Related diversification is the practice of diversifying a portfolio, with correlated assets. This means that although your portfolio might have several different positions, they all tend to move together, whether it is upwards or downwards. As investors, we are often told that diversification is the only free lunch we have, but it is not that simple.
Related diversification is a common practice among retail investors, and it can undermine your portfolio’s returns. Although diversifying can be a great strategy to implement in order to reduce risk, it can also present some challenges. Related diversification is oftentimes diworsification, and it is important to understand that.
Diversification is a risk management tool
Most investors diversify their portfolios in order to reduce risk. However, related diversification does not reduce the overall risk of the portfolio. This is because each of your portfolio positions will be correlated and therefore move in tandem. This poses an even greater risk to your investments.
The idea behind diversification is to choose assets that are uncorrelated between themselves. The higher the correlation, the higher the volatility of your portfolio. This is a great way to manage and reduce the risk and volatility of the portfolio. However, by choosing correlated assets you increase the volatility and the risk associated with your portfolio.
Why is related diversification diworsification?
Well let’s put it this way, if you are choosing two companies in the same sector to invest in, why would you choose to invest in both? Clearly, there seems to be one that will outperform the other, and as an investor, this decision shows that you are not entirely sure which one will outperform. Part of being a great investor is to pick winners, and diversifying into correlated stocks shows that an investor is not sure who the winner will be.
This can lead to subpar returns, that are driven by investors’ lack of knowledge in a particular industry or sector. By choosing correlated assets, you may fool yourself into thinking you have a very diversified portfolio. However, your portfolio is extremely concentrated and dependent on how the industry or sector performs going forward. Most of the time this is an inefficient investment strategy that can deeply affect your performance and returns.
How to avoid related diversification in your portfolio?
There are a few ways you can use to avoid related diversification in your portfolio. Start by choosing one company in each sector or industry. This is one of the most important steps to make sure you are not diversifying with related assets.
Another important thing is to calculate the correlation between all of your portfolio positions. This ensures that you have some positions that are uncorrelated, and therefore the volatility will be lower.
If an investor is extremely bullish on one sector, they might choose to pick several stocks within it. This is not in itself a bad decision, but if your whole portfolio is made up of stocks in the same sector, you will end up with a concentrated portfolio. Therefore your returns will be dependent on the overall outlook for the sector
Make sure you choose your positions carefully and backtest your bullish thesis on them. This also ensures that you are choosing the winner in a particular industry, instead of choosing several names that will negatively impact your returns.
Beta is also an important measure to take into account. It measures the correlation between a particular stock and the overall market. It is important when building a portfolio to choose stocks that have different betas. This reduces volatility, and the risk of your portfolio performing poorly during a certain period of time.
Why should you build a portfolio based on unrelated diversification?
Building a portfolio of uncorrelated assets is certainly the best approach for investors. It ensures that your portfolio is not as dependent on how the market moves, by preventing risks associated with a particular sector or industry. It allows you to weather bear markets and bull markets with ease. Reducing your volatility, and overall risk.
The greatest thing about unrelated portfolio diversification is that in theory, you can even take on more risk. The more positions you have in your portfolio, the less dependent you are on them performing well. This way, a highly diversified portfolio that is made of uncorrelated stocks, means that you can pick even more risky stocks. Thus your portfolio returns will not be as dependent on the returns of a particular security.
This is perhaps the best approach to diversification, and it is one that was used broadly by Peter Lynch when he ran the Fidelity Magellan Fund. In its heyday, the Fidelity Magellan Fund had over 1,400 stocks in its portfolio.
This certainly requires a lot of attention to each position. However, the core idea behind the strategy of the portfolio construction was to choose uncorrelated stocks. Adding them in small positions meant that they could choose increasingly more risky stocks. An incredible approach that allowed the fund to generate over 29% annualized return for its investors.
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