below in Figure 3 demonstrate clearly the benefit of including illiquid investments in an investment portfolio.

The Role of Alternatives in a Low-Return Environment

In a low-return environment, illiquid investments become an especially important component of the asset allocation in investment portfolios, offering superior risk-adjusted returns.

The Family Office has been focused in building diversified portfolios with allocations to PE, RE and private debt. We also offer income-oriented solutions aimed at preserving capital with diversification across asset classes, sectors, and geographies to help investors achieve their income targets.

We would be delighted to support you in your preserving and growing your wealth.



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Since 2004, The Family Office has been the wealth manager of choice for more than 500 ultra-high-net worth families and individuals, helping them preserve and growth their wealth through customized solutions in diversified alternatives and more. Schedule a call with our financial experts and learn more about our wealth management process.

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