Insights
Knowledge Hub

Diversification

Diversification

The American baseball catcher, Yogi Berra, once said, “It’s tough to make predictions, especially about the future.” This is why good investors do not depend upon predictions but build a portfolio capable of surviving the unpredictable.

Dec 11, 2022Education- 5 min
hero

Diversification is among the most effective tools to future-proof your investments. This article summarizes how it works and why it is important.

What is diversification?

A diversified portfolio consists of a range of “uncorrelated” assets that do not all behave the same way.

We purchase securities because we are reasonably confident that the underlying company or government is stable or likely to grow. But specific circumstances or events may cause the value of a given security to decline. With a diversified portfolio, other assets that are unaffected by the same circumstances offset their effect, or at least diminishes it.

For example, during the pandemic, airline and hospitality stocks suffered while the technology and pharmaceutical sectors were resilient and certain sub-sectors grew strongly (e.g. remote working tools, medical devices, etc.).

How does diversification work?

Without dwelling on mathematical concepts, the principles of diversification are based on two premises:

  • The greater the number of assets there are, the more diversified the portfolio.

  • The less correlated a group of assets are, the greater the effect of diversification.

The rule of risk and return still applies: the greater the expected return for a given security, the greater the risk. But a diversified portfolio of assets protects returns and reduces risk.

Diversification is not about sacrificing potential gains to limit potential losses, it is about increasing risk-adjusted returns.

How to diversify a portfolio?

A common example of diversification is a portfolio of stocks and bonds. The two asset classes have fundamentally different profiles. Stocks flourish in a strong economy with stable inflation, whereas highly-rated bonds (e.g. prime corporate and government bonds) perform relatively well during recessions or deflationary environments.

Similarly, high inflation benefits certain assets and diminishes others. For example, floating rate asset-backed loans benefit as interest income rises while their risk is reduced by the growing value of the underlying collateral assets. Technology companies, on the other hand, may suffer lower revenues as inflation-strapped consumers and advertisers reduce non-essential spending. Regardless of the situation, investors must be ready to take advantage of attractively-priced securities (e.g. during a stock market crash or a credit squeeze).

 Diversification can also be made by industry (e.g. Financial vs Technology), geography (e.g. emerging markets vs developed markets), company size (large cap vs small cap) and company stage (value vs growth).

Diversification is a complex process that must be customized to each investor’s situation. Investors whose wealth is heavily concentrated in their home country or a specific asset class (like real estate) should seek diversification internationally or in other asset classes whose performance is less correlated.

Limits of diversification

Diversification does not eliminate all risk. “Systematic” risk, for example, cannot be diversified away. These risks are inherent to the entire market and arise from a mix of factors including economic, socio-political and market-related events, such as war, recession, and natural disasters.

The aim of diversification is to lessen the impact of non-systematic risks related to specific businesses or sectors. These may include the departure of a CEO, changing regulations, disruptive competition, etc.

What you can do

There is no single rule book on how to diversify. Diversification is partly art and partly science. Over-diversification, for example, may lead to excessive transaction costs. But the most important aspect is judging the true level of correlation between assets and build a portfolio accordingly.

The financial plan you develop with a financial advisor should include the construction of a diversified portfolio that delivers the required return at an optimal level of risk. Your advisor will also help to update the asset allocation as your situation changes and market events emerge.


diversification-asset-allocation-with-david-darst

About David M. Darst, CFA

Since January 2017, David M. Darst, CFA has served as Senior Advisor and Investment Strategist of The Family Office in New York and Bahrain. In this role, he has significantly contributed to the formulation, communication, execution, and monitoring of the company’s asset allocation, investment strategy, and wealth management activities in the Gulf region, North America, Europe, and Asia.

Following a 25-year career with Goldman Sachs in Zurich and New York, David served for 17 years as a Managing Director and Chief Investment Strategist of Morgan Stanley Wealth Management. David was the founding President of the Morgan Stanley Investment Group, and has served for three years as CEO of Petiole Asset Management AG, the Zurich-based asset management arm of The Family Office.

David is the author of sixteen books, including The Complete Bond Book (McGraw-Hill), The Handbook of the Bond and Money Markets (McGraw-Hill), The Art of Asset Allocation, Second Edition (McGraw-Hill) and The Little Book that Saves Your Assets (John Wiley & Sons), which has been ranked on the bestseller lists of The New York Times and Bloomberg Business Week.

Disclaimer

This presentation is provided to you by The Family Office Co. BSC(c) (“The Family Office”) for informational purposes only, and contains proprietary information that may not be reproduced, distributed to, or used by, any third parties without The Family Office’s prior written consent.

All information, figures, calculations, graphs and other numerical representations appearing in this presentation have not been audited and may be subject to change over time. Furthermore, certain valuations (including valuations of investments) appearing in this presentation are subject to change as they may be based on either estimates or historical figures that do not reflect the latest valuation. Although all information and opinions expressed in this presentation were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to their accuracy or completeness. The information contained herein is not a substitute for a thorough due diligence investigation. Past performance is not indicative of and does not guarantee future performance. Exit timelines, prices and related projections are estimates only, and exits could happen sooner or later than expected, or at a higher or lower valuation than expected, and are conditional, among other things, on certain assumptions and future performance relating to the financial and operational health of each business and macroeconomic conditions.

The Family Office makes no representation or warranty, express or implied, with respect to any statistics or historical or current financial data, whether created by The Family Office through its own research or quoted from other sources. With respect to any such statistics or data delivered or made available by or on behalf of The Family Office, it is acknowledged that (a) the investor takes full responsibility for making its own evaluation of the materiality of the information and the integrity of the quoted source and (b) the investor has no claim against The Family Office.

Amounts in currencies other than the US Dollar are translated using prevailing market rates as calculated by The Family Office or its service providers and may differ from the rates used by banks. The rates are indicative only and do not reflect the rates at which The Family Office would be prepared to enter into any transactions with other parties.

Certain information contained in this presentation constitutes “forward-looking statements,” which can be identified by the use of words such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “plans,” “estimates,” “intend,” “continue,” or “believe” or the negatives thereof or other variations thereon or comparable terminology. To the extent this presentation contains any forecasts, projections, goals, plans and other forward-looking statements, such forward-looking statements are inherently subject to, known and unknown, significant business, economic, competitive, regulatory and other risks, contingencies and uncertainties, most of which are difficult to predict and many of which are beyond The Family Office’s control and may cause actual performance, financial results and other projections in the future to differ materially from any projections of future performance, results or achievements expressed or implied by such forward-looking statements. Investors should not place undue reliance on these forward-looking statements. The Family Office undertakes no obligation to update any forward-looking statements to conform to actual results or changes in The Family Office’s expectations, unless required by applicable law.

The Family Office makes no representation or warranty, express or implied, with respect to any financial projection or forecast. With respect to any such projection or forecast delivered or made available by or on behalf of The Family office, it is acknowledged that (a) there are uncertainties inherent in attempting to make such projections and forecasts, (b) the investor is familiar with such uncertainties, (c) the investor takes full responsibility for making its own evaluation of the adequacy and accuracy of all such projections and forecasts so furnished to it and (d) the investor has no claim against The Family Office.

This presentation represents a summary of certain information, the full terms of which are contained in a Private Placement Memorandum that should be reviewed for a more complete understanding of the investments and their risks. In addition, this presentation does not constitute an offer to sell, or a solicitation to buy, any instrument or other financial product, nor does it amount to a commitment by The Family Office to make such an offer at present or an indication of The Family Office’s willingness to make such an offer in the future.

The Family Office is a Category 1 Investment Firm regulated by the Central Bank of Bahrain C.R.No.53871 dated 21/6/2004. Paid Up Capital: US$ 10,000,000. The Family Office only offers products and services to ‘accredited investors’ as defined by the Central Bank of Bahrain.

Are you seeking private market opportunities?

Join our digital investment platform for exclusive
private market opportunities

Create an account

About The Family Office

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 grow 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.


Keep reading